On Track to an Early Retirement -- Almost

Hi Dr. Don,

Please review my portfolio to help me determine if I'm on track to meet my goals. I am 35 years old, with three children, ages 3, 8 and 12. I have been working overseas for the last six years; my annual salary and allowances total about $70,000 and my local housing and children's school fees are company-paid. I am able to invest an average of about $2,000 a month. We have a house in the U.S. assessed at $205,000; the 15-year mortgage will be paid off in about eight years. We don't have any other debts.

We have three goals: to pay off the mortgage, to pay the majority of our three children's college expenses (preferably at a good public university, such as my alma mater, the University of Wisconsin) and to retire early, i.e., before 50. I am aiming for a reasonably modest retirement, about $30,000 per annum in current dollars.

Our children's college funds are spread across three index funds, a balanced fund and a high-yield bond fund. Our retirement money is invested in about 10 stocks and a couple of mutual funds, including a large sector bet on health care. I realize that we have way too much money allocated to that sector. I'm trying to slowly reduce our weighting in health care by investing all new money outside of health care. I'm wary of investing in foreign companies, other than through ADRs, because of the foreign currency risk, having experienced this firsthand when I was working in Southeast Asia a few years ago. I fully fund my Roth IRA and my wife's Roth IRA, as well as our children's education IRAs, every January. All other funds are invested in taxable accounts. Any suggestions?

Thank you,

JM

JM's Taxable Accounts
Name	Shares	Market Price	Market Value	% Total Value	YTD Return
Avaya(AV)	7.316	14.24	104	0.1%	38.1%
Intel(INTC)	200	29.44	5,888	4.6	-2.0
Lucent Technologies(LU)	87.865	12.34	1,084	0.8	-8.5
Ericsson Telephone ADR B(ERICY)	200	8.38	1,675	1.3	-25.1
Microsoft(MSFT)	150	56.69	8,503	6.7	30.7
Vanguard Health Care(VGHCX)	322.2	120.19	38,725	30.3	-9.5
Vanguard Primecap(VPMCX)	149.455	56.10	8,384	6.6	-7.1
Cash($$$)	4,706.33	1.00	4,574	3.6
Account total:			68,938	53.9%
JM's Taxable College Funds
Vanguard 500 Index(VFINX)	58.16	114.09	6,635	5.2	-6.4
Vanguard Growth Index(VIGRX)	380.688	26.83	10,214	8.0	-12.2
Vanguard Total Stock Mkt Idx(VTSMX)	169.158	27.31	4,620	3.6	-6.7
Account total:			21,469	16.8%
JM's Kids' Education IRAs
Vanguard High-Yield Corporate(VWEHX)	220.201	6.98	1,537	1.2	6.0
Vanguard Wellington(VWELX)	149.824	29.15	4,367	3.4	3.3
Account total:			5,904	4.6%
JM's Roth IRA
Amazon.com(AMZN)	250.000	12.25	3,063	2.4	-21.3
Caterpillar(CAT)	228.116	46.84	10,685	8.4	-0.2
International Paper(IP)	134.886	39.98	5,393	4.2	-1.4
Cash($$$)	31.730	1.00	32	0.0
Account total:			19,172	15.0%
JM's Wife's Roth IRA
DuPont De Nemours E.I.(DD)	105.852	47.10	4,986	3.9	-1.7
Nokia ADR(NOK)	170.000	22.80	3,876	3.0	47.6
AT&T(T)	144.43	23.61	3,410	2.7	36.4
Cash($$$)	100.11	1.00	100	0.1
Account total:			12,372	9.7%
Portfolio total:			127,855	100%

Dear JM,

You're doing a lot of things right in your portfolio, especially contributing $2,000 monthly toward your future goals. But you're also putting a lot of pressure on your portfolio to perform when you consider those goals. Retiring at 50, about the same time you are sending your third child off to college, is an ambitious plan. If your portfolio averages 8% after taxes, things will be tight. If it averages 10% after taxes, then attaining your goals becomes a little easier.

