Tax consequences of investing in Mutual Funds

/ humblefi / 1 Comment

One of the disadvantages of investing via mutual funds is that the tax consequences are not in my (the investor) control. What does this actually mean? I will answer this in three sub sections

  • Tax Terminologies w.r.t. Mutual Funds
  • Special Dates w.r.t. Mutual Fund Distributions
  • Tax consequences of Mutual Funds

Tax Terminologies w.r.t Mutual Funds

Mutual Fund Distribution:

  1. Mutual funds give back money to investors in two ways: through dividends and/or capital gains
  2. These money give backs are called Distributions.

Long term vs Short term Capital gains distribution

  1. When a share in the mutual fund is held for less than one year and sold, the gains it generates are called Short term capital gains
  2. When a share in the mutual fund is held for more than a year and sold, the gains it generates are called Long term capital gains
  3. Short term cap gains are taxed as ordinary income….say 33% for many people in the Silicon Valley
  4. Long term cap gains are taxed at a rate less than ordinary income….say 15%.
  5. So, getting long term cap gains from mutual funds is very tax efficient.

Dividend Distributions

  1. When a share OR a bond is held in a mutual fund, it can generate dividends and/or interest.
  2. These dividends are taxed at a rate less than ordinary income…..say 15%
  3. So, getting dividend distributions from mutual funds is very tax efficient.

Tax Exempt Mutual Funds

  1. These funds are generally exempt from federal taxes, and in some cases, exempt from state taxed also depending on residence requirements.
  2. Example: Municipal bond fund VCAIX (California MUNIs)  is both federal and state tax free because I am a resident of California.
  3. I.e. distributions from tax-exempt funds like VCAIX do not pay tax!!
  4. NOTE: There is a limit on how much tax-free income a person can get in one taxable year. AMT (Alternative Minimum Tax) enforces a minimum amount of tax per year i.e. makes sure that there are not too many tax deductions claimed in one taxable year.

AMT Free Mutual Funds

  1. From Vanguard. AMT is defined as: A separate tax system designed to ensure that wealthy individuals and organizations pay at least a minimum amount of federal income taxes. Certain securities used to fund private, for-profit activities are subject to the AMT.
  2. Each mutual fund can generate gains that are AMT free OR not. If a fund has no AMT exposure, it can’t trigger the AMT, no matter how much you own.
  3. Consider the following two Vanguard mutual funds
    1. Mutual Fund with Alternative Minimum Tax = 0%
    2. Mutual Fund with Alternative Minimum Tax = 16.9%
  4. If you are a California resident, the first fund is both federal and state tax free. Whether you get $1000 tax free gain OR $1000000 tax free gain, these gains will not trigger the AMT. The second is obviously not…there is a percentage of the gain that will count against the AMT limit. For example, if the AMT trigger limit is 169, getting a $1000 gain will mean $169 of it will apply towards the AMT limit and trigger it.

Form 1099-DIV

  1. This form indicates mutual fund earnings shareholders must report on their income tax returns.

Special Dates w.r.t. Mutual Fund Distributions

There are four important dates associated with a mutual fund distribution. This is because a mutual fund goes through a two step process in making distributions.

  1. Declaration Date
    1. On this date, the board of directors (for individual stocks) OR the mutual fund company/manager announce to the whole world that the individual stock OR the mutual fund will pay a dividend.
    2. This date has no bearing on your taxes.
  2. Ex-dividend Date
    1. First, the fund “declares” the amount of distribution it intends to make and sets aside the necessary amount of cash to match the intended distribution.
    2. Setting aside cash has the effect of lowering the NAV (net asset value) of the fund by the amount of cash that has been “taken out” of the fund for distribution purposes. Note that no cash payment is made to the fund owners at this step….cash is only set aside.
    3. This date that has the most bearing on your taxes.
      1. If you buy a dividend paying stock (or mutual fund share) one day before the ex-dividend date, you will still get the dividend. If you buy on the ex-dividend date, you won’t get the dividend.See Record date section next for more details.
      2. If you want to sell a stock (or mutual fund share) and still receive a dividend that has been declared, you need to sell on (or after) the ex-dividend day.
    4. The ex-date is the second business day before the record date.
  3. Record Date
    1. This is the date on which the company looks at its records to see who the shareholders of the company are.
    2. An investor must be listed as a record holder (of the stock or fund shares) to ensure the right of a dividend payout.
    3. The ex-dividend date is usually 2 days before the Record date. And it takes 3 days to record an investor as a record holder. So, to be on the “books” on record date, the stock and/or fund purchase has to happen a day before the ex-dividend date. Purchasing on the ex-dividend date will not lead to the purchaser being on the record books and hence will not be a dividend target.
  4. Payment Date
    1. On this date, the fund actually pays the mutual fund share owners real money from the cash pool that is set aside on the ex-dividend date.
    2. This date has no bearing on your taxes

