IN FORT LAUDERDALE, an unusual property sits wedged in among a row of waterfront mansions. It’s a 35-acre patch of wooded wilderness with just a single home, called Bonnet House. It was for many decades the winter residence of a woman named Evelyn Bartlett.
She first began spending winters at Bonnet House in the 1930s, and she continued to live there following her husband’s death in the 1950s. By the 1980s, however, the property’s assessed value had reached $30 million, and Bartlett was no longer able to keep up with the taxes. She could have sold the property to solve the problem, but she had a different idea. She approached the city with a deal: She would donate the property to the government, but only if she could continue to live there—tax-free—for the rest of her life.
At the time, Bartlett was already 95 years old, so government officials figured they wouldn’t have to wait long. But she ended up getting the better end of the deal. She lived another 14 years—until age 109—and thus, over those years, avoided tens of millions in real estate taxes.
The story is unusual. But in a way, it’s also characteristic of many financial decisions. A lot of questions in personal finance require some amount of guessing, estimating or predicting. And even when we think the facts are pretty clear—guessing the life expectancy of a 95-year-old, for example—things can turn out differently. That’s the fly in the ointment with many decisions.
It’s important, though, to recognize that financial decisions fall into two categories. Many do require making projections—but many do not. In fact, some financial decisions lend themselves to simple calculations requiring minimal, if any, guesstimating. Since so much of personal finance is beyond our control, it’s important to control what we can—in other words, to know which questions can be answered without reference to a crystal ball. Below are seven key calculations that fit that category.
1. Bridge to Social Security. You may have heard of the so-called 4% rule for choosing a portfolio withdrawal rate in retirement. It’s a useful point of reference, but it has a key weakness: Retirement is rarely a straight line. Suppose you retire at age 65 but don’t start Social Security until 70. All things being equal, your withdrawal rate would be significantly higher during those first five years. If that’s the case, how should you think about the withdrawal rate? Should it be based on the initial five years or on the subsequent years? And how should your portfolio be allocated to navigate those two very different periods?
Mike Piper, a CPA and author, recommends building a “bridge to Social Security” by setting aside enough to get through those initial years. Suppose your Social Security check will bring in $4,000 a month, or $48,000 a year, when it starts. To build a five-year bridge, you would simply set aside $240,000 (5 x $48,000) and hold those funds in cash or bonds to minimize risk. With those dollars set aside, you could look beyond the initial years to set a withdrawal rate and asset allocation for the rest of your portfolio.
2. Bond returns. Buy a stock or stock fund, and it’s anyone’s guess what rate of return it’ll deliver. Fortunately, when you buy a bond, it’s the opposite. With an individual bond, you can calculate the yield to maturity at the time of purchase and know that—barring a default—that’s precisely the rate of return you’ll receive. (Yes, some bonds are callable before maturity, but they’re the minority.)
With Treasury Inflation-Protected Securities, investors enjoy an even greater level of certainty. Not only can you calculate your return, but also you can know the return you’ll receive on top of inflation, regardless of how high or low inflation turns out to be.
3. Choosing bonds. Suppose you’re deciding between a Treasury bond and a comparable municipal bond. A key selling point of municipal bonds is that they’re free of federal-income tax, and state taxes as well if you own bonds from your own state. But in exchange for that, they generally carry lower yields. It’s thus difficult with the naked eye to know which bond will provide a higher return after adjusting for munis’ tax benefit. That’s because each person’s tax rate is different.
There is a way to make an apples-to-apples comparison, though, by tax-adjusting the municipal bond’s yield. If a Treasury is yielding 5% while a muni is yielding 3.5%, and your marginal tax rate is 32%, this would be the calculation: 3.5% ÷ (1-0.32) = 5.15%. In this case, adjusting for taxes, the muni at 5.15% would be the better deal. But if your tax rate were lower—say, 22%—then the Treasury would be better.
4. Life insurance. How much life insurance should you carry? This can be a difficult question. Fortunately, it’s relatively easy to do the math. Step No. 1 is to add up outstanding debts, including any mortgage and student loans. In the event that something happened, you’d want your family to be able to eliminate the monthly overhead and stress of ongoing loan payments. If you have school-age children, you might set aside further amounts to fully fund their college tuition.
Step No. 2 is to calculate an additional sum to provide for your family’s annual expenses. You want to build an endowment of sorts that your family could draw from each year. To calculate how big an endowment you’d want to build, you could use the 4% rule referenced above. Suppose, after eliminating debt payments, your family’s ongoing expenses would be $100,000 a year. Then the calculation would be: $100,000 ÷ 0.04 = $2.5 million. From that, you’d subtract what you already have in savings. For example, if you have $500,000 saved, then the additional coverage you’d want, on top of the amount needed from Step No. 1, would be $2 million.
5. Disability coverage. This calculation is similar to the one for life insurance, with one key difference: Most disability policies stop paying at age 65. For that reason, your benefit would need to be large enough not only to pay the day-to-day bills, but also to allow you to set aside an amount from each check to build savings for those post-65 years.