When you ask your portfolio to do more, you wind up taking on risks that increase the volatility of the portfolio's return. You've got about 70% of your portfolio in taxable accounts. Keeping your money working for you vs. paying the government can make a tremendous difference in being able to attain your financial goals, and I'll suggest a few ways to do that.

It would also help to have a looser definition of retirement than "feet up at 50". Having some kind of employment in your 50s keeps more of your retirement money working for you in that decade. It's an extra safety net to help make sure you won't run out of money later.

Using the (VFINX) Vanguard 500 Index, the (VIGRX)Vanguard Growth Index, and the (VTSMX)Vanguard Total Stock Market Index together is giving you a lot of stock overlap in your mutual funds. The Total Stock Market Index includes the S&P 500, and the Vanguard Growth Index invests in 150 of the S&P 500 growth stocks. Review your tax costs in the three funds, and either consolidate or steer future contributions to these funds in a manner that will allocate more of the money to the broader-based Vanguard 500 Index or Total Stock Market Index funds.

A high-yield fund is an unusual choice for a child's education IRA, but in the context of your overall portfolio and other investments targeted for the children's education, I don't see a problem with having it in the mix.

You've got an interesting selection of individual stocks. It appears to be a mix of established technology stocks combined with Old Economy industrials. Are these core holdings, or are they actively traded? The stocks that you are trading should be in your Roth IRAs, while the core holdings can stay in your taxable accounts. As circumstances permit, branch out to include some energy and financial stocks in the portfolio. (I agree with your plan to diversify beyond health care with your new investments.)

The best college-cost calculator I've seen is on U.S.News.com. It allows you to pick three different schools, enter the number of years until college and an expected inflation rate for college costs. (Historically college costs have increased at a rate greater than the changes in the Consumer Price Index .) You've said that you may not be paying all of the college costs for your children, but I'm modeling the financial impact as if you are paying the total cost for in-state tuition at the University of Wisconsin. (U.W. trivia: The 1986 movie Back to School starring Rodney Dangerfield and Sally Kellerman was filmed in part on the U.W. campus.)

College Cost Calculating
U.W. Madison College Costs	Today's $	2007	2011	2016
One Year's Tuition/Room/Board/Books	11,800	15,813	19,220	24,531
Four Years' Tuition/Room/Board/Books	50,861	68,156	82,844	105,733
Source: USNews.com (5% inflation assumption)

The upshot is, you've got about $250,000 in college costs facing you. That's going to be tight to eke out on your current plan.

You should consider some tax-beneficial ways of investing for college. For example, there's the Section 529 Plan. The tax implications vary by plan, but generally, it allows you to contribute after-tax dollars to your kids' accounts. The investment earnings are taxed as they are distributed, at your child's presumably lower income-tax rate.

Also, states typically provide tax incentives for residents to invest in their home state's plan, and, in fact, many states don't have a residency requirement to participate in their plan. Savingforcollege.com reviews the different state plans for residents and nonresidents. With these plans, you wouldn't have the flexibility you now have of investing on your own, but having the investment returns tax-deferred at your children's tax rate provides an offset for that.

You've demonstrated an ability to live within your means, so your estimate of annual living expenses of $30,000 in today's dollars isn't unrealistic. Taxes cloud the picture here, because distributions from your Roth IRAs will be tax-free in retirement, while the withdrawals from your taxable accounts will have tax consequences. If we use an average annual inflation rate of 3% over the next 15 years, that annual expense will be about $47,000 in your first year of retirement.

Paying off the mortgage is a common financial goal. It is not, however, always the right thing to do. Refinancing your home with a 15-year mortgage may make more sense. Fifteen-year mortgages are currently hovering around 6.5%. You'd still own the home free and clear in the year that you plan to retire, and you'd free up some money in the monthly budget to invest toward your other financial goals. It makes sense if you can earn more on your investments after-tax then you pay on your mortgage after-tax. Consult with your tax adviser to determine if this is the right move for you. This refinancing calculator can help you figure out the payback period on a refinancing.

Keep stoking the fire by contributing to your retirement and taxable accounts, and your financial goals should be within your grasp.

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