One of the best experiences I enjoy authoring this blog is the e-mails I receive from different people every day. To take a peek into other people’s finances and to generate happiness by helping others. This alone is worth the effort of writing.
So recently I got this e-mail from someone, let’s call him Richard who agreed to share it with you.
Hello Michael, Reading your blogs got me thinking. You’ve done a great job with them.
A few words about myself and what is the single biggest challenge that I face right now?…….. well I am 41 years old, married with 2 teenage kids. I have worked very hard since leaving school at 17. My line of work is specialist in the sense that not many people have the experience to do the role. This is a positive thing but negatively speaking there aren’t many jobs of mine out there and I now feel it is all I know (Marine Telecoms). I am a consultant and have my own ltd co. Unfortunately my job requires me to spend 6 months of the year working away from home. It’s because of this (and the fact that I’m going through a midlife crisis!!) that I am continuously looking for a retirement exit strategy. I want to retire early and get some time back with the family.
Present financial state……….
Ltd Co. income – At present my Ltd Co. currently makes company pension contributions. I pay myself tax efficiently with salary and dividends (<40% tax threshold). My wife also gets dividends. I have approx £35K surplus cash in the business.
Personal savings – I have approx £20K savings which is sitting in a bank account making 1.5% interest. Pension pot is sitting at approx £100K
Personal debt – Mortgage is £225K for a house worth £475K (looking at the market for my house/area, I can’t see any capital appreciation within the next 5 years).
Delemma – Things I constantly think about are………do I pay more into a pension, do I invest via the business surplus, do I invest with my personal savings, should I pay more mortgage off, should I try and get a buy to let for 15 years, should I build up my business surplus then draw down later, does anyone have a investment crystal ball, ……. basically how can I best make my money work for me to help me retire early? A common concern for most people my age I’m sure!
I know many people like Richard who are wondering where does one start in order to make money work towards their goals. So instead of replying directly to Richard, he agreed to make a blog post out of it, since there are so many good questions and everyone can benefit and contribute to what I have to say.
The good thing is that Richard worries about it and plans on taking action!
Taking action is the most important step in the process and analysis paralysis is the exact opposite.
So this case study is about writing my thoughts on the situation given the limited information I have. This is not advice at all. I’m just a blogger after all, think of me as a friend, not a professional financial advisor! Let’s dive in.
Goal: To spend more time with the family, drop away-from-home work and retire early.
See how money means having time in this world which is the whole concept of financial independence. Wealthy means rich in time to pursue what you want to do whereas rich means having plenty of money but not necessarily time to spend it happily.
Current financial state
Savings: £20,000 + £35,000 (company) = £55,000
Outstanding Mortgage: £225,000
Debt excl mortgage: 0
So basically the net worth excluding mortgage is £155,000, or £405,000 including the house capital.
Questions: What do I do with my different money buckets? Pensions? Business money? Pay more into a pension? Invest business surplus? Build up a business cash pile?
When talking about early retirement and financial freedom, the usual question you need to answer is “How much is enough?”. Starting from the end and working backwards helps to define the path you need to take.
Then you select from different options depending on your risk appetite and how flexible you are with working or not if needed.
Know where the money is going. I don’t know what income portion is saved each month, but having your expenses written down in numbers helps you plan better. Food, mortgage, bills etc are measurable and can be managed.
Having done this in the past I was able to cancel forgotten Skype subscriptions and spot money leakages or things that I overpay for.
Building an emergency fund is the next step. Regardless of financial independence and long-term plans, one should always have a few months saved in cash for the rainy days. This checkbox is already ticked in Richard’s case (£20,000 in a savings account and £35,000 in business accounts).
That’s too much cash sitting idle there and any money not earning interest is just eroded by inflation – 2.4% at the time of writing. Sure, the £20,000 is earning 1.5% annually which I presume is taxed, so effectively 1.2%. The emergency fund is far bigger than it needs to be so we’ll leave £20k in savings and that’s enough.
The next step would be to clear off any high-interest debt. Again, it’s great to see 0 bad debt here, otherwise, I’d treat that as an emergency!
I don’t consider mortgage as bad debt, especially when interest rates are so low. A mortgage is good debt and forces people to save. It also provides peace of mind for when you retire so no need to worry about paying for housing.
So you want to retire early
Off to the juicy stuff. The golden rule of thumb says that you should have 25x your annual expenses in invested assets in order to retire. In other words, the Trinity study suggests that you can withdraw 4% of your investment portfolio every year, to have a good chance of not running out of money in 30 years of retirement.
