Set Budget Priorities With Net Spendable Income

When you were in school did you ever notice that most people would use all the time they had for a particular assignment? The teacher would assign a book report or a paper and most of us would work on it until the very last second it was due. Likewise most of us used up every single minute available during a test, regardless of whether the instructor gave the class extra time at the very end.

I think that we tend to fill up all the time we have available, regardless of the work load. Now clearly there are some “step-function” changes in workload that would require significantly more time to complete, but for the most part we would still work the same number of hours if our workload increased or decreased 20%.

From what I’ve observed most people tend to do the same thing with their money. We grow or shrink our spending based on our current income because it’s the easy thing to do. And we spend most of what we earn because we place spending before saving in our budget. After all, spending comes right after “Income” in every budget form I’ve ever seen. I did this too for quite some time, until I started to work from my “net spendable income” instead of my “income”.

Net Spendable Income (my definition) means the amount of income you have available to spend within your budget. When the net spendable income (NSI) runs out, you stop spending. Period.

The different between NSI and “regular” income is that it allows you to prioritize your spending in a new way. Similar to having money taken directly out of your check each pay period for investments or medical insurance, using the concept of NSI allows you to reorder your priorities within your budget.

Instead of spending in this order:

1. debt payments
2. lifestyle
3. savings (if anything is left!)

You can place your key goals above your Net Spendable Income in your budget. One example would be to place giving and saving for retirement ahead of additional spending on lifestyle:

income
- giving (tithe, or other giving)
- saving for retirement (or college or a replacement car, etc)

= Net Spendable Income

- Debt Payments

- Lifestyle spending

= 0

By figuring out your net spendable income based on your goals, you will quickly recalibrate your thinking (and budget) to work within your NSI limit. Similar to using all of the time for a test or project, you have artificially shrunk the available resource in order to achieve your goals.

I realize this is just a mental accounting trick, but it has really helped me with my budget. It has also helped me stick with it in the area of giving, because I no longer consider those funds “mine” or up for debate.

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Your Kids (probably) Aren’t Above Average

I recently read a startling survey regarding parents and their beliefs about paying for college. The survey was done in 2006, and essentially shows that parents have unrealistic beliefs about their children. The survey states that 72% of parents believe their children have special talents that will award them scholarships.

Mathematically speaking half of all children are above average, and half are below. Just like doctor’s graduating from medical school, we can’t all be above average.

In contrast to the parents’ beliefs, 92% of financial aid administrators surveyed say parents overestimate the amount of scholarships and grant funds they will receive.

I don’t have kids (yet), but it doesn’t take much of a reach to understand that parents tend to believe their kids are better, smarter, and more talented than other kids. I’m sure they are, but it’s not prudent to assume that these differences will actually generate a free or subsidized ride to college. From a savings perspective it is better to assume that your children won’t receive any grants or scholarships. If they do, great. They can use all of that “extra” money in a 529 for graduate school or medical school later in life. Or you could use it for another child or grandchild.

A previous boss of mine actually offered his college-bound daughter half of whatever grants and scholarships she was awarded. He probably had too much income for his daughter to get any other financial aid, but scholarships and grants are open to anyone who applies. This method gives his daughter an incentive to search and apply for scholarships, and he gets a benefit as well.

Image Credit: juhansonin

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Asset LOCATION Is The Key To Building Wealth, Part 2

Today I’ll cover the second half of the Asset Location series.

The second study I referred to above was conducted by Spatt, and was published in June of 2004. This study focuses more on taxable bonds and equities, and essentially makes a recommendation in line with the usual thinking: place taxable bonds in tax-deferred accounts and then fill up those accounts with equities. Any remaining investment in equities should reside in taxable accounts. Here are the recommended steps as I see them:

• First fill your tax-deferred accounts with taxable bonds until your asset allocation is reached.
• Next add equities (or the next most tax-inefficient securities), provided your taxable accounts contain only equities. In other words you should not have taxable bonds and equities in your tax-deferred accounts if you also have bonds and equities in your taxable accounts. You should move your bonds from your taxable accounts into your tax deferred accounts and then use equities to fill in the rest of your tax-deferred and taxable accounts.
• If you’re worried about liquidity issues the study says that you can keep a small bond element in your taxable accounts, but that in general the benefits of keeping all of your bonds in a tax-deferred account will outweigh the risk of having to sell out of equity positions if liquidity (funds) are needed. I have an emergency fund, so I don’t expect to have any liquidity issues.
• The paper doesn’t recommend taxable over tax-free bonds in the taxable account. I take this to mean that it’s up to us to figure out if our after-tax yield is better with municipals than it would be for taxable bonds. This, of course, will be based on your tax bracket; the higher your tax bracket, the more likely it is that municipals will be a better choice for you.
• The paper mentions the first study I discussed (Shover), and argues that their solution is correct only if the equity investments are tax in-efficient and if they outperform similar tax-efficient investments. Their recommendation is to hold tax-efficient equity investments (i.e. index funds or individual stocks that are rarely sold). Therefore these two study are in agreement. They both recommend using tax-efficient equity investments and placing these investments in the taxable accounts.

This paper is full of wonder quotes and observations. Here are a few favorites:

“…the traditional approach to financial planning, in which the interaction between the taxable and tax-deferred accounts is largely ignored.”

I haven’t worked much with financial planners, but in general I believe this is a true statement. The paper refers to studies that show 40-50% of people who own equities in tax-deffered accounts also own bonds in taxable accounts. I think most financial advisors recommend a mix of stocks and bonds in both tax-deferred and taxable accounts, or they overweight equities in the tax-deferred accounts.

“When held in the taxable account, equity generates less ordinary income than taxable bonds, provides the investor with a valuable tax-timing option to realize capital losses and defer capital gains, and allows the investor to avoid payment of the tax on capital gains altogether at the time of death.”

The key point on this one is that investment in taxable accounts benefit from a “stepped-up” basis upon death. This means that your heirs won’t own any taxes on your taxable investments, but would have to pay taxes on (traditional) IRA distributions. I’m not a financial, estate planning, or tax adviser, so you should work with a professional if you find yourself in an inheritance situation.

“equity is less valuable when held in the tax-deferred account”

I’m assuming these is referring to the fact that you can’t harvest losses, manage your taxes, or pass on retirement funds on a stepped-up basis to heirs.

Two other factoids came up during my research. One piece of data that was thrown around was that only 15% of investors use index funds. The second was that investors can lose up to 20% of their after-tax returns by locating investments in the wrong type of account.

Summary: Asset Location is a major key to achieving long-term after-tax wealth. Asset location is also easy to overlook, and it can be a costly mistake to fix later in one’s investing timeline.

Image Credit: odalaigh

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I.O.U.S.A. Movie In Theaters This Week

I.O.U.S.A. is a movie about our (America’s) national debt, and how it’s way out of control. I’m not usually that interested in independent films, but I’ll probably rent this one on Netflix when it comes out. After all, I don’t want to slow down my debt repayment progress by spending $5-$10 on a movie about overspending!

Either way it looks interesting, and if you’ve already seen the new Batman movie this might be worth a look.

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