We love getting emails from readers here at Frugalwoods HQ and were intrigued recently by reader Jeff’s question as to what he and his wife should do with a $250,000 windfall they’ll soon receive. A good problem to have! Other than swim in it, buy treats for Frugal Hound, or shove it under a mattress (none of which we would actually advise), what’s a person with an unexpected lump sum to do?
I want to put this one to the Frugalwoods readership and ask you all to weigh in on Jeff’s quandary. But first, let’s hear from Jeff himself.
Jeff wrote in:
I’m 30, married, and have two little kids (both under 5) at home. I’m currently employed as a professional in a fairly comfortable job and my wife stays home. Over the past few years, we’ve been working feverishly at paying off substantial debt from my grad school education (six-figures and then some).
Fortunately, I make a pretty good salary, due in large part to my expensive degree, so we were able to hack away at it pretty quickly. Now, there is finally light at the end of the tunnel! We expect to pay off the last chunk of debt within the next few months. It’s been a long, hard journey but we’re glad to be almost done.
There is an even brighter light at the end of the tunnel, though. Through a series of fortunate circumstances, we’ll be coming into a pretty large chunk of cash within the next year – to the tune of around $250,000, taxes-paid. Our question now is: what should we do with it?
We own a home (with a mortgage still), our cars, and have no debt other than mortgage. We have some paltry retirement savings, but not much else. So, obviously, we’ll max out our retirement accounts for the year and keep enough cash handy to max them out for the following year. After that’s done, though, we’ll still have a fair bit left over. What should we do with the remainder?
I’ve always fancied the idea of becoming a landlord and would love to own rental property, but that aspiration is countered by my aversion to taking on any more debt. Should I pursue that? Any other ideas?
An interesting dilemma to be sure. I applaud Jeff and his wife for paying off Jeff’s hefty six-figure graduate school debt, that’s no small feat! A number of follow-up questions immediately sprang to mind after I read his initial email and Jeff was kind enough to indulge me with his answers:
Mrs. FW: First and foremost, what’s your overall goal? And the timeline for that goal? Do you hope to retire early? Or something else?
Jeff: I think my overall goal is financial security for my family. Obviously there’s no timeline for that since it’s ongoing, but each paycheck brings it closer in my mind. I’m not sure that I want to retire early or that I’ll even be able to do that, but I would like to be more free to pursue a few business ventures that I’ve got in my mind. That being said, I’m a bit of a fraidy cat when it comes to pursuing my business ideas. My conservative, spend-no-money side always seems to win out over my risk-taking, entrepreneurial side.
Mrs. FW: Regarding the idea of you becoming a landlord: Are you handy with DIY projects and home renovation-type work?
Jeff: Not in the least. Haha. That could be a problem. However, I’m a pretty quick learner and think I could pick up handyman skills with some practice.
Mrs. FW: Where in the United States do you live?
Jeff: The Midwest. Unfortunately, real estate and rental prices in my area aren’t great for a buy/rent-out strategy. It’s very tough to meet the 1% rule.
Mrs. FW: What’s your tolerance for financial risk?
Jeff: Low, although I think that’s more the influence of my better half and the fact that I’m a father. If I were single, I’d have a much higher appetite.
Mrs. FW: What’s your annual salary? Do you get a 401K match?
Jeff: Annual salary is roughly $125,000. No 401k match 🙁
Mrs. FW: What are your annual expenses?
Jeff: Higher than they should be at around $40,000-$45,000.
Mrs. FW: What are your after-tax liquid assets (checking, savings account, brokerage account)?
Jeff: Liquid of about $25,000.
Mrs. FW: What are your retirement assets (401K, IRA, Pension, etc…)?
Jeff: Non-liquid of about $250,000 (that includes the windfall money since we already have access to it, we’re just holding it for certain reasons). Plus around $30,000 in my retirement account. Not much in the way of retirement savings since we’ve basically put everything we have toward the debt.
Mrs. FW: Does your wife plan to work in the future or continue staying at home?
Jeff: She wants to stay at home. Maybe when the kids grow up she’ll go back to work since she has solid work experience and an attractive degree. We’ll see.
Mrs. FW: What are your wife’s goals? Are you two aligned in your vision of frugality/savings/the future? I’m assuming you probably are since you were able to pay down your monster debt!
Jeff: We’re definitely aligned and her goal is the same as mine – financial security for our family. We also put a pretty high value on being independent from a schedule/location/job perspective (i.e. free to do what we want, when we want it). That being said, we’re not quite as gung-ho as others out there about reaching that stage of independence and I’m not sure we’ll ever be. I think we’re okay with that.
Mrs. FW: Tell me about your current mortgage:
Jeff: Home value is $250,000; mortgage principal owed is $150,000; mortgage interest rate is 4%.
Many thanks to Jeff for sharing this case study with us! And now, for our thoughts…
Before we get into the money mechanics, I must stress that we of the Frugalwoods family aren’t financial advisors. Point in fact, some of our blog posts are written by a less-than-smart (though very pretty) greyhound. Use this as a starting point for your own exploration; the below is simply what Mr. Frugalwoods and I would do if we received a $250K windfall in Jeff’s situation.
Mrs. Frugalwoods: In holistically assessing Jeff’s financial situation, I’d say he and his wife have done a number of things extremely well! Becoming debt-free (other than their mortgage) is an incredible accomplishment! What’s too bad is that it was done to the detriment of their retirement savings. Lucky for them, this windfall of $250,000 could go a long way in making up lost ground on that front.
