You just sold a piece of real estate, and reaped a seven figure windfall; good “problem”, right?
But how do you invest that kind of money in a way that will make it last for the rest of your life?
That's the question that a recent reader posed:
“I have close to $1.5 million in cash after a real estate sale. As a senior (over 70), I think I can easily put away half a million and draw about 10% from it from the bank and whittle it down to zero over the next 10 years. That means, $48,000 per year, or $4,000 per month, plus pension income, of course.
The other $1million? I will invest in stocks (50%) and bonds (50%), AND when 10 years rolls around after the half million is depleted, I can start dipping into this one and start spending. Do you see this as a good strategy, or do you have other alternative plans to approach this? Where will I invest the $1 million? Any ideas?”
The reader is at expressing at least three concerns:
- He wants $500,000 in a safe place so that he can withdraw $50,000 per year for the next 10 years;
- He wants to invest and preserve the remaining $1 million for income once the initial $500,000 is exhausted; and
- He wants to invest the $1 million using a blend of both conservative and aggressive asset classes.
He's thinking in the right direction, but I think he can likely create a more suitable arrangement using some of the different investment products that are available.
My first recommendation is to split the proceeds into two categories, short-term and long-term.
Creating the Short-term Portfolio
This will hold the first $500,000 that the reader plans to live on during the first 10 years. We want to focus on safety of principal since this is the money that he needs for living expenses, but at the same time I think he can earn a higher return on his money than what might be available just sitting in a bank account.
We can start by investing $200,000 in some type of bank savings, such as a money market fund or a certificate of deposit. Either will earn a little bit of interest, while keeping the cash absolutely safe.
The next $300,000 would be invested in a five year fixed rate annuity. This would enable him to earn a return of between 3.00% and 3.25% – compared with less than 1% in bank investments. That would enable him to earn between $9,000 and $9,750 per year, while still providing a guarantee of principal. It would also earn him close to an additional $50,000 over the five years that it would be invested.
He'll have to make sure that it's the type of annuity that will allow him to take withdrawals without having to pay a penalty.
My recommendation would be to take only $40,000 per year out of the bank investments over five years, after which that portion would be depleted. He could take the remaining $10,000 per year from the five year annuity. Even with the annuity withdrawals, he'd still have close to $300,000 remaining in the annuity after the first five years, due to the high interest rate return.
Creating the Long-term Portfolio
This side of the portfolio will hold the remaining $1 million that the reader plans to access when the short-term portion has been used up. This portion can also be set up into two separate categories, conservative and aggressive. The fact that at least 10 years will pass before he will need to tap the long-term side of the portfolio for living expenses gives him a moderate investment horizon. We can work with that.
The reader has suggested a 50/50 split between stocks and bonds, but once again, I think he can do better. Here's how I recommend investing this part of the investment portfolio…
The Conservative Portion.
We can be safe here but without resorting to bonds. We can do this by using a fixed-indexed annuity. It provides two major advantages that bonds don't: principal protection and a tax advantage, which I'll go into in a bit.
A fixed-indexed annuity offers protection of principal by limiting losses due to market declines. It grows at the higher of either:
- A) The return of a specified stock market index, or
- B) The annual guaranteed minimum rate of return.
And as the owner of a fixed-indexed annuity, you're guaranteed to receive at least the amount of your principal, plus investment returns, less any withdrawals. That will offer a much higher rate of return than what you can get on fixed income investments, but generally not as high as what you might earn in a pure index fund in a steadily rising stock market.
But once again, the idea here is to balance return with safety of principal, and that's what a fixed-indexed annuity does. This will prove to be a smart investment if the stock market is flat or declines over the next 10 years.
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I'd commit about $300,000 to this investment.
The Aggressive Portion.
I'd put the remaining $700,000 of the long-term portfolio, or nearly half of the overall portfolio, into low cost mutual funds or ETF’s. These offer the twin advantages of liquidity – he can access his money at any time – and many different investment options.
There are thousands of individual mutual funds and ETF’s available in hundreds of different investment sectors and categories. That means that the reader can choose, and later adjust, to any desired level of aggressiveness. I won't make any specific fund recommendations however, since that will depend entirely upon the reader's own risk tolerance. But suffice it to say that he can invest in index funds, specific industry sector funds, aggressive growth, emerging markets or tried-and-true blue chips.
Now I want to go back to the tax advantages that I was talking about earlier in connection with the fixed-indexed annuity. A windfall of $1.5 million will generate significant investment income, and that will create a higher income tax liability. This is especially true since the reader mentioned “plus pension income” in his question.
Since it's likely that the sale of real estate has already created an income tax event, we want to be certain that investing activities don't add to that liability. That means, in part, avoiding capital gains on investment transactions.
For example, let's say that the reader invests $1 million in a mix of bonds and aggressive stocks. If he earns, say 8%, that will produce investment income of $80,000 per year. Even though he may take only $50,000 for living expenses, he'll still owe tax on an $80,000 income. This problem can be compounded by actively managed mutual funds that buy and sell component shares aggressively. When this is added to pension income, the reader's income may be pushed up into higher tax brackets for both federal and state taxes.
That needs to be avoided.
Part of this is remedied by the two annuities – both the fixed rate annuity and the fixed-indexed annuity. The allocation I'm recommending has $300,000 in each, for a total of $600,000.
When you have money invested in annuities, regardless of the type, investment income accumulates in the plan on a tax-deferred basis. This is much the same as with tax-deferred retirement plans, except that the contributions to an annuity are not tax deductible. With an annuity, as long as the investment income remains in the plan, there is no tax liability created.
That means that the investment income building up in the two annuities will not increase the reader's tax liability. Meanwhile, the $200,000 invested in bank assets will generate very little income, and therefore a very small tax liability.
The biggest tax liability in this portfolio will be that generated by the $700,000 portion that is invested in mutual funds. However, even there he might have certain tax advantages.
For example, the value of the funds can continue to grow without generating a tax liability (as long as he doesn't sell the funds themselves). And any gains generated by the funds themselves will be taxable at lower long-term capital gains rates, as long as they are held for more than one year.
Short-term capital gains, which may be generated by very actively managed funds, will be subject to ordinary tax rates, which could be significant if the short-term gains are substantial. But once again, the reader could reduce or avoid that liability by favoring mutual funds that have low turnover rates, and/or tend to favor long-term capital gains over short-term.
Taxes will have to be minimized on an investment nest egg of this size, so creating a largely tax advantaged portfolio, like the one I'm recommending here, will need to be a priority.
It’s important to note that every annuity is not created equal. Before you buy any type of annuity make sure you trust the advisor you are working with to ensure you’re getting the highest rate possible.
Summing it All Up
Here's what the portfolio I'm recommending will look like:
- Bank investments, $200,000 (conservative)
- Fixed rate annuity, $300,000 (conservative)
- Fixed-indexed annuity, $300,000 (moderately aggressive AND safe)
- Mutual funds or ETF’s, $700,000 (moderately to very aggressive, depending on the reader's investment temperament)
That kind of portfolio mix will provide the reader with plenty of growth potential, reasonable protection of principal, and tax advantaged investing. Just as important, it will enable him to have liberal income, as well as most of his initial investment principal, throughout his entire life.
In a real way, what we're doing here is laddering various asset classes, so that the reader has liquid cash in the short run, plus growth for the longer term for his retirement income plan. In it's own proper time, each asset class will be available for living expenses. And in the process, income taxes will be minimized.
That's not a bad combination in the super low interest rate environment we're in right now, and likely will be in for the foreseeable future.
This post originally appeared in Business Insider.