Reader Profile: KJ

The following is the latest post in my "Reader Profiles" series. Each post in this series details the financial situation and challenges of an FMF reader. The purpose of this series is to help us all identify with people like us (in similar situations -- not all will be, of course, but eventually I'm sure you will find someone like you here), get to know the frequent commenters on the site, and hear some financial wisdom/challenges from people other than me.

If you're interested in contributing to this series, then drop me an email. The series seems to be very popular with readers and I need a steady stream of new ones to keep it going.

Next in the series is FMF reader KJ. He answered my questions (in red below) as follows:

Please tell us a bit about yourself.

I'm 36, my wife is 37.  We have one child with another on the way.  We live in a major midwest metropolitaion area.  The cost of living is very, very reasonable- a huge plus for us after moving here from a major Northeast city recently. 
 
I took one personal finance course in college, but otherwise have taught myself everything that I know about finance and investing through blogs such as FMF and magazines/books.  I have enjoyed David Bach's books, as well as FMF's favorite Millionaire Next Door.  Jeremy Siegel's Stocks for the Long Run was most influential to my investment strategy.  I spend most of my "spare" time researching stocks and reading articles on the web.  Real Clear Markets is probably my favorite website, other than FMF, of course!  My parents always had money issues (credit card debt, etc) and I never wanted to have to deal with that.  I wasn't ever really taught that many money lessons growing up.

Describe your financial situation (who works in your family, how your income is (general), how your expenses are, etc.).

We both work and have BS degrees.  I graduated with about $17K in student loans and had those paid off in about 6 years.  Depending on bonuses, we make about $260,000/year.  We are very, very fortunate- but have also worked very hard to be successful at our careers.
 
Our monthly breakdown is as follows...

After taxes,401k max contributions, and dependent care account contributions...our take home = $11,754

• Mortgage- $1520 (30 year fixed at 4.5% with $291,000 left)
• Childcare expenses- $915 (soon to be about $2K when we have another child)
• Cell phone/internet- $290 
• Utilities- $360
• Insurance (property/life/car)- $350
• Credit cards- ~$2500 (we pay these off every month and charge groceries, etc to get cash rewards)
• Cash expenditures (ATM)- $800

Quarterly estimated taxes = $3570 every three months
 
We directly transfer $2500/month into a savings account and $250/month into a 529 plan for my son- this will double when we have another child.  We sometimes have extra cash that builds up in our checking account, and I regularly move that into savings.  I try to always keep at least $4K in a checking account as a buffer.

What are the current financial issues you're facing (saving, paying off debt, etc.)?
 
We have always lived within our means and never taken on any debt other than a mortgage.  If you don't live in it or it doesn't apprecaite in value- don't go into debt to pay for it.  I have always lived by that addage.  That said, we don't have any debt besides our mortgage.  We have two cars- one a 2004 with 111K miles and the other a 2007 with 80K miles.  We paid cash for them and plan to drive them until they have any major mechanical issues.  I prefer Hondas and that's all I've ever owned.
 
One of the major factors in building our wealth, other than having well-paying jobs, is that we have hardly spent any BONUS money.  We NEVER plan on using that money and assume we aren't even going to get bonuses each year.  They're a bonus- truly and literally- and go right to a savings account as soon as we get them.
 
Here is what we have saved so far (as of the close of markets the day I wrote this)...
 
Taxable accounts:

• Basic savings account- $20,201
• Brokerage cash account- $70,089
• **(The above two accounts serve as our emergency funds)
• CDs- $100,544
• DRIPs (PG and SO)- $15,500
• Other stocks (KO, GE, AAPL, DE) and ETFs (PFF, SPLV)- $74,985

Non-Taxable Retirement accounts:

• 401k's- combined balance of $447,630
• Roth IRA-  combined balance of $35,800 (although we can no longer contribute because income is too high)

GRAND TOTAL of Taxable and Non-Taxable savings = $764,659
 
Kids:

• UTMA and 529 for our son- $18,211

If I had an "issue"- I think it would be that I am concerned that I'm not taking enough risk with some of our savings.  Between the cash savings and CDs- we have about $191K sitting there earning, at the most, 1.2%.  What advice would any readers have for that money?  It's my 'sleep well at night' money and I don't know how much risk I should even take, given the current global environment- but I am concerned that I will kick myself one day for not making that money work harder.
 