Savings Accounts Side Note
One of the easiest ways to optimize your money is to keep it in a high-interest savings account. With these accounts, interest works in YOUR favor (as opposed to the interest rates on debt, which work against you). Having money in a no (or low) interest savings account is a waste of resources because your money is sitting there doing nothing. Don’t let your money be lazy! Make it work for you! And now, enjoy some explanatory math:
- Let’s say you have $5,000 in a savings account that earns 0% interest. In a year’s time, your $5,000 will still be… $5,000.
- Let’s say you instead put that $5,000 into an American Express Personal Savings account that–as of this writing–earns 1.70% in interest. In one year, your $5,000 will have increased to $5,085.67. That means you earned $85.67 just by having your money in a high-interest account.
And you didn’t have to do anything! I’m a big fan of earning money while doing nothing. I mean, is anybody not a fan of that? Apparently so, because anyone who uses a low (or no) interest savings account is NOT making money while doing nothing. Don’t be that person. Be the person who earns money while sleeping. Rack up the interest and prosper. More about high-interest savings accounts, as well as the ones I recommend, here: The Best High Interest Rate Online Savings Accounts.
Additionally, Jeff admits that his family’s annual expenses of $40,000-$50,000 are higher than they ought to be (and I agree). If Jeff decides to truly work towards a version of financial security and/or independence, those expenses must come way down. But, this is a personal preference–Jeff and his wife will need to determine exactly what they want for their future. Hint: if you’re looking for tips on how to reduce your spending, check out How We Save 65% Annually and take our Uber Frugal Month Challenge.
Another wonderful aspect of Jeff’s finances is his relationship with his wife and the fact that they’re aligned in their goals. If you have a partner, I’d argue that nothing is more integral to your long-term success than being on the same financial page. Can you imagine how different this case study would be if Jeff wanted to blow the dough on a car while his wife begged him to invest it? Wouldn’t be so fun.
Regarding Jeff’s question on becoming a landlord–while I appreciate his entrepreneurial spirit, it seems like it might be something he should consider in the future. In the meantime, I suggest he get to know his local real estate market well and research the intricacies of owning rental properties. And if his local market doesn’t have good valuations for renting, becoming a remote landlord is a possibility–though it certainly comes with a set of challenges.
Furthermore, rental properties are not passive income–even if you hire a property manager. It’s more of a second job. Jeff should carefully consider the time and energy he’d need to invest in order to receive a return on his rental properties. It’s not like investing in the stock market–the stock market doesn’t call you at 3am to let you know that its basement is flooded. And based on Jeff’s answers regarding his level of DIY prowess, I’m thinking this is a no go. Can’t be calling a plumber/electrician/handyman every time something breaks or you’ll quickly eat up your profits. What do our rental property-owning readers advise?
Mr. Frugalwoods: First, let’s cover Jeff’s retirement bases. Fill up those pre-tax savings! At his income level ($125K/year), there are serious savings to be gained by shielding earned income from the tax man. This year, max out and then keep it up in subsequent years even without the windfall.
- $18K into Jeff’s 401K
- $5.5K into Jeff’s Roth IRA
- $5.5K into Jeff’s wife’s Roth IRA
(update: Clearly I have no idea what year it is, previously this said to put $5,000 in their roths but the actual limit for 2014 is $5,500. Thanks to reader Mysticaltyger for catching it in the comments!)
Those are the obvious moves, which I think he’s planning on already, but that only uses $29K of Jeff’s $250K windfall.
I’d consider Jeff’s mortgage interest rate too low to bother paying off. Some people will disagree, and I’m all for doing what makes you sleep well at night, but the math-based approach that I personally find comforting is to invest instead of paying off super low interest debt.
My advice is to put the after-retirement $221,000 into a broadly diversified stock portfolio.
When designing this portfolio I’m going to consider the total amount ($250K) and we’ll talk about what account to use for what portion later when we consider taxes.
I’m a fan of the Boglehead style three-fund portfolio. So simple even Frugal Hound could set it up, the three-fund portfolio provides nice diversity while keeping expenses really low. And since it’s so simple, there’s less to tweak and monitor. For the most part you can set it and forget it! Except for continuing to invest additional funds, of course.
Given Jeff’s age (30) I’d go heavily towards equities (more volatile, but better long term returns) and less towards bonds. In a three-fund scenario that looks like:
- 60% Total Market Index FSTVX ($150K)
- 30% Global Market Ex-US Index FSGDX ($75K)
- 10% Bond Index FSITX ($25K)
(I included the Fidelity funds I use as an example, but you could build the same thing out of Vanguard funds just as easily. Those Fidelity Spartan funds are basically 1:1 copies of Vanguard anyway.)
Now before the Internet calls me reckless for recommending 90% equities, remember a couple of things:
- Jeff is young. At 30, with his spending and income levels, it’s going to be many years before he retires. He can afford some volatility in the short term.
- This $250K isn’t actually Jeff’s entire portfolio. He has $25K in cash (he doesn’t call it an emergency fund, but we’ll assume it is) so his real “low growth, low volatility” holding would be 18%.
Here’s the hard part about this strategy: Jeff should keep this money saved. Since he’s 30, with little retirement savings up to this point, this entire amount needs to be considered retirement savings. Treat it like you’d treat a 401K: no withdrawals. This windfall is the magic retirement savings reset button. Don’t mess it up!