Tax Consequences of Mutual Funds

One of the main disadvantages of investing via mutual funds is that the tax consequences are not in my (the investor) control. What does this mean? Lets see…

  1. From the previous section, we saw that Mutual funds can distribute two types of taxable gain to shareholders: ordinary dividends and capital gains distributions.
  2. Let us say that I purchase shares of a mutual fund at $10 per share and the share prices rises to $100. Now, if I sell the 10 shares, there can be a taxable gain for the mutual fund because of the increased share price. This taxable gain will be distributed to all the mutual fund shareholders..in proportion to the number of shares that they own. Lets say that this year, I do not have money to pay taxes for the gain. So, I decide to not sell my shares this year.
  3. But, if the mutual fund manager sells shares of one of the components of the mutual fund to re-balance it and there is a profit on the shares, then the mutual fund will distribute the gain to all the share holders.
  4. This will lead to a gain for me for this year when I do not have the money to pay taxes for it. In the worst case, I may be forced to sell some shares to pay the tax to the government. This is what I meant by saying that the tax consequences are not in my (investor) control.

The other main disadvantage is the timing of the taxes paid. What does this mean?

Assumptions:

  • New calendar start date: Jan 1
  • Ex-date is Dec15th
  • Record date is Dec 17th
  • Payment date is Dec 20th.
  • Tax year ends on Dec 31st

Scenario 1:

  • Assume that Investor A bought 100 shares of a fund for $10 a share on Jan 1st. The shares rose in value to $20 on May 1st. Investor A then sells her shares on May 1st, and owes taxes on $1,000—the capital gain of $10 a share ($20-$10) times 100 shares.NOTE that this tax will be due when taxes are filed in the next calendar year (April 15th of next year is the tax deadline).
  • Investor B buys 100 shares at the fund’s new NAV of $20 a share on May 1st, which includes the embedded gains ($20-$10). The shares rise to $30 a share on Dec 1st, and Investor B sells his shares. Investor B would owe taxes on $1,000—the capital gain of $10 a share ($30-$20), times 100 shares.NOTE that this tax will be due when taxes are filed in the next calendar year (April 15th of next year is the tax deadline).
  • In other words, Investor A owes taxes on the $10 gain accrued while she owned the fund (Jan 1st to May 1st), and Investor B owes taxes on the $10 gain accrued while he is invested (May 1st to Dec 1st). Each shareholder is paying for his or her own gains earned.

Scenario 2:

  • Assume that Investor A bought 100 shares of a fund for $10 a share like in Scenario 1 i.e. Jan 1st. The shares rose in value to $20 on May 1st. Investor A then sells her shares on May 1st, and owes taxes on $1,000—the capital gain of $10 a share ($20-$10) times 100 shares. This is the same as in Scenario 1.
  • Now assume Investor B bought his shares on Dec 14th i.e. one day before the ex-dividend date. So, on record date, Investor B will qualify as a record holder. So, Investor B buys his shares at $20 on Dec 14th.
  • On ex-date, cash is set aside proportional to the distribution needed. So, the NAV falls to $10 per share, with $1000 (($20-$10) * 100) set aside as cash for distribution. On record date, it is decided that both Investor A and B are record holders and would get the dividend distribution.
  • Investor A still owes taxes on $1,000—the $10 gain on her shares, bought at $10 and sold at $20, times 100 shares.
  • Investor B bought the stock at $20 and did not realize any gain…but must now pay taxes on $1,000—the $10 per-share distribution ($20-$10), times 100 shares. I.e. it seems like Investor B is paying taxes on zero gain…is this possible? No. Read next.
  • The distribution reduces the fund’s NAV to $10. If Investor B pays the taxes from other assets and reinvests the full amount of the $1,000 distribution, he will now own 200 shares. The first 100 shares were purchased at $20 a share, while the second 100 were purchased at $10 a share. Investor B’s average cost basis for tax purposes is $15 a share.
  • Post the distribution (say May 1st of next year), lets say that the shares then rise by 50 percent, as in Scenario 1, to a new value of $15 a share.
  • When investor B sells his 200 shares at $15 a share on May 1st of next year, for tax purposes he is treated as having purchased all those shares at his average cost basis of $15 per share. Thus, he has no new tax liability because he has already paid taxes on his own gain.

