November Grab Bag

Hi everybody – sorry it’s been a while, life gets in the way! Nothing bad, just been busy with family and work and nothing has really drawn me in for a full post. So I thought I’d post a few thoughts on two topics today, and some thoughts on upcoming posts.

Inflation & Investing

Most of the talk on the various finance communities I frequent seems to be some variation on “what to do with such high inflation?!?” Lots of variations on a theme: how to protect my investment from inflation, should I buy bonds with such high inflation and low yields, what should I do about an emergency fund so I don’t lose money to inflation, and so on. My thoughts:

  • First, calm down, inflation isn’t that high, when you compare to history or to other economies. 4.2% in the UK, 6.2% in the US – yes, these are big numbers when we’re used to 2% or so, but it’s a long, long way from hyperinflation. Nobody is trucking around dollars or sterling in wheelbarrows!
  • But, interest rates are also extremely low, when usually you can get a risk-free return that matches or beats inflation. The last time inflation was above 5%, in 1990, 10 year treasuries were above 8% yield – today, they’re at 1.375%. Quick graph of 10 year treasuries vs annual US inflation – the UK data I have isn’t as clean, but it’s a similar trend:
Data from NYU Stern
  • So, what to do about it? Realistically, is there anything you can and should do, now that inflation is actually here? A few of the more commonly recommend approaches include:
    • Inflation-indexed bonds/gilts are designed for to mitigate against inflation, but their yields, aside from the inflation adjustment, are practically (sometimes literally) 0%. And any bonds traded openly are subject to interest rate risk if rates rise from their current very low levels. I don’t have a crystal ball to say when or how much rates will rise, but rising inflation feels like it increases the risk of rises in the near future, and we’re seeing the market price that in with mortgage rates coming off their record lows. Plus, inflation is already here, so the higher inflation linked adjustments are priced in – I don’t see these as especially attractive, except maybe as a portion of your overall bond allocation.
    • US I bonds take away the interest rate risk, since they aren’t openly traded, only bought and sold to the US government. And the current rates of 7%+ (all of that being inflation adjustment) are clearly attractive, although that’s only guaranteed for 6 months before the inflation adjustment changes, and you’re stuck with the 0% coupon rate. The 1 year lockup, 5 year penalty on interest, and $10k annual limit don’t help, either, and as UK spenders we take on currency risk with USD investments. I think there’s a place for these, but given the limits they’re hardly a panacea for an inflationary environment.
    • Some people are recommending crypto as a store of value in an inflationary environment. Not sure I buy that crypto won’t be impacted by inflation (no historical data), but I do know the day to day fluctuations in crypto prices make me hesitant to use crypto as a safe store of value even if those fluctuations aren’t linked to inflation. I don’t want my “safe” money bouncing around that much! Crypto as a long-term investment is a topic for a different day…
From Yahoo! finance
  • For me, this is the time to stay the course. If you trust your overall asset allocation and investment policy statement, it’s designed to handle anything life can throw at it, within the foreseeable possibilities. I’m still at my 79% equities, 21% bonds+cash allocation with no intention of changing, except bumping to 78/22 next year as planned. Changing your plans just because people and the media are making a lot of noise is a good way to chase performance and lose out overall.
    • Within the bonds+cash allocation, it always makes sense to move money to the best combination of yield, access, and risk – leaving all your cash in a 0.01% high street bank account isn’t a good idea in any environment! Same if you have a dedicated emergency fund, at least get the best rate you can (probably the 1% prize rate on Premium Bonds, as of today, unless you can lock some of it up for a fix). If you wanted some of your emergency fund in I bonds, that seems reasonable, too.

S&S ISA Experiment Update

I haven’t done a proper update in a few months, mostly because the experiment is going well. I’m within a percent or so of the FTSE 100 – sometimes ahead, sometimes behind, but close. Individual investments are all over the place, with the best (M&S) up 61% and the worst (IAG, owner of British Airways) down 23%. Not through any investing acumen on my part, just my almost-random approach to a DIY index.

I’ll do a bigger update, probably at the end of the year, but so far I call the experiment a success and plan to continue my ISA contributions next UK tax year.

Upcoming Topics – Suggestions?

I keep a running list of topics I’d like to explore – some of the ones that I expect to come up in the next few months are listed below. But I’m eager to hear from you – what would you like to read? More diving into the details of IRS and HMRC publications, tax treaties, and the like? Modeling and projection? My own financial story and approach?

Some topics I might tackle in the next few months include:

  • Expanded US Child Tax Credit and what it means for Americans in the UK – they’ve made it a bit complicated this year…
  • Comparison of US tax filing tools – I’ve used TurboTax previously, just started playing around with TaxAct and I’m impressed so far. Any others you think I should try?
  • Breakdown of my 2021 taxes – I expect 2021 to be a reasonably typical year, might be a good example of what a US tax return looks like for an American in the UK
  • 2021 year in review – it’s been a good year from a personal finance perspective, at least!
  • Tools for tracking investments and FIRE in two countries, two currencies – at least the approach that works for me
  • Impact of Biden’s Build Back Better Bill on Americans in the UK, once/if it’s actually passed…

What else should I take a look at? Thanks for reading!

