There are benefits to having a hobby in personal finance. In a world where money moves products and services, understanding how it works is a powerful thing. When you enjoy learning about it, that makes things even easier. From complex tax law to convoluted retirement accounts, it is worth spending some time figuring all this stuff out.
But there are also some basic things we should keep an eye on.
One of the metrics that got away from me over the years is how much of our net worth is easy to access. These days I call this our asset liquidity ratio.
Earlier this year, I started wondering if I put too much away for retirement in my 20s. I even mentioned it in a personal finance round-up I participated in back in December. Was my laser focus on maximizing tax advantage accounts to get to financial independence an error? Was I robbing young Max to pay the old and decrepit Max? What if I didn’t make it to my golden years?
Did I have balance?
Retirement accounts are great. They can save us some serious money. From the 401(k) deferring taxes to the Roth IRA providing tax-free growth, there is no question they will accelerate our way to becoming financially independent.
The problem is they also lock your money up for years. Complicated rules are in place that aim to keep us from accessing our money before the traditional retirement age of about 60. There are plenty of workarounds and exceptions, but understanding those take time.
The bottom line is these accounts are not meant to be liquid in the near term. We usually need to jump through more than a few hoops to access the money before the traditional retirement age.
And let me tell you, 60 is a long way off.
Taxable accounts, on the other hand, are extremely liquid. Checking and brokerage accounts grant us almost instant access to our money. The drawback? Interest, dividends, and capital gains on investments are all taxed the year the income is realized. In other words, there is a “tax drag” on this piece of our portfolio. A larger balance equates to a larger tax drag. I consider this just part of the cost of liquidity.
But outside of the tax drag, money in these accounts is generally easy to access.
Asset Liquidity Ratio
So how do we balance capitalizing on tax-advantaged accounts while also keeping liquidity in check? Well, one place to start is knowing how much of our net worth is in liquid accounts.
Liquid Net Worth / Total Net Worth = Asset Liquidity Ratio
I’m sure this doesn’t meet the technical accounting definition, and I don’t really care. That’s another good thing about having a hobby in personal finance, you can make up ratios out of thin air. Even if they are probably technically percentages.
For the Max Out of Pocket crew, we have been running an average of 28.68% in liquid net worth since early 2018. As of August 2020, we are up to 31.16%.
In other words, 31.16% of our assets are easy to access. This includes things like our taxable brokerage accounts, checking accounts, Fidelity cash management account, government I-bonds, and even the cash in our pockets.
It does not include things like our 403(b), Traditional IRA, Roth IRA, H.S.A., or state pensions. I also do not include other non-liquid assets such as our cars or a house (if we owned one). The majority of our net worth currently sits in tax-deferred IRAs.
That Seems Low, Max
There are two sides to this.
The fact that we only have easy access to 30% of our assets does seem low to me. I was noticing the folks over at TicTocLife are at a much healthier 47% in their checking and brokerage. I think that is a good spot to be considering their total assets.
Ultimately, it is a percentage I would like to increase a bit. It is one of the reasons I decided not to front-load my 403(b) account in 2020. I needed some time to think through this. Now I am not even planning on maxing it out.
On the flip side, this shows that despite not having an explosive income out of college, I have been doing a great job prioritizing retirement savings. Even when I had a much lower income, I always made it a priority to dump truckloads of money into my retirement accounts. That money grew exponentially over the last decade. In fact, with our reasonable standard of living, we probably do not need to save another dime for retirement because we still have a super long time horizon for these assets to grow through the stock market.
Did Max Overutilize Retirement Accounts?
I do not think I necessarily made a mistake here. Our tax-deferred accounts have been able to take advantage of the roaring stock market over the last 12 years. Additionally, our federal effective tax rate was extremely low for most of those years. For several of them, I was able to capitalize on a 0% capital gain rate in my taxable accounts by deflating our adjusted gross income with tax-deferred accounts. One year shortly after Mrs. Max OOP came on the scene, I got it so low I even accessed the saver’s tax credit. One of the few benefits of her meager teacher salary.
Through all of that, never once did I feel I was depriving ourselves for the sake of saving. I certainly kept an eye on things, but we definitely weren’t slumming it. We regularly traveled internationally and lived in nice places.
That said, there is a chance the future me might wish we had easier access to our assets. I can think of two things that might trigger that reaction: buying a house or starting a business.
Although I enjoy renting, we will likely eventually buy a house again. Depending on the market, we could definitely absorb a purchase, but our liquidity ratio would suffer. Unfortunately, I don’t think we could pay cash for a house in some of the markets we are looking at. We could easily put 50% or more down, though, which isn’t a bad place to be.
Opening a business is a wildcard. Mrs. Max OOP is currently in training out in Alberta, and we have no idea what the next steps to that project are, but it could turn into a significant investment. I suppose a small business loan would always be an option.
Early Withdrawal Options
All that said, we do have options for early withdrawal, and I understand them. The Roth IRA gives us some liquidity after contributions sit for five years and our 401(k) offers loan options. There are also those fancy Roth IRA conversion ladders that might make sense in an early retirement scenario.
But for the average Joe-Max learning about personal finance, we should put early withdrawal strategy aside. A liquidity ratio is a good metric to keep in check and can make sure you are balancing the goals of both your future self and your current self.
Do I sound like Dr. Emmet Brown yet?
Fixing This Ratio
Ultimately, so far in 2020 I have been attempting to correct our liquidity ratio. There are challenges, though.
One thing I am finding is the money in our retirement accounts is working harder than we can. Capital gains and dividend distributions keep those retirement balances growing and it is a hard thing to offset with regular income. While that’s certainly not a bad thing, it could make correcting our liquidity ratio a challenge.
Most of our liquid assets are invested in the stock market. But I also hold most of our “cash equivalent” allocation in our liquid accounts as well. So we do not benefit from market returns on that money. This comes to $51,436 (representing a full year of expenses) and is a number I am considering increasing, which will further slow us down. This money barely keeps up with inflation.
I am also still making small contributions to my Roth 403(b) to capture my employer’s contribution match. This doesn’t help the ratio.
I am always looking at financial ratios of health systems. Cost to charge ratios, net to gross revenue ratios, and cash on hand can give me a good pulse on the organization. The same goes for personal finance.
But this is just one metric. There are plenty of other indicators to check when looking at the big picture. But I think it is a good one to monitor early on in personal finance to make sure you are not locking too much up in retirement accounts.
Overall, I don’t think I made a mistake here. Theoretically, assuming we stay the course, our net worth will grow to a point where this doesn’t even matter. Our reasonable standard of living just does not take much to sustain. When you think about it, 30% of a lot of money, is still a lot of money. The ratio is probably something we only need to look at early on in personal finance.
For us, we still need to keep an eye on this for a few more years.
Frankly, 2020 will likely be the first year in a long time that I don’t max out my retirement account. With Mrs. Max OOP on sabbatical, we will be on the cusp of a lower tax bracket, and I want to pay the tax now and take advantage of it. Additionally, early retirement is seeming more and more unlikely for me these days. It turns out I like working. and the odds are I will fill up my $572,570 standard deduction bucket anyway.
As a result, we have been able to move our ratio from 28.83% to 31.16% over the last 8 months. I expect that number to continue to improve, especially if the overall stock market dips again.
What is your asset liquidity ratio? I’m almost sure it is better than ours.