Is Investor B paying taxes on zero gain?

  • Investor A paid her own taxes on the $1,000 gain when she sold shares at $20 with a cost basis of $10; she delayed paying taxes until she sold.
  • Investor B paid taxes on the $1,000 distribution up front, but owed no additional taxes when he sold his shares with the same price ($15) as his cost basis. Thus, he pays taxes only on the $1,000 that he earned while he owned the shares.
  • For Investor B to pay taxes upfront, he has to have some additional money set aside OR have other assets. If he has no money set aside, then other assets may have to be sold to pay taxes. This forced sale may lead to a loss (selling low, bought high) OR may lead to more taxation due to capital gains. This is the other main disadvantage of mutual funds.

Compared to other forms of investments, the only issue with a mutual fund is the timing of the taxes paid, not the amount of taxes paid.

  • Taxes may be paid sooner (if gains accrued before purchase are realized and distributed) or
  • Taxes may be paid later (if losses accrued before purchase offset realized gains)
  • But total taxes paid will be the same.

Reference:

I read many web links to understand this, but I will list one main link that was helpful to me with actual examples.

Causes of Stress in Life

/ humblefi / Leave a comment

I run into many people who are stressed about various things in their day to day life. Apart from me, one such person happens to be my wife. My wife has been stressed out lately and that has resulted in her asking some questions much more frequently

  • When can we have a normal and relaxed life?
  • When can we buy a house and settle down?
  • When can you not work weekends?
  • …..

I have tried to offload work off of her plate, but push comes to shove, I have to put food on the table and hold the fort. To me, the answer is quite simple…it boils down to two things:

  • You got to do what you have to do to survive in the area you live
  • We all want everything, but do not want to give up anything.

So, it is hard for me to understand sometimes why my wife is having issues…we live in the Silicon Valley…some of the brightest minds come to work in the Valley and everybody wants the best for themselves and their families. This is bound to make things more competitive and such….basically, a rat race. If you have to survive, you have to run the race. Or do you?

After one such emotionally charged discussion, I decided to explore the question of what factors can cause stress in people. Having paid a costly price w.r.t health in the fight for survival, I have some personal expertise in this area. But, I wanted to be fair and treat this as a new problem and see what come up. I wanted to see if I can solve my wife’s issues better than I have been doing. If she is happy, the family is more happy 🙂 So, I did some digging.

The following factors seem to be the most common causes of stress in life

  • Uncertainty about various things
    • Work Life
      • unemployment, colleagues leaving, company dying, etc etc
    • Social Life
      • Friends moving away, Peer pressure, politics of social life, etc etc
    • Financial Life
      • Can I afford a home at all? Can I afford a new car? Can we handle an emergency? When can I achieve financial independence? etc
    • Personal Life
      • Am I being a good parent? Am I being a good spouse? Am I being a good friend?
      • etc etc
  • Quality of Life
    • Cost of living, Commute Time, Crime, Pollution, Weather, Population Density, Integration into Neighborhood, Work Hours per day, Sleep hours per day, time spent with family per day, etc
  • Health
    • Family Health, Parents health, etc
  • Standard of Living
    • Nice House, Nice Car, Travel the world, etc

Over the next few weeks, I will take each of the above stressors and talk about the stressor and potential solutions to the problems that arise out of the stressor.

