Approaching Financial Independence

Monica writes in with a great question:

I read Your Money or Your Life in 2002 and it changed my life. My dream has always been to be able to focus all of my energies on painting and I realized that if I didn’t actually make that my goal it would never happen. So I started drastically changing my life so that I could do that.

Over the last few months, I’ve begun to realize that I’m on the home stretch. I have $600,000 in my savings account that came from spending very little over the last decade. I own my home and have no debts of any kind. When I got my statement from the bank last month, I saw that I had made about $8,000 in interest over the last year on that money and so I started investigating how to set things up so that I could live in perpetuity on this money I saved.

Right now, I make about $1,000 a month on my paintings in profit after the expenses are paid. I have four or five slots at a local gallery, where I sell on average two paintings a month, which is about the same as my painting output as I do it in my spare time.

My living expenses are about $1,400 a month, meaning I need to consistently come up with a $400 shortfall each month beyond my paintings. The interest on that money in savings would provide that, so it would appear that I’m financially ready for this leap.

My question to you is how would you organize all of this so that it’s easy for me to step away? What’s the best way of moving from where I am right now to walking away from my job in six months or a year? I want to do this right, not just rush into something.

Right off the bat, I’d say that your current savings account is probably the best deal out there. My back-of-the-envelope math says that your savings account is earning you 1.2% or 1.25% interest or so, which is better than almost any other rock solid investment with a relatively short term out there on the market right now.

There are usually two options that people follow when it comes to setting things up for such long-term living. One, they buy certificates of deposit from a bank and set up a “ladder” or two, they buy long term treasuries from the government and live off of the payments. Let’s look at these two options.

CD “Ladder”
A certificate of deposit (often called a CD) is something you can buy from a bank. CDs are usually sold at a particular length of time and at a particular interest rate.

Typically, people will go to the bank, buy a CD with a particular interest rate and length, and wait for that length of time. At the end of that length of time, the buyer gets their money back plus the interest earned on the money during that period. If you try to get your money early, though, you usually have to pay a stiff penalty.

So, let’s say you find a 1 year CD at your local bank with an APY of 2%. You put $10,000 into it. At the end of the year, you get your $10,000 back and get another $200 back in interest. You can set this up to happen automatically so that the $200 gets rolled into your checking account and the $10,000 goes to buy another CD. All you see is the $200 in your checking account each year.

So, what’s a “ladder”? Let’s say you buy one of these CDs at the start of each month for a year. This means you’ve spent $120,000 on CDs over a year.

At the start of each month, one $10,000 CD matures, paying you $200 (assuming they’re always at 2% interest). That $10,000 then automatically buys another one year CD. That way, when that month rolls around next year, the same exact thing happens again.

The problem with this approach right now is that the interest rates on CDs are so incredibly low that you’re not really getting much of a boost at all beyond what interest rate you can get for an ordinary savings account. As the economy rebounds, these rates will go up and, eventually, CD rates will exceed savings account rates by enough to make it worthwhile.

If you’re thinking of this option, I offer a couple points of advice.

One, don’t put all of your money into this CD “ladder.” Keep at least a month’s worth of living expenses outside of this in savings as an emergency fund so that you don’t have to sell a CD early.

Two, wait to start this until there’s at least half a percent between a one year CD rate and what you can get in your savings account. Since you have to lock away your money for a year, you shouldn’t do it unless you’re getting some reasonable compensation for it.

Treasuries
Treasuries are sold by the United States government under several different names (treasury notes, treasury bonds, etc.), but they all function in more or less the same way.

In essence, when you buy a treasury from the government, it has a maturity date, a face value and a coupon value. Let’s say that the face value is $10,000 and the coupon value is 2% and the maturity date is 30 years down the road.

For the next thirty years, you’ll receive a payment every six months. That payment is equal to half of the face value times the coupon value. So, you’d receive a payment of $100 every six months for the next thirty years, at which point you’d get your original $10,000 back.

Most of the time, when you buy a treasury, you pay either a bit more or a bit less than the face value of the treasury, depending on the market at the time. The federal government makes buying them pretty easy using TreasuryDirect, but you can also buy them through brokerages.

