How Should Using Roth IRA as E-Fund Affect Asset Allocation?

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minneapples
Posts: 43
Joined: Fri Jun 10, 2011 10:51 am

How Should Using Roth IRA as E-Fund Affect Asset Allocation?

Post by minneapples » Wed Apr 08, 2015 9:12 am

I am 35, my husband is 37. We currently have $25k in "emergency savings" which is the equivalent of:
-about 5 months expenses with one child in day care
-about 3.5 months expenses with a second child in day care (we are due this fall, and after taking leave, that second daycare bill will kick in in Jan/Feb 2016)
-about 7.5 months in the event of catastrophic job loss, if we pulled the kids out of day care and had the out-of-work parent stay home. Honestly, the money would last longer than 7.5 months if we did this, because without the daycare bill to cover, either of our incomes is enough to cash flow many or most monthly expenses.

This emergency money is in a combination of savings account, I-bonds (out of the 1-year redemption period), and taxable account. We have been contributing very little cash savings in the last couple of years ($200-300/month) because we were prioritizing maxing out retirement accounts and cash flowing a major home project, which is now nearly done.

We also have the following retirement accounts:
My Roth IRA (Vanguard): $138k
My rollover IRA (Vanguard): $84k
My 401k (Fidelity): $77k, no match
My husband's retirement accounts: $232 total (I don't have his Roth/401k breakdown handy, but his is weighted toward the 401k, which also has no match)

This is with a 70/30 AA. The bonds are 100% in my Roth because the bond options in my 401k are not good. The Roth contains equities, too.

Given the amount we have saved in accessible places and in Roths, I don't plan to bump up our cash savings considerably as we finish our home project and finish repaying some other debts (low-rate student loan that will be paid off in a few months; probably refinance the mortgage on our forever home from 5% to something below 4%). Instead, I plan to use that freed-up cash to put toward #2's daycare costs and minimize the hit that #2's day care bill will take on our retirement contributions for the next couple of years. (We will not be able to continue maxing out our retirement accounts and pay for two kids in day care. Each child's tuition is the equivalent of a mortgage, and that's basically unaviodable for this area unless you can use family or someone who is unlicensed, which are not options for us.) Instead, I plan to treat the Roth IRAs as an emergency fund if we need it in the next few years. Barring unforeseen catastrophe, once the kids are in school and our childcare costs drop waaaaaay off, we will be back at over 6 months saved in accessible locations, whether or not we add new funds.

So my question after that very long build up is, how should the fact that I am treating the Roth IRA as an emergency fund affect my asset allocation within the Roth, or even specific funds held within the Roth? I don't want to deviate too much from my long-term investment strategy because the likelihood is that we will not need to touch it for that purpose, and after 2020 or so we won't need to think if it as a backup emergency fund, and the money will go back to being solely for retirement.

Thoughts?

sawhorse
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Re: How Should Using Roth IRA as E-Fund Affect Asset Allocat

Post by sawhorse » Wed Apr 08, 2015 12:04 pm

To clarify, your Roth will serve as a backup emergency fund, not the primary emergency fund, right? In other words, if s**t really hits the fan and your 7.5 months of emergency savings is insufficient, then you dip into the Roth contributions?

How much of the Roth is contributions, and how much is earnings?

By any chance, does your employer offer a childcare FSA? My former employer did, but for an odd reason they didn't advertise it, and you had to ask. :confused

You may also want to check into daycares that offer discounts for having more than one kid there. Again, sometimes you have to ask because they don't advertise this.

My colleague said that a daytime nanny actually cost less than daycare. This is for three kids though.

minneapples
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Joined: Fri Jun 10, 2011 10:51 am