Blog Roll

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Implementation of Passive Income Streams

/ humblefi / 12 Comments

There are a few core design principles I have used in designing my version of the Passive Income Streams. These principles guide me in deciding where to invest the money in my taxable accounts. Here goes.

  1. Spread the money into different risk buckets (Vanguard 1 to 5 risk buckets)
  2. For each risk bucket, have a minimum of two investment vehicles.
  3. Almost every dollar has to provide some income in return.
  4. Invest some money in Capital Appreciation (high risk) buckets
  5. All the investments coming from taxable accounts have to be TAX-EFFICIENT.
  6. Automate as many investments as possible

6. Automate as many investments as possible

As I have said before, I do not have the knowledge nor the time to acquire it for individual stock picking at this time. In addition to that, I am not very organized to keep tabs on the investments and make investment changes based on market and/or life events at this time. So, fund based investing was the way to go for me. I am ready to pay for a mutual fund that has exhibited good characteristics…whether it be managing risk, growth, etc etc.

That said, the next question was: Mutual Fund OR ETF. There has been tonnes of info published on the web about these two. In my mind, here is what appeals to me about the two options:

  • Mutual Fund
    • Best suited for regular and automated investments
    • Investment amount does not have to be on stock boundaries
    • Tax loss harvesting…up market accumulates gains in the fund, downmarket uses tax loss harvesting.
    • Capital gain distributions is out of my control…some other investor in the same mutual fund might sell and hence capital gains will be distributed to all mutual fund participants.
    • Instant fund purchases are not possible…..if stock market fell big time today, I cannot purchase more of the fund right away. There is a wait time till end of day when the fund NAV prices are published.
  • ETF
    • More tax efficient in that capital gains distributions will not happen out of my control i.e. I do not sell etf shares, I do not realize capital gains or losses.
    • More suited for a relatively active investor (compared to a lazy mutual fund investor)
      • Automated investments are not possible.
      • Investment amount has to be on exact stock boundaries…no fraction of stocks can be purchased.
      • Tax loss harvesting is the responsibility of the investor.
      • Instant (intra-day) purchases possible.
      • ETF shares have a bid-ask spread i.e. they trade like stocks. So, one has to know stock valuation techniques to evaluate ETF shares…basically, ask the question of: how much is good value for each ETF share, etc tec.
      • Each ETF shares buy/sell may cost brokerage fees…just like normal shares.

Considering the above points, I chose mutual funds as the vehicle, inspite of ETFs being considered the more Tax Efficient Vehicle. The advantages of mutual funds fit more cleanly with my current requirements of automated investments and lack of time.

5. All the investments coming from taxable accounts have to be TAX-EFFICIENT.

Being in the higher tax bracket, tax efficiency in investments would be really nice. What does tax efficiency mean to me?

  • If possible, don’t pay taxes on the gains/profits/interest/dividends 🙂
    • Bank account Interest => pay taxes
    • MUNI bond dividends => may not pay both federal and state taxes
  • If  I do have to pay taxes on the gains, limit the taxes
    • Short term capital gains taxed as ordinary income; Long term gains at a lower rate.
    • Qualified dividends (most US companies) less rate; Unqualified dividends taxed as ordinary income
    • REIT investments => taxed as ordinary income …avoid it in taxable accounts
  • Invest in some stocks fur purely capital appreciation and no dividends.
    1. No dividends => no taxable distributions.

4. Invest some money in Capital Appreciation (high risk) buckets

As I have said before, Taxable account investments are getting funded from money saved through the entire month. There have been a lot of sacrifices that went in to saving this money. So, the safe place to actually invest this money is in cash (CDs, high interest rate online banks, etc). But, low risk => low gain. So, the next level up is bonds and dividend paying stocks. But, even bonds and div paying stocks payout somewhere between 1 – 3%.