A couple of thoughts:

Even if you own several treasuries, you’ll usually just get a single lump payment every six months. With good money management, this isn’t a problem. Of course, without good money management, you wouldn’t ever find yourself in this situation.

Treasuries are really really low right now. Just like CDs, I would be hesitant to lock down my money for such a long term with rates this low. I would wait for a while.

What Should Monica Do?
If I were her, I would jump on board with this sooner rather than later. She has more than enough money saved up to make this work and she already has her foot in the door with her painting.

I would live out of my savings account for a while until rates begin to rebound, then I would choose one of the above paths and set it up. Which one? I’d probably choose the CD ladder unless 30 year treasuries begin to have rates above 6 or 7%.

After that, the only worry is great painting.

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30 thoughts on “Approaching Financial Independence

  1. Arvin says:

    What about Series I Bonds?

  2. Johanna says:

    I wouldn’t worry too much about interest rates. Even if you have to pull $400/month out of your principal, your $600K nest egg will last you 125 years.

    However, you need to account for inflation. YMOYL tries to argue that inflation doesn’t exist, but that’s BS. You won’t be able to live on $1400/month forever. But without knowing how old you are, it’s hard to say what you should do about it.

  3. Steve says:

    What about health insurance?

  4. Nick says:

    Find a financial advisor. Trents advice is not prudent given your age and inflation risks.

  5. Des says:

    Two things to think about:

    1. Do you have private health insurance? Its hard for me to imagine that is included in the $1400 a month, but maybe you just have a very low cost of living.

    2. Do you pay taxes on your $1,000 painting income? If not, have you run the numbers on how much this will take? Self-employment tax is shockingly high. Also, is your $8,000 in interest before or after taxes?

    Other than that, you seem like you’re in a great position to make the leap! If you wanted to be cautious, you could dump your whole salary into savings and try living off your painting income plus $400 for the next 6-12 months. That would give you a feel for what it would be like (with the ups and downs of irregular income). I would also say, depending on your preferences and location, you like think about investing some of that $600k into a rental property. Where I live, $150k will buy a house that generates $700 a month after all expenses and taxes. A couple of those would pay all your expenses, plus leave $300k in savings, and relive any pressure to make your living from your art. YMMV.

  6. Vanessa says:

    Anyone who can save over half a million in ten years should be giving financial advice, not taking it!

  7. K Ann says:

    I’m with Vanessa!

  8. valleycat1 says:

    Once you’re putting all your energies into your art, you can assume you’ll be creating more pieces and having more time to market them or find additional galleries to increase your sales, so you’re not relying on your savings to take up the slack.

    But do be sure to find out how much your tax obligations are (as #5 mentioned) and set aside the $ for that – + once you’ve been full-time self-employed awhile you’ll need to be making quarterly estimated payments of income and social security. The IRS publications about this are pretty straightforward.

  9. prodgod says:

    I’m curious as to how you have such low living expenses. I’ll guess that you don’t have family expenses, but I wonder how you can cover property taxes, insurance, utilities, groceries, etc. on just $1,400 a month. Perhaps you have no car, no cell phone and you use the internet at the library. Others have asked about health insurance, which, as you get older, will be nearly as much as your total living expenses now. Anyway, sorry for all of the assumptions; I’m just very curious how one lives on so little. Kudos on the extreme saving!!!

  10. Gretchen says:

    Over half a mill cash on hand, basically?

    I can’t quite wrap my head around that on multiple levels.

    How old is Monica?

  11. Diane says:

    Without knowing Monica’s age, any answer(s) are mere speculation.
    If, in fact, her 600K was really saved in only ten years starting from zero and does not include an inheritance, I’d then say that her age is a moot point. More critical details are needed to provide a truly helpful response.

  12. Joanna says:

    Based on the info she gave, we can just assume she’s saved about 5,000 a month for the last ten years or so. If she has a good job, and her expenses are only 1400/mo, that’s not unbelievable. 1000/mo of that is coming from her art, so she’s only using 400/mo from her work salary, which would need to be over 80k a year for this to make sense.

    I would chime in with the others though, I don’t think she realizes the cost of health insurance once she loses her employers contribution. It could very well double her monthy expenditures. Even if it did, she could spend nearly 2 decades not working at double her current spending level. Most people are thrilled to retire with as much money in the bank as she has now.