Re: How Should Using Roth IRA as E-Fund Affect Asset Allocat

Post by minneapples » Wed Apr 08, 2015 1:11 pm

sawhorse wrote:To clarify, your Roth will serve as a backup emergency fund, not the primary emergency fund, right? In other words, if s**t really hits the fan and your 7.5 months of emergency savings is insufficient, then you dip into the Roth contributions?
Correct. It would only be a last resort. No joke, I'd sell plasma before touching it, but having kiddos also makes me want to have a plan for the worst-of-worst-case scenario.
How much of the Roth is contributions, and how much is earnings?
A quick, conservative estimate is at least $52k is contributions, probably somewhat more. I'm only counting those years I know I maxed it out; when I was still in college I did not, but contributed as much as I could. In addition to those cash contributions, there is also about 20k that was rolled over from a Roth401k more than 5 years ago, and I'm not sure how much of that amount was originally contributions versus earnings, and I'm not sure how that would be treated for withdrawal purposes (it may be a simple answer, I've just never had to care about it). The remaining is earnings.
By any chance, does your employer offer a childcare FSA? My former employer did, but for an odd reason they didn't advertise it, and you had to ask. :confused
Yes, and I do max it out, and will continue to.
You may also want to check into daycares that offer discounts for having more than one kid there. Again, sometimes you have to ask because they don't advertise this.
Good point. Ours does offer a 10% discount off tuition for any additional children, taken off the older children's (lower) tuition. These numbers don't account for that discount, but it wouldn't make an appreciable difference to how long the $25k cash would last if we kept both kids in day care.
My colleague said that a daytime nanny actually cost less than daycare. This is for three kids though.
If we had 3 in day care at once, we would look into it, as I suspect it would be much cheaper, and at that point cost would start to be a real concern instead of a temporary inconvenience. And if we had odd hours at work, that would make a nanny more appealing, too. But right now working with our day care's hours is working for us. Child #1 is very social, and really enjoys being around other kids all day. He gets bored when we have long weekends at home (holidays or fever-exclusion days when he's fully recovered but not allowed back under the center's rules), even with planning lots of extra activities. Plus I've been told the waiting lists for full-time preschools around here are really long, and one advantage of being at our day care is they have a preschool program our kids can age up into, with a spot guaranteed for them if we choose to use it.

sawhorse
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Re: How Should Using Roth IRA as E-Fund Affect Asset Allocat

Post by sawhorse » Wed Apr 08, 2015 1:20 pm

So you have $25k for 7.5 months of unemployment.

Unemployment is probably the most common, but by no means the only type of emergency. The most common other type of emergency is probably medical. That raises the questions of a) how good your insurance plan is and how much it would cost with COBRA (perhaps you've included that in your emergency fund calculation); and b) whether you and your husband have disability insurance.

It also depends to some extent on whether your jobs are tied to stock market performance and the overall economy. Nursing jobs, for example, are little affected by the stock market. Banking jobs are clearly more affected.

minneapples
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Re: How Should Using Roth IRA as E-Fund Affect Asset Allocat

Post by minneapples » Wed Apr 08, 2015 2:14 pm

sawhorse wrote:So you have $25k for 7.5 months of unemployment.

Unemployment is probably the most common, but by no means the only type of emergency. The most common other type of emergency is probably medical. That raises the questions of a) how good your insurance plan is and how much it would cost with COBRA (perhaps you've included that in your emergency fund calculation); and b) whether you and your husband have disability insurance.
Well, like I said, 7.5 months of unemployment assuming we both lose our jobs at the same time and cannot cashflow any monthly expenses with a still-employed spouse's earnings. An extremely unlikely worst-of-the-worst-case scenario.

Medical insurance is hard to predict that far in advance right now. Current COBRA costs are built into monthly expenses, above, but that doesn't reflect what our situation will be during the future time period I am asking about. Currently I am insured through my employer, great coverage, 100% of premiums paid by employer, and I have an OOP max of $5k. But it's very expensive to add other family members. Husband and Child #1 currently are insured through husband's employer, for comparable coverage, fairly cheap. But with 2 children, he will have to switch to a family plan rather than his current +1 plan, his premiums will jump, and all four of us will roll onto his family plan (I'll get some additional money from my employer for coming off their plan and their premium payments). Due to some internal changes in HR, his employer will likely be switching some coverage options for 2016 (when this would begin to apply to us), so specifics for future costs are really a question mark at this point. I do not doubt they'll be good, his industry and employer have a solid track record in terms of offering good benefits, but I can't be more specific right now about COBRA costs or coverage.

We both have STD and LTD through work, 50% of salary. I have an individual LTD plan, too, that provides an additional benefit, totaling about 70% of salary (not expenses). Plus SSD if it came to that. Husband is not eligible for indivdual LTD at this time due to some past health issues (he is fine and has been for a couple of years). Basically because his was a diagnosis of exclusion, no one would touch him for a period of time on the off-chance that some of the very serious, probably debilitating possibilities were incorrectly excluded. He will be eligible to reapply for indivdual LTD in a few months, and we'll see what happens then.

I'm happy to answer these or other questions in case I've missed something, but a medical catastrophe or long-term disability would be life-changing situations where we'd tap any available asset necessary, including the Roth. You seem to be focusing on whether I have a sufficient cash emergency fund to cover those, which isn't really my question. No amount of cash savings we could possibly bank would cover those enormous costs. I'm comfortable with, for the 3-year period we have 2 kids in daycare, having a primary emergency fund of 7.5 months expenses, with an additional "backup" Roth emergency fund of at least $50k (actually, at least $80k, counting contributions in my husband's Roth, which is a conservative estimate I didn't include in my original post, but should have). My question is about whether the way we manage that portion of the Roth should change during that 3-year period.