So, cash, bonds and dividend paying stocks are more tuned towards capital preservation, with small gains rather than big gains. IMO, this approach will not make you rich…or rather, it will take a long time to do so. Is there a way to score a home run and get rick faster 😉

In that vein, I have decided to set aside some percentage of the investments to fund high growth stocks….like funding a lottery ticket purchase. These stocks have the capacity to score big once in a while, but there is a high risk of loss of capital also. Since these stocks tend to be growth oriented, there will be no dividend distributions from them i.e. they can lose money but they are tax efficient 🙂

3. Almost every dollar has to provide some income in return.

Apart from the captial appreciation investments, every investment dollar has to work hard to get me some money 🙂 Each dollar can get me different amounts of money based on whether they are invested in bonds, stocks, etc. But, they have to get me some money. It does not matter also if the gains are a bit tax inefficient in the short term (say dividends) but hopefully in the long run when our tax brackets go down, the tax efficiency will kick in. I would rather get $10 and give away $3 than getting $0.

2. For each risk bucket, have a minimum of two investment vehicles

A big risk with mutual funds is that investment control is with one fund manager most of the time. If the manager lays one wrong bet, then there is cause for concern. So, for the same investment risk bucket, I would like to spread the risk by choosing two different funds that provide similar investments, but under different fund managers. For example, VCAIX is a Vanguard municipal bond fund. A similar tax efficient bond fund is VWAHX or VWITX. Splitting the investments in two similar but different vehicles will create some diversity and spread the risk.

1. Spread the money into different risk buckets (Vanguard 1 to 5 risk buckets)

Vanguard has a risk reward scale of 1 through 5, 1 being the least risky and least rewarding and 5 being the most risky and most rewarding. All my investment money is spread into the 5 different buckets based on some percentage. For example, cash (1), bonds(2), dividend funds(3), large cap capital appreciation (4), and small cap capital appreciation(5). In each risk bucket, the ultimate goal for me is to have two different investment vehicles to balance out the risk.

Investment Vehicles Update 10/18/2014
Risk Bucket Name Investment Vehicle 1 Investment Vehicle 2
Risk 1 (Cash in banks) Smarty Pig (online) Credit Union (brick & mortar)
Risk 2 (Bonds) VCAIX (ca munis) N/A
Risk 3 (Balanced Funds) VTMFX (has natl munis) N/A
Risk 4 (Dividend Investing) VDIGX (div growth) VHDYX (high curr div)
Risk 5 (Capital Growth) VTCLX (large+mid cap) VTMSX (small cap)
Risk 5 (International Funds) VTMGX (large blend) N/A

2014 Financial Independence Progress Report

/ humblefi / Leave a comment
12/31/2014
Emergency Fund ($72K) 100.0% 100.0%
College Fund (80K) 30.83% 31.04%
Passive Income Streams ($4000 pm) 5.66% 7.36%
Retirement Fund ($900K) 51.74% 53.91%
Roof for our Family($1 mil) 00.00%
Medical Fund 00.00%
Life Insurance Done (term life insurance payments initiated)
11/30/2014
Emergency Fund ($72K) 100.0% 100.0%
College Fund (80K) 30.03% 30.83%
Passive Income Streams ($4000 pm) 5.35% 5.66 %
Retirement Fund ($900K) 50.86% 51.74%
Roof for our Family($1 mil) 00.00%
Medical Fund 00.00%
Life Insurance Done (term life insurance payments initiated)
10/31/2014
Emergency Fund ($72K) 100.0% 100.0%
College Fund (80K) 28.98% 30.03%
Passive Income Streams ($4000 pm) 04.27% 5.35 %
Retirement Fund ($900K) 46.00% 50.86%
Roof for our Family($1 mil) 00.00%
Medical Fund 00.00%
Life Insurance Done (term life insurance payments initiated)
09/29/2014
Emergency Fund ($72K) 100
College Fund (80K) 28.25 28.98
Passive Income Streams ($4000 pm) 3.72% 4.47%
Retirement Fund ($900K) 46%
Roof for our Family($1 mil) 0%
Medical Fund 0%
Life Insurance Done (term life insurance payments initiated)
07/25/2014
Emergency Fund ($72K) 100%
College Fund (80K) 28.25
Passive Income Streams ($4000 pm) 3.72%
Retirement Fund ($900K) 46%
Roof for our Family ($1 mil) 0%
Medical Fund 0%
Life Insurance 0% (term life insurance to be initiated)

Design Principles behind Passive Income Streams

/ humblefi / 2 Comments

There are a few core design principles I have used in designing my version of the Passive Income Streams. These principles guide me in deciding where to invest the money in my taxable accounts. Here goes.