  13. valleycat1 says:

    Another thing I don’t recall ever seeing in these discussions on TSD is writing up a business plan – both the narrative of how you plan to develop things over 5 years or so, a detailed budget (broken down quarterly, if not monthly) that will outline anticipated income/expenses, plus a cash flow analysis. Monica seems to be well capitalized, but it’s very helpful to get things down on paper – there can be some surprises when you get into the details. There are a lot of resources online or at the library for doing this.

  14. AnnJo says:

    First: It’s scary to read that Monica saw her balance on her SINGULAR bank statement. Monica, run, don’t walk, to split your savings among enough banks and credit unions to be sure it is all FDIC protected!!! I don’t consider that 100% protection, but your savings are at huge risk when you keep them all in one bank. If that bank goes belly-up, your savings are protected only up to the FDIC limit. The rest could be lost.

    Second, Monica’s ability to save is impressive. But I agree with Johanna that she has some exposure to inflation risks. When Trent calls savings accounts “rock solid” he is ignoring the loss of principal that inflation causes. That is unwise.

    Assuming her home is paid off, once she starts painting her primary expenses are going to be self-employment taxes, property taxes, food, utilities, other state and local taxes and licenses (sales, utility, gas, business receipts), and health insurance, all of which are experiencing greater increases than the overall CPI.

    CPI inflation over the last 12 months was 3.9%; Monica’s savings account earned 1.3%, so her savings actually LOST a net of $15,400 in purchasing power (at least) last year.

    There are a number of reasonably solid stocks with dividend yields of 3-4% in the energy and pharma sectors and some comsumer stocks. While there is a risk of principal loss with stocks, there is also a prospect of at least some inflation protection. If she can find a knowledgeable, conservative and honest financial advisor, Monica should consider diversifying her investments a little, to give herself some inflation protection.

  15. Mark Gavagan says:

    Monica,

    Depending upon your appetite for risk, interest in being a landlord and market conditions and opportunities near where you want to live, CONSIDER buying a multi-family house and living in one apartment.

    There are plenty of negatives in this, but if you find a great property (location, condition, easy to rent, on-premises laundry/parking, etc.) at a good price, it might be a great option.

    You could put 1/3 down and get a very low interest rate mortgage for the rest. You can always use part of your rental income to pay someone to do the work you don’t want to. Another benefit is that you’ll have two hedges against long-term inflation (the value of the property itself and the rental income – though both can fluctuate up or down).

    Thanks for reading.

    -Mark Gavagan, author of “12 Critical Things Your Family Needs to Know”

  16. Riki says:

    I agree that Trent’s advice is very simplistic given the amount of money Monica has to manage. A CD ladder isn’t going to cut it here at all.

    #1 Monica, get yourself a reputable financial planner ASAP. You need some solid advice targeted towards your age and personal situation. Trent is not the person to provide that information. Let me repeat: GET A FINANCIAL PLANNER. This is really important and it kind of scares me that you haven’t done it yet. $600K is too much money to have sitting in a savings account.

    #2 I agree with valleycat that you need a business plan. A detailed one. How many more paintings will you be able to produce if you’re painting full time? Will you want to paint full time? If you produce more paintings will you be able to sell them? Where will you sell them? What will you plan to spend on materials? You need to start thinking about painting as a business, get a tax number, and do it right (if you haven’t already).

    #3 Figure out what you’re going to do for Health Insurance. You don’t give any indication in your letter where you live, but even if you’re Canadian you still need to think about private health insurance once you leave your job. This cost needs to be factored into your budget.

    Overall, Monica, I worry that you’ve been a little naive with your money. BIG kudos to you for being able to save so much — but now you really need to take active control of this money. Being able to save is only part of the equation, now it needs good management.

  17. moom says:

    If she can consistently make $1000 a month from painting part-time then she should be able to make more from painting full time?

  18. Adam P says:

    Riki – your post is awesome. Great points! 100% agree with all of it. Monica, listen to Riki!

  19. Riki says:

    Why thank you, Adam! Too bad I don’t have $600K of my own money to manage, eh?