So when can Richard retire? If we assume the mortgage is paid off in 15 years time, and his family needs £30,000 per year (£2,500 a month) to live comfortably they will need an investment pot of £750,000 to achieve that. That includes pensions, ISAs, rental properties and anything really that counts as an income-generating asset.
As you can see, the whole “when can I retire” question depends not on your investment returns but on your savings rate! Not surprisingly, if you need less, let’s say £1,500 a month after housing which is equivalent to £3,500 a month if you pay rent/mortgage for an average 3-bed house in London, that’ll need a £450,000 pot to achieve that.
The number may look enormous but I have some good news for you.
Investment pot needed: £450,000
Current assets: £100,000 pension, £55,000 savings
Remaining pot: £295,000
In 15 years, Richard can build this pot if he saves and invests £500 a month! Accounting for a modest 2.5% of real returns (5% if you account for 2.5% inflation) this online calculator tells me this:
Of course, I have not accounted for tax as this would complicate things a lot more, but thankfully, in this modern era, we get such a good tax treatment with all the tax wrappers that are available. For example, the £500 a month that Richard will invest will produce tax-free returns inside an ISA. Also, drawing down from the pension, he and his wife would be able to withdraw 11,850*2 = £23,700 tax-free every year. And that’s just today, expect the tax-free income to increase.
A cautious reader will notice I have not mentioned inflation-adjusted expenses. But the 4% safe withdrawal rate in subsequent years are calculated by adding inflation to the previous year’s amount.
Priority of money buckets (invest more in pension? overpay mortgage?)
To get the most out of your investments, you need to take advantage of the different money buckets available.
Pay the low-interest debt first or invest? How much to invest in a pension and how much to keep in an accessible ISA?
One would think ISA is the best bucket to invest in (see how to choose the best ISA provider) but in fact, pensions (SIPP) are even better! That’s because you benefit from the tax break. ISA money is only your after-tax money but pension money comes before tax is applied. This means you’re only taxed on the remaining after-tax money but your money is locked in until your pension age.
Pension contributions is something I was debating with myself for a long time. How much do I contribute? If I contribute too much, I defer enjoying the money for too long. If I contribute too little I lose valuable tax benefits and pay a lot of tax right now.
The sweet spot according to my thinking should be to contribute as much as you can after reserving the money that you’ll need for all mid-term goals (kid’s college in 5-10 years etc). Why? Permanent employees will save on income tax and self-employed will save on corporation tax.
So first have an idea of big sums that you’ll likely need before the age you can access your pension. Deduct all your living costs, deduct those big sums and then some for unexpected events, and invest the rest into your pension.
It is very important to know about everything that happens inside your pension. Let me repeat that. IT’S IS VERY IMPORTANT TO KNOW ABOUT EVERYTHING THAT HAPPENS INSIDE YOUR PENSION.
Mainly: What are the fees? When can you access the money? Which funds do you invest in? Are these aligned with your goals? Generally, pensions should invest for capital growth and for the long-term, therefore globally low-cost index funds win the race once again.
I know that my pension is with Bestinvest, I can access it when I hit 58, I pay 0.3% platform fees and 0.22% fund fees for the Vanguard Lifestrategy autopilot fund I invest in. That’s it.
Overpay mortgage or invest?
This question depends more on your psychology than on the maths side. If you want the long story I’ve written this in the past (with numbers): Should I overpay my mortgage or invest?
TL;DR: How do you feel having a mortgage? Paying down the mortgage may make you feel great but money-wise is currently very cheap to have a mortgage. You can put the money to work elsewhere and let the debt shrink until interest-rates go higher.
However, overpaying the mortgage is a secure return on your money and you never know what happens with investments. I have yet to meet someone regretting they paid down theirs 🙂
Should I invest my business money?
If you plan to take a break from work, then it’s good to have a buffer. Otherwise, you should invest your company profits. This is not as hard as it sounds. Read this extensive post on how to invest your company money.
You can either lend money from your trading company to your investment company, or you can form a holding company which receives dividends. I have recently met with a good accountant who prepared my investment company books, PM me if you need one.
We certainly tackled a lot of topics here. Money management is not easy, but it’s worth planning for. Then you can adjust if needed.
The best thing that can happen to any early retiree is to retire at the beginning of a bull market. The worst is to retire just before a
market crash temporary decline.
The truth will be somewhere in the middle. The best course of action is to first plan and then flexibly draw down according to how markets perform.
But early retirees are smart people and I’m quite optimistic about their future 🙂 For example, how about working part-time for short periods? If you have this option then you’re in a much better situation – you can either retire even earlier or provide more safety to your retirement portfolio.
On that note, I wish Richard and everyone best of luck. Stay in touch and take it steady!
Disclaimer: This is not investment advice but general information for educational purposes only. As always, do your own research.