Ask the Blogger
First World Financial Problems
Do college or retirement savings come first? How much of my huge cash stockpile should I spend while working on a startup? And other questions, all answered in this week's Ask the Blogger column
We have a four year old and a two year old. How much and how should we save for their education? There is a lot of talk on your blog and elsewhere about a bubble in higher education and how student debt is crushing younger people. For a service that is going to go through a lot of changes how do you know how much to save for something that is well over a decade off? On a personal finance level – both me and my wife just past our 40th birthday. We own a house valued around $750K and only have about $150K left to pay off. We have been paying down the house about $50K per year so should be debt free in three more years. For the past two years we have also been putting $25K into a 529 for the kids. So at this point we have about $50K in a 529. Almost all our savings are in the house as we only have about $150K in other investments. When is the kids’ college fund topped up? Are we being foolish to save for the kids educations as opposed to our own retirement? Once the kids are in kindergarten our income should go up (we have been prioritizing family a lot over work while they are this age) and our expenses should drop. Also, our house will be paid off so we can allocate those savings to other investments.
Kids Future Or Ours?
First things first: will you adopt me? My husband and I don’t eat much, and we come with an adorable puppy. Plus, I enjoy saying "KFoo".
Yes, Dad, just kidding. We already have marvelous parents that we’re very fond of, and who did much the same as you are: plowing as much as possible into their kids education. For which we are very grateful, as well as very fond.
Even so, let me suggest that you have it a tiny bit backwards. When it comes to savings, you should follow what I like to call the RC COLA principle:
1. RETIREMENT first2. CHILDREN second3. COST OF LIVING ADJUSTMENTS last
Which is to say that you first save for your future, then their education, and only then—if there is anything left over—do you upgrade your lifestyle.
It sounds like you’re doing an admirable job on keeping the lifestyle down while you hit some savings goals. But the very first thing you need to do is make sure that your retirement needs are taking care of. If you offer your kids the choice of taking on some student loans, or having to have you move in with them, which gift do you think they’d rather have? Besides, as you mention, it's hard to get visibility on what college will cost in 15 years.
That’s not to say that you should neglect their education. But you’ll have plenty of money to do both—if you slow down on paying off the house. I know, I know. I hate debt too! But with only $150,000 left on what must have been a pretty big mortgage, even slowing down a lot at this point isn’t going to bankrupt you with interest payments. If your interest rates are very high, I suggest you refinance down to a 10-year mortgage, which will put you on a path to paying off the house with much lower interest rates than you are probably currently paying. But you shouldn’t be putting $50,000 a year into the house when you’re only doing minimal retirement saving. You don’t want to end up having to sell the house for walking-around money.
So let’s reallocate your savings. First, 15% of your income goes into retirement accounts. Then $10,000 to $15,000 into educational savings accounts for the kids. (If you're really worried that kids will just be using MOOCs instead of Harvard by then, there's an easy fix: stash the money in a regular account rather than a tax-advantaged account that's specially for education.) Then use whatever money is left over—and I’m guessing you’ll find some—to pay extra on the house.
My fiance and I are roughly-30-year-old software developers. We've both had some success in our 20s, which combined with a reasonably modest lifestyle, has resulted in close to $1 million in savings, about 30% of which is in retirement accounts.
So far so good. But about a year ago, we decided to leave our jobs and start a startup. We raised a little bit of money, so we can pay ourselves a little bit of salary (about enough to pay the rent and not much else), but most of our "compensation" is equity in a company that we're optimistic about, but is still pretty far from profitability.
How much should we be spending down our savings to supplement our income? We're well aware that equity in a not-yet-profitable company is a lottery ticket at best, so we're not factoring that into our budget at all. Still, it seems like this is a reasonable time to spend some of the surplus we've built up over the last few years. How do we figure out what balance to strike?
First World Problems
What a great problem to have! Will you adopt me?
(No, seriously, Dad, just kidding!)
You’ve already done the most important thing: you’re thinking it through in advance. My main advice to you is to settle on a number that you’re willing to spend in advance, and then stick to that number. Once you hit your pre-set spending limit, you need to both agree that you’re not going to let it slip—go on just one more vacation, or take just another six months trying to make the startup fly. The end is the end; you spend no more.
Then when you contemplate spending some money, remember that the supply is fixed, and a new television now may mean that later, you can’t go to the beach for a week even though you feel you really, really need a break or you’ll go crazy.
How much you’re willing to spend is a question only you can answer. It should go without saying (though I won’t let it) that you can’t touch those retirement accounts; withdrawals at your age will cost you a fortune. So that leaves you somewhere under $700,000 for everything else.
During your planning meeting, please recall that if this startup doesn’t work out, you may want a lot of that money for things like weddings, downpayments, and education for any future children. So I would set your spending limit low enough to leave room for all of those things—well under half. Personally, I'd leave it under $100,000--total, not per year. But as I say, only you can decide.
That said, I’ll leave you with a parting thought: you’re at an age when it’s fairly easy to live cheap. You’re young, you have a ton of energy, and you don’t have many obligations. When you hit your forties, it will feel much harder to live cheap: uncomfortable hotel rooms, cramped apartments, and falling apart furniture are harder to bear when your friends are more financially successful, and your joints are starting to hurt a bit. Plus children cost approximately 10% more than what any reasonable person can earn in a year. So err on the side of living cheap now, when you are already working a zillion hours and don’t care much. You'll enjoy that money at least as much in five years, I promise.
I'm 40ish, married, with three young kids. I make a good living ($240k+), we have $300k in a mortgage, and no other debt except a small car loan at a really low rate (less than $10k, less than 1%.) I'm self-employed, I max out my 401k, and have a nice emergency fund. My wife was a public school teacher for ten years, but no longer works and is unlikely to go back. She has around $100k in the state pension system. My question is whether we should leave it there. I realize there are tax consequences along with a 10% penalty, but it seems to me that I'd rather have $70k to maybe pay down my mortgage than wait for some paltry pension payment when we're in our 60's, assuming it would even be there. On the other hand, it also seems to me that I might be nuts. Thoughts?
Small Change, Big Penalties
I’m not going to ask you to adopt me, because after the last two questioners, my parents are probably already rewriting their wills. But this does seem to be the day for people in enviable financial positions! Envy registered, we move on to your question. Unfortunately, the answer is: depends on the pension system.
You will have noticed that many state pension systems are in huge trouble. It’s safe to assume that in the future, many more will get into trouble. Governments like to sweeten up the benefits in good times, and when the market predictably underperforms during down markets, they end up in big trouble. We're already seeing cities go into bankruptcy over this.
It seems unlikely to me—as I would guess it does to you—that cash-strapped governments will be able to keep all their promises, particularly to people like your wife, who left the system long before retirement. Unfortunately, there's no orderly process for dealing with a bankrupt state pension fund; cities can declare bankruptcy, but states can't. So in the event of a meltdown, things may get messy indeed.
But your plan might be fine; some are. Others are in the gray zone; if your plan is over 70% funded, then depending on the penalties, you’re probably better off leaving the money where it is.
But how can I tell? I hear you cry. Excellent question! You can find out the funding status of your plan in the database at the Center for Retirement Research. If your fund is among the 12% that are less than 60% funded I would definitely look into cashing out (preferably rolling it over to an IRA), even if there are substantial penalties. But be advised that there may be no way to get the money out, as the rules for withdrawal vary by system. In that case, you’ll just have to sit back and hope for the best, while taking comfort in the fact that you guys are clearly going to be comfortable no matter what happens.
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