We also get hammered in taxes every year.  AMT hits us every year and we end up paying about $14K on top of our withholdings from each paycheck.  I fear that it's only going to get worse, given our country's financial situation.

What are your plans for the future (retire early, build your career, etc.)?

We will continue to build our careers, but my focus has started to become much more aligned with work/life balance now that we have kids.  So the climb up the ladder may likely plateau somewhat to ensure that we spend plenty of time as a family.
 
I'd like to retire early, if possible.  I don't sit still well though, so I don't know how I would handle not working.  I'd like to pay for our kids to go to college.

What's your best piece(s) of financial advice and/or your general philosophy on personal finances?

(1) Don't spend more than you make.
(2) Don't ever come even remotely close to breaking rule #1.
 
My first boss out of college sat me down one day and explained to me what a 401k was, what a company match was, and how he had his money invested.  (This was also 1998 and stocks were roaring, so there was much to be impressed with.)  That left an impression on me- mostly that I had no clue about investing and saving and needed to learn more.  He explained that if I didn't participate in the savings program the company offered, I was really foolish because the match was free money.  So I set up my deductions based on his advice and never considered not contributing money to retirement savings.  Then I watched how it built up and was surprised at how much it grew.  I then started to follow some stocks and have bought established, blue-chip companies on the dips over the years.  I hardly ever speculate and most of my holdings have to pay at least a 2% dividend.  (AAPL is an exception.)  Dividends are awesome!
 
For me, the biggest factor in building wealth has not been picking the right investments, but making the effort to contribute as much as possible.  It's your contributions that count the most, not picking the hottest/best funds or stocks.  Maxing out the 401k, the ROTH IRA, and other vehicles that are out there is crucial to building wealth.
 
My father-in-law has also had a big impression on me financially.  He retired early and invested with a similar strategy to the one that I employ.

Comments

[Luis]

Have you thought about doing property management? If so, you could use the savings to buy a rental property. That will keep you busy in retirement, diversity your investment in ways that whatever happens to the economy you'll be covered, give you more tax advantages, and possible gift options to your kids in the future.

[tvd]

In addition to Luis' advice, I'd take the CDs and a chunk of the brokerage cash and make a point of paying down / off the mortgage. You could probably do it in a year or two, with bonuses.

We bought in cash a few years ago (@33 and 32), and the peace of mind is outstanding. It basically eliminated all my career stress.

[JimL]

Like yourself, I am sitting on cash in CD's and money markets that I wish I could get a better return. As I have 4 kids (one in college and another one soon to be in college) I have left e cash alone.

One thing to think about is paying off the mortgage early. If you take the 2500 a month and put it towards the loan, you will pay off the house in 6 years. Any bonus payments applied, will make that even shorter.

[Keith]

Could you refinance? I think a 15 year term would be better as you would have a paid for house much sooner. Maybe you could even get a better rate.

[Brian]

Like you, I'm not too much of an investor in the markets outside of my retirement accounts. I have all of my non-retirement savings in Ally bank 5 year CDs earning 2.4%. Not as good as the 8% that you could possibly make in the stock market, but better than the 1.2% you're getting now.

The thing I like about the Ally Bank 5 year CD is that the early withdrawal penalty is only 2 months of interest. If you calculate it out, as long as you don't touch the money for about 120 days after you open it, you will make more money than you would in a 1.2% savings account, even if you withdraw early and take the penalty.

[CoolMouseLuke]

If you don't have it already, I'd recommend having a very strong CPA to help with the tax planning. Not just the paperwork, you need a professional to regularly discuss the various options and implications/risks. You can of course increase your witholding to not get a large bill at tax time. It also sounds like you need some write offs. Something with lots of deductions, but doesn't take a lot of time, which I'm assuming is very short with both of you working and soon two children. I love rental properties, but you would likely want to have professional management. But there are many other options, a side business, charities, etc...