6. Tax rates. Thinking about making a charitable donation? On the surface, it might seem like the potential tax savings would be easy to calculate. You’d simply multiply the dollar amount of the prospective donation by your marginal tax rate. But especially with the 2018 increase to the standard deduction, that calculation could be misleading. For a more accurate estimate, use tax software or consult an advisor who can do the calculation for you. If you complete this calculation near the end of the year, when you’ll have a good handle on the rest of your tax picture, you can make a reasonably accurate estimate.
7. Pensions. If you’re fortunate enough to have a traditional pension, you may be given two options at retirement: to receive monthly payments for life or to take a single lump sum. On the surface, this looks like an Evelyn Bartlett type of question. If you knew you were going to live to 109, you’d almost certainly take the monthly payments.
But the reality is, she was an outlier. None of us knows how long we’ll live. But there’s a calculation that can be helpful: If you total up the cumulative present value of the proposed annuity payments for each future year, you’ll find a breakeven point at which the monthly payments would become more valuable than the lump sum. Depending on how far out that point is, and how you feel about your health, you can make a reasoned judgment.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Great article. Thanks so much!
The story reminds me of Jeanne Calment. She made a deal at age 94 to keep her home and the buyer would pay 2500 francs/month. Well, she ended becoming the oldest person on earth and he died when she was 120 and he had paid twice the value of the place.
Or maybe she wasn’t the oldest person on earth. Adam Grossman wrote about her:
The jury’s still out on that… but it doesn’t change the buyer’s bad luck.
A good list. Thank you.
Your #6 note about charitable contributions doesn’t fit your criteria very well. But for a seat-of-the-pants calculation of what your charitable contributions will do for your taxes, this might work. Congress did not continue the modest charitable contribution add-on to the standard deduction that existed last year. So, if you don’t itemize, your charitable contribution can have no independent benefit to your taxes. You will be making the gift out of the goodness of your heart.
But if you do itemize, you should add up all your other deductions first to see what that total will be. (More than likely, your state and local taxes will be the highest component.) If that sum is lower than your standard deduction, at least a portion of your charitable contributions will still offer you no tax benefit. But any amount that leads you to exceed your standard deduction will be worth roughly your marginal rate in reducing your taxes. So if your contributions put you $100 over the standard deduction limit and you are in the 32% bracket, I believe your contribution will save you 32% of that overage, or $32. You might save a small bit more on your state taxes as well. (Alternatively, you can think about it as your contribution only cost you $68. That mind set could lead you to become more generous in the future.)
I loved the story about Evelyn Bartlett.
trust insurance companies-my bad
and I have no faith in insurance companies and the whole financial field as Wm Bernstein said. “Treat every advisor, broker, and ins. salesman as if they r a hardened criminal”
I would take a lump sum any day as who here really trusts insects and annuities are not guaranteed
It appears you don’t understand how a pension trust works.
Thanks for the article. I should probably rerun the muni calculation, although at this point I am just reinvesting interest in VWIUX.
I was offered a lump sum buyout on my pension way back when the megacorp was trying to get out of the pension business. I checked to see what size annuity it would buy, and it was so much lower than my pension that the decision was simple. I have no idea whether I would have reached the same conclusion using your technique, never having heard of present value and being somewhat risk-averse.
Excellent article as usual Adam. I certainly don’t disagree with what you say, but I do think in the real world for the majority of people much of what is written here, including by me, is not practical even while being correct and logical advice.
“Simply set aside $250,000?” I’m guessing if someone had their retirement savings and an extra $250,000 they need not worry about increasing their SS benefit.
Similarly, I suggest most people should never take a lump sum in lieu of annuity pension regardless of what the math says. They are likely unprepared to invest it or manage it or deal with the stress associated with both.
Your muni calculation was very helpful. Now I know for sure my muni decisions were not the best financial decision, but I still like that monthly tax-free income. Deludes me into thinking I beat the system.
I agreed, Dick…The annuitized stream of monthly income provided via a defined benefit plan / pension provides at least two other benefits:
First, pensions automatically incorporate some “spendthrift” protection for retirees, particularly as the primary recipient ages and others may be needed on to help “manage” retirement finances. A frugal pension recipient may have married / remarried a profligate “spender” – this could also be a behavior found among their adult children. Lump-sum distributions from a pension are way too tempting of a target, should this be case.
Second, as mentioned in prior HD articles, the NPV (net present value) of both a pension and social security can help shine a different light on what constitutes the proper ratio of stocks vs. bonds held inside a retirement portfolio. The classic “60/40” retiree stocks/bonds ratio looks a bit different when the NPV of a pension and/or social security are factored into the bond side of their asset ledger. It’s not a strategy that’s right for everyone – we all have a different tolerance levels for risk – but it’s definitely worth doing the math on.
i was thinking most people who bother to plan their retirement do have an extra $250,000 precisely to maximize their SS benefit.
Or might have received an unexpected severance payout some years before SS FRA
Adam: The most consistent hitter on team HD. Constantly hitting doubles time after time. (I’d say home runs, but I don’t want to give Adam too big of a head.)
Thank you for another great article with lots of great information.