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The windfall question

December 30th, 2008 at 05:54 pm

"What would you do if you had received $10k? Or $100k? Or $1 million?"

Ah, those question never seems to get old do they? How nice it would be to dream. Oh, don't get me wrong though. I'm not complaining. It never gets old for me either.

Unfortunately, I think many overestimate the buying power of their windfalls....

For example, a common response to the windfall question is, "I'd take some and buy a reasonable car." Certainly, it would be wise to not have a car payment, but the expenses doesn't stop there, right? At the very least, you'll still need money to put gas in the tank, oil changes, tire replacements, insurance, tag, inspection, so on and so forth. That too is a part of the total cost of ownership, and wouldn't it be nice to be able to pay that with your windfall as well?

And how much does all that add up to? Well, for the sake of this conversation, let's just assume that it's an average of $200 per month, or $2400 a year. I'm low-balling this by the way, and some could be paying that much on insurance alone.

Now, because this is a frequent, recurring expense, it's going to have to be in some kind of taxable investment in order to generate a monthly income. Let's pretend that you can find an average of 4% somewhere fairly guaranteed.

That means you'll need an investment principal of $60,000 to generate about $200 a month at 4%. Yikes.

Now, I admit, that's a concept in generating the money in perpetuity. While I love the idea of perpetuity, in real life, it's not easy to achieve at all. But if you really care about perpetuity-- which again, would really be nice-- then you'll also want to factor in the historical rate of inflation, which could be another 3%. But to be nice and continue low-balling this figure, I'm going to skip this part.

What we can't get away from is the fact that the interest will also be taxed. Let's again make this easy and low ball the capital gains tax at, oh say, 15%. The capital gains taxes on the interest then is $360, which means the total passive income you have to generate each year is $2760. That increases the investment principal you need to more like $70k total.

Whew! Scary. Are we done yet? Sadly no, because realistically, our car can't last forever right? But it would sure be nice if our car fund also has the power to generate enough money to replace our car as well. And how much would that be?

Let's pretend that you want to buy a $10k car every 10 years, or $1k of extra income each year. To be nice, let's pretend you found a way to minimize your taxes, and feeling especially generous, I won't factor that in. Aren't I a nice low-baller? So, you "only" have to add an additional $25K into your car fund, pushing up the total principal to about $95k.

Now, let's revisit the windfall question again: What would you do if you received a nice windfall of $100k? For me, based on the above, I would simply say, "Well, I'd buy a car." and that's it. Hehe. And it wouldn't be a bad way to go either because cars are a terrible depreciating asset to begin with, and you'll always have a car knowing that you'd never have pay a single dime in car loan interest again.

But now, imagine how much money you'll need to cover the rest of your life's expenses. Just the thought of it is enough to make this man's skin crawl.

I suppose if there is a moral of this story, it would be not to underestimate the amount of money you really need just to survive. I think not realizing this is why so many lottery winners fail in the end. It also illustrates the tremendous power of earned income.

14 Responses to “The windfall question”

  1. disneysteve Says:

    Interesting point of view. It does hammer in the point of why we talk about saving a couple million dollars for retirement. It may sound like a lot of money, but when you break it down to what it will actually provide in income, it isn't all that much.

  2. Broken Arrow Says:

    You're absolutely right Steve. I've made that point elsewhere before as well: That I don't want to be a millionaire. I NEED to be a millionaire.

  3. jIM_Ohio Says:

    The 4% rule includes taxes (meaning 3% for withdraw and 1% for taxes), so if the money for the car was in a taxable account, you could withdraw more or choose a tax free/ tax efficient method. For example 1/2 muni bonds (tax free 3%), 1/4 dividends (taxed at 15%) and 1/4 cash (not taxed) or interest (taxed at 15 or 25%).

    I deal with this in retirement planning. A NEW car probably costs an owner around $80k over life of car (right now).

    20k for purchase and taxes
    $50 for annual registation (assume $500 over life of car)
    $1000 for annual insurance first 5 years and $500 for next 5 (total cost of $7500).
    $400 for yearly oil changes and maintainance (assume filters, tires etc are included in this). $4000 over life of car.
    Last 5 years add another $500 to car repair budget (to be on safe side).
    $34400 is what I added this up to be over 10 years.
    **as you pointed out the insurance is a higher cost for some (might triple what I listed) and repairs will also depend on make/model (costs more to fix a porsche than a cavalier).

    So the yearly car budget is $3440. This number is in "retirement expenses" as a fixed cost. My car more expensive than yours and I came out with a lower per year amount, I think. Check my math.
    While working this is a variable cost (20k one year, then $1000 the next, for example).

    So from a retirement/ passive standpoint it is easier to budget this backwards. Assuming a 5% withdraw (because of tax efficiency)
    $3440 (yearly cost)/.05=$68800 needed.

    Invest $68800
    year 1 take out $3440, drive what you have now
    year 2 take out another $3440. drive what you have now
    and so on... in year 6 or 7 BUY the car.