[Leigh]

You guys are doing quite well - I want to be in your position when I'm your age :)

You say that you are no longer eligible to contribute to the Roth IRA. It looks like you don't have any Traditional IRAs, so you should be able to do so using the backdoor: http://www.bogleheads.org/wiki/Backdoor_Roth_IRA I like this idea because the alternative (for me at least) is investing in taxable accounts and at least this way, I know I'll never pay tax again later. Plus, who knows how long this loophole will be around for?

I am totally with you on not assuming the bonuses will happen! I certainly wouldn't be saving much beyond my 401(k) if they didn't happen, but I set my monthly budget completely assuming they won't and it's played out quite nicely so far.

Are your CDs earmarked for something? $100,000 is quite a bit to have in cash savings/CDs on top of the $90,000 that you indicated was your emergency reserves. I would either throw this at the mortgage or invest it. Once you have the mortgage gone, that would really help with the high cost of childcare each month and then you would have more room to save for college.

[texashaze]

Get a rental -- mortgage interest (if applicable) + cost of upkeep + depreciation = great tax shelter!

[savvy]

One comment in response to texashaze - If they OP gets a rental, they need to be sure the property has positive cash flow (including upkeep and depreciation). At their income level, they can't write off rental losses.

[Rick Francis]

KJ,
Given your high income and thus high tax bracket Tax efficiency is really important for you. You stated that AMT is costing you $14K/year- consulting with a CPA that specializes in AMT should pay for itself if they can to give you strategies to avoid AMT.
If you can’t totally avoid AMT completely - then perhaps you can avoid it every other year by changing the timing of AMT triggers. For example if exercising stock options every dec triggered AMT for you, instead of exercising every options every year in Dec one year exercise nothing then exercise twice the next calendar year- say Jan 1st and in Dec. In the years you don’t have AMT you maximize the disallowed deductions.
CDs are NOT tax efficient, I understand wanting to have a real cash emergency fund, but not only do you earn almost no interest but you will lose a lot of that to taxes. I’m sure that $100K is losing a few %/year due to inflation and taxes. Another good reason to consult with a CPA- they should be able to steer you to more tax efficient investments.
Roth IRA- you can no longer directly contribute but you could do a conversion to a Roth IRA. Note: You should be careful here- your income is very high so converting to a Roth only makes sense if you are really sure your income will be high enough in retirement that you would be in as high a tax bracket. To get a $260K income with a 4% withdrawal rate you would need a balance of $10.4 million dollars. If you would stop working long before reaching that amount I wouldn’t bother with the Roth IRA.
-Rick Francis

[Old Limey]

You state:
"Between the cash savings and CDs- we have about $191K sitting there earning, at the most, 1.2%."

I am also a father-in-law and a father that has trading authorization over his family's investments because of my track record over the last 20 years since I retired.

Right now the best low volatility mutual funds, if you are interested in income rather than capital gains, are municipal bond funds.
My first choice is: Wells Fargo Municipal Bond Inv CL(SXFIX)
It's yield for 2011 was 4.52%, free of federal taxes, and its volatility and 'max drawdown' is easy to live with. I even have some of it in our IRA accounts because I find that corporate taxable bond funds have volatilities that far exceed my comfort levels.

[Carol]

Kevin,
Contribute to a tradition IRA. You'll need all the money you can for retirement. I'd keep the 30-year mortgage and pay extra per month; that's insurance in case something happens to your wife's or your job. It also gives you more wiggle room in the monthly budget. Keep a good cash cushion, just in case. Don't make the mistake of moving into a larger home unless you're really squeezed in your present home. Finally, keep up the good work!

[Evan H.]

KJ -

I would recommend putting together an asset allocation profile on the Bogleheads (bogleheads.org) investment forum. The community there will give you great recommendations for your taxable and tax-deferred/tax-free spaces.

[jim]

You say AMT hits you every year and you pay "about $14K on top of our withholdings". First, if AMT is hitting you then I really do not think AMT alone is costing you $14,000. Your witholdings are probably too low. What you pay for witholding doesn't really have much to do with your actual tax bill. Your normal non-AMT tax bill could be very close to the AMT bill, so AMT may not be costing you much above the standard tax rate. There isn't enough info here to know whats going on but theres not much in the way of deductions.