  1. Spread the money into different risk buckets
    1. Vanguard has a risk rating scale of 1-5 for all the investment vehicles it provides….1 being the most conservative/least risky and 5 being the least conservative/most risky.
    2. My design principle is to invest money in all risk buckets.The percentage of investments in each bucket varies depending on how the market is doing.
      1. For example, as of today (09/02/2014), the stocks are highly overvalued….don’t take my word for it…the experts thinks so too 🙂 So, more money towards buckets 2 and 3 and less in 4 and 5 risk buckets. If the market tanks, then change the skew more towards buckets 4 and 5.
      2. I can hear comments about market timing already 🙂
  2. For each risk bucket, have a minimum of two investment vehicles.
    1. Each fund manager may go through his/her own mistake prone period. By having two different investment vehicles, I am betting on the fact that both fund managers do not have their respective bad times at the same time.
  3. Almost every dollar has to provide some income in return.
    1. I want assets and not liabilities 🙂
    2. Almost all the money is spent in dividend producing vehicles: muni bond funds and dividend stock funds.
  4. Invest some money in Capital Appreciation (high risk) buckets
    1. I call this the lottery ticket investments.
    2. I.e. small cap and mid cap investments.
  5. All the investments coming from taxable accounts have to be TAX-EFFICIENT.
    1. I will talk in detail about Tax-efficient investing in another post.
    2. The basic idea is to postpone paying taxes to a more opportune time when the tax bracket is low, invest in tax-friendly investments like muni bonds, etc.
  6. Automate as many investments as possible
    1. I have no time, no knowledge, no patience, etc etc to spend a lot of time doing stock tracking and investing.
    2. So, automatic investments and hence mutual funds are my best friends.

In a subsequent post, I will talk more about the actual funds where I have invested money in, based on the above design principles.

Multiple Passive Income Streams….why?

/ humblefi / 1 Comment

On and off, I used to search online, in many different places, for a way to become Financially Independent. I came across many videos on youtube, many links on google, etc but nothing struck a chord in me. After a life changing event leading to some difficult times, personally and professionally, my search for peace and calm led me back to financial independence but this time, it struck a chord.

A couple of the important sites I came across were Extreme Early Retirement and Mr.Money Mustache. I cannot remember how I came across these sites, but I was hooked for a month or two on these. I realized that these sites espouse one path to Financial Independence….the path of Extreme Saving

I then came across a different set of websites that espoused multiple income streams as a path to Financial Independence i.e. earn your way to freedom. There are many sites to mention, but mainly, Dividend Mantra, Conservative Income Investor, etc etc.

I also read and listened to Rich Dad Poor Dad by Robert Kiyosaki, which espoused the difference between assets and liabilities….the philosophy being spend on income-producing assets rather than income-sucking liabilities.

So, I decided to adopt a two pronged approach to financial independence

  • Save as much as possible
  • Invest in income producing assets

Articles in this category will talk about my goal to build multiple passive income streams that together produce a yearly income of $50000.

College Funding for our kid

/ humblefi / 2 Comments

When it comes to college funding, there are a few main questions to answer.

  • How much to fund?
  • Where to fund?
  • What if unused for college purposes?

How much to fund?

College cost is soaring like crazy…looks like there is no end in sight. I wish I could fund the entire cost, but I am not sure I can. So, I have set a target of $20000 per year for 4 years. Anything more than this, the kid has to manage.

Where to fund?

I wanted a most generic college funding option. By generic I mean the following:

  • 529 plan
  • basic age based investment option
  • passive fund is okay
  • good set of low-cost investment options
  • acceptable in any college across the US
  • any state tax advantages
  • online acct management possible
  • automatic investment possible

Since I am a fan of Vanguard, I have a bias towards Vanguard 529 plans. But, I did dig into many articles on the web to find a good 529 options. Turns out, most of the good plans happened to be Vanguard ones. I picked Nevada 529 plan as satisfied all the above requirements.

What if unused for college purposes?