  20. Bettsi says:

    I have no advice for Monica- I just want to say “WELL DONE!”. What an incredible accomplishment! Trent, I find stories like this so inspiring, don’t you?

  21. valleycat1 says:

    RE #9′s comment on ‘such low living expenses” – my spouse & I live on approximately the same amount in California with NONE of the deprivations you assume: our home & vehicles are paid for; we own several small producing farm properties outright (all net income from them goes into retirement/savings); we have DSL/Wifi, cell phones with more than adequate data/talk plans, cable TV, recently renovated our kitchen, carry no CC debt, comfortably live within our budget, travel a little, & don’t feel deprived.

  22. Jonathan says:

    @Riki (#16) – I cannot say that on principle I disagree with anything you’ve said. I did want to point out, however, that we don’t know that Monica wants to grow her investment. Based on her email it seems possible that she simply wants to use her investment in order to supplement her art so that she can focus on her art full time. If she has no interest in growing her money, then it may not be necessary for her to use a financial planner. Based on 3% annual inflation and 1.25% interest on her savings account she should be able to survive for around 35 years with no other changes. This might be all that she wants to do, in which case her current plan seems sufficient. Although like you I would suggest she split her money into separate banks to ensure it is all insured by the FDIC.

  23. prodgod says:

    @valleycat1: I don’t know how you do it, but kudos to you, too.

  24. Courtney20 says:

    AnnJo – YES, the FDIC limit was my first thought as well and I can’t believe that Trent didn’t mention it. If her bank should happen to fail she is at risk of losing nearly 60% of her account balance, which is as bad as nearly any stock market crash.

  25. Riki says:

    Jonathan —

    I’m not assuming she wants to grow her investment either. I AM assuming, I suppose, that she wants to protect it. Allowing $600K to sit in a savings account isn’t very financialy savvy, as far as I’m concerned, and I think Monica really needs somebody to help her figure out what her goals are and then structure her money so it meets those needs AND is protected.

    Sure, she can survive without doing anything different. But we don’t know Monica’s age (that’s a big factor) and by not protecting herself against inflation, she’s opening up a lot of risk. What if she’s only 40? Sure, surviving for 35 years sounds like a long time but that only puts her at 75 . . . she could have a lot of life left with no money in the bank.

    She does need a financial planner. ASAP.

  26. Tom says:

    RE #9′s comment on ‘such low living expenses” – my spouse & I live on approximately the same amount in California
    If I didn’t have a mortgage and a student Loan, I think I would be around $1400-1500 a month too. I live in Delaware where property tax and home insurance would be approximately $2200 for the year.

    Speaking of insurance, someone with $600k in cash can acquire cheap insurance through bearing more risk by selecting a high deductible health plan with an HSA. Just because your company pays $15k per year for insurance doesn’t mean you have to pay that much. Also, the HSA can act as another savings account, where she can realize gains tax-free for medical purchases. I think this assumes no pre-existing conditions, YMMV by state.

  27. Jan says:

    Please pay attention to the advice on the FDIC limits and take action ASAP. I worked for the FDIC during the 80′s in Nebraska. I will never forget the faces of the retired farm couple in their 60′s who had just lost the majority of the savings because their bank failed. They had worked hard their whole lives only to lose it all because they were loyal to a certain bank. This really does happen.

    Also, keep in mind that if you are over the FDIC limit, your bank has no responsibility to inform you. It is your responsibility to watch the limits.

  28. Ugh. Bad advice today. GET A FINANCIAL PLANNER!

  29. getagrip says:

    If Monica is going to get a financial planner, I strongly suggest she take a little time and research the best ways to find one to meet her goals and needs and then screen them carefully. Too many are not truly “planners” and are nothing more than commission salesmen. For example, she could find herself getting hard pressured to buy an annuity with a nice fat commission to the “planner”, like my MIL recently faced when she met with someone on a friend’s recommendation.

    I also agree with everyone else that she should spread that money among banks below the FDIC limits (giving them a little room to grow). Even if she does nothing else.

    Finally, major kudos to Monica for having $600K in liquid assets.

  30. wink says:

    I can believe someone could live on $1400/mo but has Monica budgeted for expected and unexpected irregular financial outlays that always exist. Cars dont last forever, houses need repaired, medical emergencies, etc

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