Second, From the info given I'm not sure how AMT how you'd owe AMT tax. I don't see too much in the way of deductions. So there must be some deductions you're not mentioning? AMT is lower than the tax rate with standard deductions. Its often lower than the tax rate with some itemized deductions. So in order to have AMT tax bill you would have to have a lot of deductions. THis is my understanding at least... AMT is complex. :(

[Mark]

@jim: AMT can hit if he has high capital gains, exercises stock options, has high state or property taxes, etc. SOme deductions don't count and there is a phaseout of the AMT exemption which can make the effective rate on dividends and cap gains 22% instead of 15%.

[jim]

Mark, Yeah one or more of those things might explain why they'd have AMT. But we're missing detail here. Still I question how AMT would cost them $14k more over standard taxes. He says AMT costs $14 above witholding. But that doesn't mean AMT is $14k more than the normal tax liability.

[KJ]

Wow, thanks everyone for all the great advice!

I have thought about a rental property, but need to educate myself more on this before I take the plunge. My personality also doesn't lend itself well to buying a place and letting someone live in it and possibly trash the place.

@Rick- I have an old 401(k) that I rolled into a Rollover IRA. From what I understand, if I contributed to a non-deductible IRA, then tried to convert, I'd be subjected to the 'pro-rata' rule that taxes all IRA funds?

@OldLimey- thanks for your advice. I'm a long-time fan of yours. Would you also recommend VFIIX for some of this extra money? I think I remember you mentioning GNMAs before.

@Carol- I agree that sticking with a 30 year mortgage makes sense from a security standpoint. We will throw some extra $$ at the principal when we can.

@Jim and Mark- you're right- AMT doesn't cost us $14K, rather AMT cost us $6315 last year. I think we may need to up the withholdings more. But I might rather just keep some of that money and try to get some return on it before I hand it over to Uncle Sam every quarter.

For deductions, we have the usual mortgage and property taxes, then charitable giving, etc. Stock options get us. We exercise those every spring instead of leaving them in company stock. That's a likely culprit.

Thanks everyone for your time. Greatly appreciated!

[fka CPA Abroad]

KJ - on the Rollover IRA, you are correct. That will get you on the pro-rata rules. Sadly I know from similar experience. However, if you have not added to it since rolling it over (i.e. made IRA contributions to it) then you may be able to roll it into your current employer's 401k plan, depending on the plan's rules. May be something to look into because it can get you out of that situation and back into a situation where you can do a backdoor Roth.

Also to note, your IRA account and your wife's are separate. This means that as long as your wife did not do a rollover IRA she could still do the backdoor Roth without worrying about the pro-rata rule.

As an aside, I have never seen this exact topic addressed in any financial magazine or website that I have read. Everyone urges you to do a Rollover but they never mention this consequence.

[KJ]

CPA- you're exactly right in my experience- I never saw this addressed at all when many publications discussed the ROTH conversions. Luckily, a financial planner that I happened to speak to told me to be careful with conversions. I have opened a non-deduct IRA for my wife and will convert. Thanks!

[jim]

Ah, ok if you have ISO options then that would explain the AMT issue. Thats the detail I was missing. My understanding is that ISO options are NOT subject to normal witholding when exercised and you're allowed to hold them and potentially only pay capital gains. However the spread for ISO between grant and exercise IS counted when figuring AMT. So you would effectively have a large income source that isn't being taxed ordinarily but is caught by AMT. Seems that if you exercise an ISO for enough then you'll likely be hit with AMT. ISO spread is one of the things that AMT is actually meant to catch. ISO's could potentially be better for you cause they allow you to potentially only pay capital gains 15% tax rather than regular marginal income tax.

NSO options on the other hand are taxed as regular income when you exercise them, so no AMT cause you're just paying normal income tax on the profit. (I get NSO options at work)

I agree with Rick about talking to a CPA. You might want to see if you can find a CPA who is good with handling stock options and and see if they can help you structure it best to minimize the tax impact.

ref :
http://www.nceo.org/main/article.php/id/16