If unused, the 529 plan can be withdrawn but with a 10% penalty. The penalty is applicable ONLY on the earnings in the plan and not on the principal (because I am using post-tax money for investing into the 529 plan). There is a wonderful article from savingforcollege.com that I will refer to here for further reference.

Starting Status

07/25/2014        $22600        28.25% complete

09/29/2014        $23185         28.98% complete

07/04/2020         DONE

….. (see Progress Report for more updates)

Emergency Fund

/ humblefi / 2 Comments

Why an Emergency Fund?

There are many events in life that cannot be planned for. Let us consider some examples:

  • My close friend used to work for a company that closed down without a hint as to this event happening. This happened when the market was in the dumps…but he was able to ride through it because he had some money stashed up. It was not that he planned to have an emergency fund..it was just that he was not financially aware on what to do with that money.
  • My colleague at work had mom continuing to stay in another (home) country. Mom was suddenly diagnosed with a fast acting cancer. My colleague dropped everything and left to take care of mom. Mom lived for another 6 months, but she got to spend the last 6 months with my colleague and died in peace. If my colleague did not have an emergency fund, my colleague could not have afforded those 6 months without pay…6 months that gave my colleague peace for the rest of life.
  • One of my other friends lost a job unexpectedly. His company was doing okay, but they canned his entire product line. He was given two weeks to search for a job inside the company, but it was a time of job freezes every where and he could not get any. Since he had two kids, the COBRA insurance payment for the entire family turned out to cost almost 1900+ dollars! This was a total surprise to him as well as me. Did I say that rent is expensive where I stay? His total monthly expense was almost $5000 per month. He was out of a job for almost 6 months and that is 30 grand right there.

So, for reasons like the above, I wanted to have an emergency fund that will at least give me and my family some months without pay in the event of any emergency. This is especially important since we do not have any relatives or friends that can support us financially.

Size of the Emergency Fund

Having decided to build an emergency fund, the question that arises next is…how much?

  • From seeing my family’s expenses and from seeing what my friends had gone through, I think a minimum of $5000 pm is an absolute necessity.
  • A year’s worth of expenses is what is recommended everywhere.I have nobody I can rely on to host me and my family. I am it.
  • I have a pre-existing health condition for which insurance would be almost impossible to get. So, I added $1000 in addition to account for a high cost insurance.

Considering all that, I decided to have 12 months of expenses for my emergency fund i.e. $72000.

Where to keep the Emergency Money?

Having $72000 in a Bank of America account was earning brutally low interest rate. Based on a tip from a wise soul, I came across Smarty Pig, a FDIC insured online bank that was providing 1% interest for the money. So, I decided to move the emergency fund into a Smarty Pig savings bank account.

Status of this Goal

Done!

What is Financial Independence to me?

/ humblefi / 14 Comments

There are many definitions of Financial Independence out there is the web world. For example, “FUMoney”, Eary Retirement, etc etc. Each person who defined it was solving a problem in his/her life i.e. was trying to get free in some way. So, what does financial independence mean to me?

  1. Emergency Fund for 12 months of expenses
  2. Multiple Passive Income Streams that produce $50000 per year for years 50-70
  3. College Fund for my kid
  4. A retirement fund that covers 30 years of expenses for years 70-100
  5. A paid off roof for my family
  6. A $100K medical fund to help fix emergency health issues…not sure about insurance with preexisting health issues.
  7. Life Insurance to cover my family.

I am not sure if this is a realistic number yet….but this is a start. I hope to refine it over the next year or so when I have some more clarity on issues like housing.

Emergency Fund ($72K)

We live in the age of uncertainty in many areas and one of them is the source of income. I do not have super intelligence or super will power, but I sacrifice many things and work really hard. Inspite of that, I cannot say that I will never face a loss of income streams. So, this fund is there to take care of my worries for a while. $6000 pm for 12 months = $72K.

Details here.

College Fund for my kid ($80K)

College cost is soaring like crazy…looks like there is no end in sight. I wish I could fund the entire cost, but I am not sure I can. So, I have set a target of $20000 per year for 4 years of college. Anything more than this, the kid has to manage. I feel since we brought the kid into this world, it is our responsibility to build a proper foundation for our kid. A college fund is one part of the foundation. Maybe I will write another post about all the parts of the foundation I have planned to provide for my kid…..but that comes later.

