In Ft. Lauderdale, Florida, 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.
Mrs. Bartlett 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, though, the property’s assessed value had reached $30 million, and Mrs. 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, Mrs. Bartlett was already 95 years old, so government officials figured they wouldn’t have to wait long. She ended up getting the better end of the deal, though. Mrs. Bartlett proceeded to live for another 14 years—until the age of 109—and thus, over those years, avoided tens of millions in real estate taxes.
This story is unusual, but in a way, it’s also characteristic of many financial decisions: A lot of questions in personal finance, unfortunately, 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 out of our control, it’s key to control what we can control—in other words, to know which questions can be answered without reference to a crystal ball. Below are some key calculations that fit that category.
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 65 but don’t start Social Security until 70. All things being equal, your withdrawal rate would be significantly higher for those first five years. If that’s the case, then 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, for example, your Social Security check will bring in $4,000 per month, or $48,000 per 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.
Bond returns. Buy a stock or a stock market fund, and it’s anyone’s guess what rate of return it will 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 (TIPS), investors enjoy an even greater level of certainty. Not only can you calculate its return, but you can know the return you’ll receive on top of inflation, regardless of how high, or low, inflation turns out to be during the years you own your bond.
Choosing bonds. Suppose you’re choosing between a Treasury bond and a comparable municipal bond. A key selling point of municipal bonds is that they’re free of Federal tax, 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. For example, 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% / (1-32%) = 5.2%. In this case, adjusting for taxes, the muni, at 5.2%, would be the better deal. If your tax rate were lower, though—say, 22%—then the Treasury would be the better deal.
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 1 is to add up outstanding debts, including any mortgage, student loan or other loan balances. 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 2 is to calculate an additional amount 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 per year. Then the calculation would be: $100,000 / 4% = $2.5 million. From that, you’d subtract what you already have in savings. For example, if you have $500,000, then the additional coverage you’d want, on top of the amount needed from Step 1, would be $2 million.
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.
Tax rates. Thinking about making a charitable donation? Many things about future taxes are unknowable, but this is one calculation you can do with some certainty. One caution: 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.
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 within a more typical range, there is 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.