Or are you trying to assess whether you think it would be better to stop contributing to retirement accounts during that 3-year period in favor of saving additional cash? I'm definitely not inclined to do that, but I'm open to hearing a counterargument. Help me see where you are going with this.

(Edited to include detail about husband's Roth contributions)

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powermega
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Re: How Should Using Roth IRA as E-Fund Affect Asset Allocat

Post by powermega » Wed Apr 08, 2015 2:24 pm

Here is a relevant Wiki article about this exact topic, if you haven't seen it already.
Even a stopped clock is right twice a day.

sawhorse
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Re: How Should Using Roth IRA as E-Fund Affect Asset Allocat

Post by sawhorse » Wed Apr 08, 2015 5:20 pm

powermega wrote:Here is a relevant Wiki article about this exact topic, if you haven't seen it already.
The article is definitely very helpful, but minneapples' situation differs a bit in that there is already a lot of money in the Roth, and her Roth contributions are actually twice her regular emergency fund. I'm not sure all the shifting is necessary.

I'm throwing out some scenarios to see how you feel about them. If 25k is 7.5 months, another 25k would cover you for over a year. Based on what you say, it seems unrealistic that you'll withdraw more than 25k. So let's look at a 25k withdrawal scenario.

Currently, the Roth is 54/138 (39%) contributions, and 84/138 (61%) earnings. If you are going for a 40/60 bond to stock allocation, then just put 54k in bonds and 84k in stocks.

Here are other allocations for bond/stock ratios

30/70 = 41.4k bonds, 96.6k stocks
20/80 = 27.6k bonds, 110.4k stocks

A riskier allocation than 20/80 is not recommended for your age, so I won't calculate that.

Let's say that the worst case scenario happens: stocks drop 50%, bonds drop 10%. This is very unlikely, but it's not impossible. For the riskiest portfolio (20/80), you would have 55.04k left in the Roth after withdrawing 25k.

Personally, I would feel uncomfortable with having only 55.04k left in the Roth. And if the economy is that bad to incur a 50% stock loss and a 10% bond loss, there's a greater chance that you'll have to withdraw the 25k I mentioned. The worse the economy is, the more likely it is that you'll have a period of extended unemployment and thus have to withdraw your contributions.

This scenario is highly unlikely, but if you have very low risk tolerance, it indicates that you probably shouldn't go 20/80 stocks. With 40/60, you would have 65.6k left after withdrawing the 25k, with 30/70 you would have 60.56k left.

Another possibility is to allocate 25k to a high yield Roth savings, which isn't so high yield these days, and then go risky with the rest. Let's say you use the Ally Bank Roth and get 1% guaranteed. That's 18% guaranteed, 82% (113k) stocks. The worst case scenario described above would give you $25.25k (guaranteed) plus 56.5k (fallen stocks) for a total of 81.75k. If you withdraw 25k, that is 56.75k left. That is better than the 20/80 scenario described above but not by much.

Let's look at the extreme flip side. Suppose stocks rise 50% and bonds rise 10%. While such a scenario makes it less likely that you'll have to withdraw the 25k since the economy as a whole is booming, let's stick with a withdrawal of $25k. Here would be the results of the allocations after withdrawing 25k.

40/60: 160.4k
30/70: 165.44k
20/80: 170.96
25k guaranteed/rest stocks: 169.75

So putting 25k in a 1% guaranteed fund is roughly the same as 20/80 but with slightly less variability than a 20/80 allocation in both very good times and very bad.

The difference would be psychological, especially on the downturn when you are more likely to need to withdraw. How would you handle seeing both your stock and your bond portion dropping everyday?

Now let's take a look at realistic mixed return scenarios. First, bonds are up 3%, stocks are down 15%. After withdrawing 25k, these are the figures.

40/60: 102.02k
30/70: 99.75k
20/80: 97.27
25k guaranteed, rest stocks: 96.3k

And the opposite of bonds down 3%, stocks up 15%.

40/60: 123.98
30/70: 126.25
20/80: 128.73
25k guaranteed/rest stocks: 130.2k

In mixed scenarios, as you see, the 25k guaranteed/rest stocks has slightly more variability than 20/80. Because this allocation does not include bonds, it will underperform when bonds go up and outperform when bonds go down.

Now getting to current events: The consensus is that interest rates will rise. If that is true, and they've been saying that for years without it happening, that bodes poorly for bonds and well for the guaranteed account because interest is likely to rise on the guaranteed account. So if you think interest rates will rise, then 25k guaranteed/remaining stocks is better than 20/80. If you think they will fall, the opposite is true.

That's only comparing it to 20/80. If you want a more conservative allocation such as 40/60 or 30/70, then there is little point putting 25k in the guaranteed, as that would be riskier, and that also would mean putting more in the guaranteed than you think you'll need.

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