Details here.

Multiple Passive Income Streams that produce $50000 per year ($1million Taxable account investments….for years 50-70)

Where I live, $4000 pm is an absolute necessity. A major portion of this expense is housing costs. A 2bed/2bath apartment costs around 2.5K to rent in a good school district. A mortgage for the same house will cost $4500 at least. If housing is taken care of, then $4000 pm will afford some luxuries like travel, etc. Else, this money would be necessary for basic living….sad, but true. Moving out of this area is not an option for me….my entire social circle is here and it is almost impossible to find such a set of good people anywhere else.

Details here.

A retirement fund that covers 30 years of expenses at $30000 per year ($900K Tax-advantaged account investments….for years 70-100)

I have been contributing to 401K over the past 14 years of working…but not much to show for this yet. I was not maxing out my 401K in the initial few years and the 2008 downturn wiped out a decent chunk. My current company does not match 401K. 401K has recovered a bit now but still way off target. PS: With my health issues, I realize that won’t live until 100…but running short for my family is not something I want.

One question to ask is: what is the difference between the passive income streams (yrs 50-70) and this retirement fund?

  • The first difference is the source of the money…taxable account vs tax advantaged accounts.
  • The second difference is that I want to give the tax advantaged accounts as much time as possible to accumulate and grow. If at all possible, I would like to not touch it until I hit year 70. After that the plan is to just take $30K out of it every year…which roughly works out to 3% withdraw rate. PS: Need to study issue of Required Minimum Distribution (RMD) from the 401k/IRA funds later.
  • The third difference is the type of investments. The money in the tax-advantaged accounts will be in target date funds..which get super conservative as the target date approaches. So, effectively, there will not be much growth for the money beyond the target date. But, the taxable account investments will continue to be invested in slightly more riskier and hence growth oriented vehicles so that there is some percentage of the portfolio that is geared towards growing the money.

The expectation is that a combination of the passive income streams and the retirement fund should provide a reasonably comfortable money pool for each month spent in retirement.

A paid off roof for my family ($850K $1millon)

This is one I am having most trouble with. In the past, I was unsure of taking on such a big commitment, especially due to many uncertainties in personal and professional life. Now, it seems like it is next to impossible, even with a more than reasonable down payment. I just don’t feel like paying a million dollars for a house that needs a million dollars worth of repairs. But, without this, I will surely not be financially independent. I do not have anyone else to rely on for housing…no parents or relatives. So, this is a must. I am hoping that when I reach a state where passive income streams are generating money to take care of basic necessities (say $1000 pm), I can take the plunge into housing…..which hopefully would have cooled a bit down by then.

A $100K medical fund to fix broken health issues.

I have accumulated some nasty health issues which need to be managed over the rest of my life. With uncertainties about health insurance for folks with preexisting conditions, I do not want to saddle my family with a huge medical bill. So, this fund should cover for any emergency health expenses. My current plan is that if the Emergency Fund is unused until retirement (touch wood), it will morph into a Health Fund for me. So, I am not going to work on this actively in the immediate future.

Life Insurance

There are few questions to answer when it comes to life insurance:

  • term life or whole life
  • how many years
  • policy value

I wanted to protect my family from any emergencies for my earning years i.e. until 65-70 years of age. I decided to go with Term Life Insurance and not Whole life. Apart from Whole life being a whole lot more expensive, the main reason for term life insurance is that by policy expiry time (65 or 70), I hope to have a reasonable financial plan for my family, even if I am not there. So, I have applied for term life insurance…the approval process took a long time but the policy has been approved! It costs me a packet every month…a bottomless pit…but, at least my family is covered until 70yrs of age.

Status at the start of the marathon called Financial Independence

07/25/2014        Emergency Fund                        100% complete

07/25/2014         College Fund                             29% complete

07/25/2014         Passive Income Streams            3.75% complete ($150 pm vs $4000 pm)

07/25/2014         Retirement Fund                        46% complete

07/25/2014         Roof for our family                     not yet

07/25/2014         Medical fund                              not yet

09/01/2014          Life Insurance                           100% complete