When you are accustomed to saving a high percentage of income every month, quitting your job and living off your portfolio can be intimidating. It was for us, at least
Now instead of receiving a steady stream of paychecks, making big contributions to a 401k and depositing healthy sums into a brokerage account each month, suddenly money is flowing out of those accounts!
And unlike a paycheck, income is inconsistent. Some months, dividends and interest cover all of our expenses. Most months, it doesn’t.
To further complicate things, there is a mix of 401k/IRA, Roth, and Brokerage accounts with different rules and tax treatment for withdrawals, as well as typical checking and savings accounts.
Should we spend the money in our taxable Brokerage account now, allowing the money in the 401k/IRA to continue to grow? What if we need a lump sum for a large expense? Should we keep a large cash buffer? Should dividends be automatically reinvested or deposited as cash? Does it make sense to harvest capital gains for cash spending?
I’ll share how we manage our Cash Flow, and hopefully answer these questions and more
2014 was one of our most expensive years to date, even more than our cost of living in the United States. When we started the year we had no idea how much we would spend, since it was unclear how much our IVF treatments would cost or how long they would take. This combination of unknowns, volatility, and large expenses provide for a great Cash Flow management example
The chart below shows our 2014 Expenses, Income, and Cash Buffer. Expenses varied significantly from month to month, as did income. Our cash buffer started the year at at a healthy sum, and declined throughout the year
I’ll explain the how and why
We have multiple sources of income: a seller-financed private mortgage, a few individual dividend stocks, and large holdings in equity funds.
As shown in the Cash Flow Management graph (Red columns), income is very inconsistent. Sometimes our private mortgage is paid on time, but often it is late. Sometimes it will not get paid one month, and then the following month we will receive 2 payments
Dividends are also cyclical, with the majority of income received quarterly in March, June, August, and December. December is a big month, as some funds only pay out at the end of the year
Because of the income volatility, we keep a Cash Buffer in our Capital One 360 account (Free $20 when you open an account.) This pays much better interest than our Brokerage account reserve.
All of our dividends are received as cash, which is deposited directly into our Brokerage account. When the cash account exceeds a few thousand dollars, I transfer it to the Capital One 360 account. I prefer to receive dividends as cash as opposed to automatically reinvest, as it simplifies tax time and eliminates any risk of a wash sale if/when harvesting capital losses
The size of our cash buffer varies. Because most of our income is received quarterly, I’ve typically held 3 months of expenses in cash. This year because of IVF expenses, I increased that significantly. You can see we started the year with nearly $40k in cash and it reduced steadily through the year
Cash Flow Smoothing
Rather than just hit the ATM every time we make a purchase or have a meal out, we make every purchase possible with a credit card. (See how we use credit cards to travel for free.)
With a No Foreign Transaction Fee card that offers either cash back or rewards points, we are able to save for our next airplane ticket or reduce our balance due.
Because credit card payment terms allow us to pay for a purchase up to 60 days later, we effectively get a short term loan with zero interest. Purchases made in February can be paid with March dividends instead of with cash on hand.
Year End Asset Management and Capital Gains
December is when we do our tax planning and adjust asset allocation. This involves our Roth IRA Conversion and Capital Gain Harvesting as part of our long term tax minimization strategy. I went through the process in just 7 minutes this year.
Last year in December 2013, because our IVF expenses were unknown I put an extra $25k +/- into our cash account. This year I estimated our spending to be much less, so I returned some of our cash hoard to index funds.
Some retirees prefer to have a larger cash buffer. Jim Collins prefers to carry almost none at all. This preference for a large cash reserve is generally based in the idea that in a major stock market decline, the cash reserves & income would be sufficient to fund years of expenses, preventing stock sales when prices are down. This is a fine strategy for sleeping better at night, even though it historically has reduced total return.
I prefer to keep most of our assets invested. In a market decline, we could quite easily reduce our spending to a level below our income. We could also take advantage of our location independence to reduce total spending substantially. We can continue to harvest capital gains in an up market, and avoid selling them in a downturn except to harvest capital losses.
401k / IRA / Roth
We currently don’t access any of the funds in our 401k / IRA / Roth accounts except as part of building our Roth IRA Conversion Ladder. There are methods to access these funds prior to Age 59.5 without penalty, but we prefer to allow those funds to continue growing tax free.
As discussed here, when saving a high percentage of income it is inevitable that we would accumulate savings in a taxable account. Our strategy is to primarily fund our early retirement years from the Brokerage account, and then access the tax-deferred accounts later in life if necessary.
Were we to expect a large purchase in the future (a home, a boat, another baby), we would build up a larger cash reserve in the previous year or years to use for that purpose.
If the case of a large emergency expense, in an up market we would sell stock in our taxable account. In a down market, we have our cash buffer, credit cards to smooth out the expense, and worst case we can sell some stock or access the contributions to our Roth or even pay a penalty and access the 401k/IRA, whichever is the most advantageous at the time.
Easier Cash Flow Tracking
After a couple hours playing with Excel to make the above graph, I took a look at our investment account in Personal Capital. And there it was, our income and expense graph with no work at all.
I’ve used Personal Capital for at least the last year to track our investments, but never linked our cash or credit cards. As a result, some of our fund transfers appear as expenses and others as income, so the chart isn’t 100% correct. I just linked those accounts so instant access to our full spending picture is now a lot easier
Why not give Personal Capital a try yourself. It’s free.
For funding early retirement, we primarily drawn down our taxable Brokerage account along with our private mortgage, which allows our tax-deferred accounts to continue to grow tax free.
We manage our cash flow using a Capital One 360 savings account as a cash buffer, and top it off as based on estimates for next year’s spending as part of our annual tax and asset management process.
We use a No Foreign Transaction Fee Credit Card with a Rewards Program as a way to build up points, but also as a short term interest free loan that smooths out our cash flow.
It is our intent to follow this process for as long as the Brokerage account has a positive balance, which ideally is forever.