High Income or Net Worth: Where Should You Focus?

For some people, investing in the stock market gives the same thrill as betting on horses or bungee jumping.

But for prudent investors, the object is to accumulate enough capital so that working for a living becomes optional. I call this "making your number." The "number" is the amount of capital that, with continued appreciation, covers your family's living, health and recreational expenses for the rest of your life (assuming a drawdown rate of 5% to 8% a year).

My firm's clients are geographically dispersed and are in a variety of professions and stages of life. You might assume high-income clients would reach their number faster than average-income clients. In fact, having a high income is not a predictor. How can this be?

In answering this question, I'll describe two hypothetical clients. Both are families made up of two 45-year-old working adults and two children. Both hypothetical clients live in New York, where living expenses, a car, a housekeeper, two nice vacations a year and rent on a three-bedroom condominium runs about $200,000 a year, and where combined federal, state and city income taxes run about 45%.

Client A has family income of $800,000 a year, composed almost entirely of salary and bonuses. Client A works long hours and incurs large business expenses that, due to sloppy record-keeping, aren't always reimbursed. This client rewards himself with expensive dinners out and a new luxury car every two years.

Because of time constraints, he rarely has time to bargain-hunt and pays full price for everything from children's clothes to vacations. Again, because of sloppy record-keeping, Client A's accountant gets late and incomplete information. As a result, possible deductions are overlooked and Client A owes the full 45%, or $360,000, in annual income taxes. At the end of each year, Client A wonders why the family has saved nothing.

Client B has family income of $200,000 a year, two-thirds from salary, and one-third from long-term capital gains. Client B has neither the high-powered job nor the stress level of Client A. Client B takes pride in her gourmet-cooking skills and keeps her car an average of six years, when the cost of maintenance becomes excessive. She favors cars with low operating expenses and checks with her insurance company to find out which models carry the lowest theft and collision premiums.

This client is obsessed with bargain-hunting. In the last year, she researched car prices and vacations over the Internet, refinanced her mortgage over the Internet and bought a computer, software and children's toys over the Internet (cheap prices and no sales tax!). She uses Quicken to manage the family budget and downloads transactions from her checking account, American Express and Visa cards directly into the program to speed data entry. Her accountant gets a preliminary run of the family's deductions on Dec. 15 so he can see whether there's an advantage to prepaying state and city taxes. The accountant gets final numbers Feb. 1 and has plenty of time to find the optimal way to file her taxes. As a result, Client B paid 25% taxes on income of $200,000 and 22% on the long-term capital gains for a total tax bill of $72,000.

Wait a minute! Where did those capital gains come from for Client B? Client A and Client B each inherited $200,000 21 years ago. Client A spent half the money right away and invested the rest somewhat haphazardly over the next 20 years without putting any in savings. At an average rate of return of 12%, the inheritance grew to $1 million by the end of 1998 and to $1.25 million in 1999 (a 25% return last year).

Client B invested her entire inheritance carefully and automatically invests $500 a month into the account as well. By investing more carefully, she achieved returns averaging 15% through 1998. The original $200,000, combined with the annual deposits of about $6,000, had grown to $4 million. With last year's 25% gain, her account topped $5 million. Client B started out with mutual funds and switched to individual stocks along the way to take better control of when capital gains would generate taxes. She keeps turnover to under 20% a year and holds stocks for an average of five years. Thus, she pays only the 20% federal capital gains rate (plus state and local taxes) on positions held more than 12 months. Positions held less than 12 months would be taxed at her higher, ordinary tax rate.

Client A guesses that his annual living expenses must be about $440,000 a year because he spent all of last year's income. He doesn't know how much of this money was wasted or whether his expenses for dining out last year, for example, were extravagant. Client B has about $12,000 in miscellaneous expenses she can't account for. (So she has a category in her Quicken labeled "miscellaneous" to budget for this expense.) Her family lives comfortably though not luxuriously on her income, so her investment returns get plowed back into her account.

Recently, Client A called wanting to know how to get the maximum mortgage possible to trade up to a larger apartment. We drew up a limited list of options that indicated he couldn't really afford the move. Client B called recently to discuss a career change. After 20 years in "old media" she had received a job offer to work in "new media" at a substantial salary cut but with a healthy options package. Given that her investment portfolio can throw off at least $250,000 a year without depleting principal, we said, "Go for it!"

What are the important lessons here?

• It's not what you earn, it's what you keep.

• Regular small investments lead to substantial portfolios.

• Squeeze every percentage point you can out of your investments -- an extra 1% return over 20 years increases the value of the final portfolio by about 20%.

• Taxes matter. Put as much of your investment resources as possible in tax-deferred accounts. In your taxable accounts, choose investments that generate long-term capital gains rather than income. Keep turnover as low as practical.

• Keep good records. You'll do better at tax time and you'll end up spending your money wisely.

Fine-Tuning Your Portfolio

In my previous column, Tune Your Portfolio, I offered the following formula for calculating portfolio returns net of cash flows:

But reader David Diamond commented that this formula is better expressed as:

I did some scenario testing of both formulas, compared both with recommendations from the Association of Investment Management Research performance presentation standards handbook and concluded that the second formulation indeed gives a better estimate. Kudos to David Diamond on the careful read.

In the investment management world, performance calculations net of cash flows are determined using a sophisticated internal rate of return calculation that is impractical to replicate in a spreadsheet. However, this second formula is good enough and better than the original. We have updated our sample Excel spreadsheet accordingly.