    This technique has many advantages- only take the $3440 withdraw in a year where the investment of choice had a positive return (the 4% or 5% rule has "down markets" built into the withdraw rate, if you avoid withdrawing in down markets, you can up withdraw rate to 6-8%).

    If you have a windfall (like 100k) my best advice-
    set aside 33% for federal taxes, another 2-8% for state taxes (41% total).
    Spend 10% of the balance (so $4900)
    let the other 90% of the post tax balance sit there for about 6-12 months then make a decision.

    I know someone which has won the lottery twice. Squandered it the first time and got smarter the second time around.

  4. Broken Arrow Says:

    Ah, a wonderful response Jim.

    Yes, a good point to pick out is tax efficiency. That's why I didn't tax the car replacement portion of the fund, but I used the short term capital gains rule for the car maintenance portion.

    Though the exact figures we are using are different, it seems we can basically agree on the conclusion for such a windfall.

    Thank you for adding your thoughts on the matter. (I also pruned the first duplicate comment, if you don't mind.)

  5. swimgirl Says:

    So even if we win a ton of money, we're all screwed, huh, BA?!

  6. Broken Arrow Says:

    Oh no, swimgirl! Winning a ton of money is still winning a ton of money, which in a ton more than... not winning it.

    And I should emphasize again that I'm looking at it in terms of passive income as well as near-perpetuity. People don't have to look at it that way, but I do as a way to offer a different perspective. After all, isn't financial freedom or at least financial wellness what we're all working towards?

    People only screw themselves when they spend it like it can last forever.

  7. jIM_Ohio Says:

    I think this "perpetual" discussion needs some other parameters.

    For example a person only perpetually needs a car from age 20-80. Car lasts 10 years, so only 6 cars are needed, and the expense is not needed EVERY year, just every decade. And an 85 year old probably should not be driving.

    Where as if we are talking about eating, that is done 3-5X a day 365 times a year from age 0 to age 90 or 100.

    If you get volatility with the car (poor investment performance) you can skip the new car until year 11 or 12 when market recovers, where as food would need a more conservative philosphy to remove volatility so I could eat tommorrow or next year.

    It is easier to withdraw from taxable accounts than it is from IRAs or similar as well. Taxes are less (than a 401k or any deductable account), and tax efficiency is easier to control than market performance for the individual investor.

  8. swimgirl Says:

    I know, I know... I wouldn't turn down a ton of money! But y'all were making it sound so dismal!

    Jim, I try to minimize grocery costs for just that reason. You eat it and it's gone. Like just eating cash out of your wallet! Of course, there ARE health and growth benefits, but...

    Our cars are 10 year old and 6 years old. Both need a little work, which I hope to take care of in the first few months of 2009. But it's right around the 6 year old mark that I start feeling SO happy that I have a car that costs me nothing but gas and a few repairs (okay, and insurance). When I think of people with $400-700 car payments... yikes! I hope we don't need another car for at least 2 years. Then I'll feel like we really got our money's worth out of that 1998 Toyota! It could probably run forever, and for that reason we'll probably keep it for things around town. But I have safety concerns on the freeway.

    But which of us, anyway, would spend a windfall on a CAR?!!!!

  9. merch Says:

    Aston Martin DBS


  10. baselle Says:

    At 46, I definitely behind in my car buying. What if you don't need a car? Big Grin The windfall question boils down to the fact that you need to train yourself to manage and handle small amounts of money first before you get the "windfall". If you are bad with small amounts of money, you will not magically improve with the windfall.

    And I agree with the general sentiment that several desires outstrip a windfall, even a large one.

  11. gamecock43 Says:

    I have ALWAYS seen peoples standards of living increase with every windfall in their life. My standards of living increased dramatically as well when I had a windfall...though after a year I scaled back a lot- but I still think I live beyond my salary level a bit.- even though my friends think I am frugal- BB and I live much better than a couple with a 30k yr income normally lives. Getting money DOES cost money. Its amazing.

  12. fern Says:

    Jim, i think your estimate of total car ownership costs is way off. If you see my Sept. 6 post, i documented all costs associated with my 10-year old Honda. I plan to hold onto it a few more years, but as of the time i wrote it, the total cot was just $33,597, nowhere close to $80,000. I bought it new.

  13. jIM Says:

    The 80k number assumes inflation for retirement purposes. You are correct in that current costs of ownership are lower.

  14. Broken Arrow Says:

    Heh. That's another good point Jim. The duration in which this car fund will vary from one person to another, and it technically does not have pay in perpetuity. I did come out and say that in so many words, though perhaps not explicitly. But that's also why the funds may not need to be as large as I am making it out to be.

    I think another point I want to emphasize is that this is only ONE route to consider the windfall question, as many other can apply as well, such as buying a house, fund retirement/college educations, and even just knowing how much to blow.

    In any case, I just wanted to bring to light the option of establishing passive income in the face of a large windfall. After all, a finite sum does not have to addressed with finite options. Again, mostly just food for thought, and there have been excellent thoughts in this thread. Thanks again!

    Oh, and merch, can I ride in your Aston Martin when you get it?

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