A Phased Approach to Emergency Funds

In my recent post on my approach to bonds and cash, I mentioned that I don’t have any dedicated emergency fund at all. I know this flies in the face of conventional personal finance wisdom, but I think I’ve got a pretty sound justification. My personal approach is not quite so aggressive as somebody like Early Retirement Now, with a 100% equity portfolio and emergencies funded through a combination of credit card float, cashflow, home equity line of credit, and a worst case equity sale. It’s not that I disagree with ERN’s logic, and I fully believe that his approach is mathematically the highest return one, but my risk appetite is a bit lower – that’s just what helps me sleep at night.

Over the years, I’ve gone through three distinct phases of emergency funds – while these might not be for everybody, I think they’re a reasonable framework for thinking about an emergency fund as you mature in your finances.

Phase 0: Crisis Finance

I’m cheating with Phase 0 because I’m in the very fortunate position that I never really went through it myself. This is where you’re living paycheck to paycheck and frequently not having enough at the end of the month, dipping into payday loans, borrowing from friends, racking up credit card debt, and the like.

In this situation, it totally makes sense to me to have a small emergency fund (few hundred £ maybe) just to smooth out the inevitable bumps in life. Clearly the main focus here is getting out of the paycheck to paycheck cycle!

Phase 1 : Dedicated Emergency Fund

This is where I was basically from leaving home through most of my 20s, and lines up with conventional personal finance advice. I was starting to invest, but most of those investments were locked away in my TSP (military 401k), not much I could call on in an emergency. So, I had a dedicated high-yield savings account I considered my “emergency fund.”

You’d want to tailor how much is in this fund to your own situation – I had a very secure job for most of this time (the Navy tends not to fire people on short notice) that also came with very good healthcare, plus relatively low fixed expenses (I was single, renting, no major loans), so this didn’t need to be a ton of money, maybe a few months of expenses. I can’t really recall having to dip into it for anything big, maybe some car repairs, but it gave me piece of mind.

Of course, if you have large fixed expenses, a “flexible” (aka unreliable) job, and/or health issues (for those readers in the US – not as much as concern if you’re in the UK with the NHS), then that argues for a substantially larger pot.

I grew out of this phase from a combination of three factors:

  1. Got out of the military and into a good job, but it wasn’t rock-solid like the Navy
  2. Bought a house, got married, had kids – bigger fixed expenses and less ability to tighten my belt
  3. Steadily growing net worth, including starting to have more money in easily accessible investments through a taxable brokerage account

Phase 2: Discrete Savings Pots

All those things happened around the same time – I don’t think any one of them alone pushed me into this next phase, and it’s kind of a fuzzy line. But I started realizing that my “emergency fund” was doing two very different things:

  1. Insuring us against a major emergency – protracted job loss being the most likely, major health spending the other primary possibility (still in the US at this point, although my insurance was pretty decent).
  2. Smoothing out irregular expenses – some of this was lumpy within a year (oil-fired heating costs a lot in the winter, car insurance paid annually, that kind of thing), and some spread over multiple years (boilers, hot water heaters, roofs, appliances, cars – all eventually need replacing and maybe irregular repairs).

Bucket #2 isn’t really an emergency, since these are things that we know will happen, even if we don’t know exactly when or how much. At this point, I had some guesstimates on what this spending looked like, and set up buckets to build up incrementally every month. For example, $250 a month to utilities, but in the summer it’s more like $100 and winter more like $400 actual spend, so the account grew in summer and shrank in winter, aiming to be just a bit above $0 come the warmth in spring. At the time, these were actual separate bank accounts, although all at my main bank. Eventually they just became lines on a spreadsheet, mostly due to moving to the UK and not wanting to deal with so many actual accounts – you could do the same thing with “pots” in Monzo, Starling, etc.

Bucket #1 was still a “real” emergency fund, but as my investments grew, I started to get comfortable with some of that fund being invested. Given my experience and the Boston area job market, I wasn’t expecting to be out of work for long, even if I was laid off or my company folded, so I was pretty ok having maybe three months of expenses in cash, and the rest accessible from a taxable brokerage account. I was doing a gut feel calculation, not too much math behind it, but figured the expected returns were worth the potential risk of having to sell in a downturn. Everybody will make a different call on this, and that’s ok!

That risk panned out for me – whether that’s luck or just good risk management, I’ll leave to you. But this was around 2015, so with reinvested dividends that money has nearly tripled since then!

I kept this approach for a good 6 years or so, until very recently. There’s no time limit on it, and I think the transition to the next phase is more emotional than quantitative.

Phase 3: Consolidated Cash & Bonds

As part of my recent thinking on asset allocation and the role of cash+bonds in my portfolio, I realized that my dedicated “emergency fund” served no real purpose. I’d actually been slowly reducing that line on the spreadsheet anyway, because my other short-term cash savings were high enough that it seemed silly to keep so much cash, but that wasn’t entirely a deliberate decision, more just gut feel.

Now, I actually have a logical basis:

  1. My cash+bonds allocation, at 21%, is already about 2.5 years of normal budgeted spending, more than any emergency worth planning for. In a real emergency, we’d cut spending back to push that well past 3 years.
    • There are “black swan” kind of events this won’t cover – if my wife and I both get injured and can never work again, say. But no emergency fund can practically insure against that – you only insure against never working again by fully achieving financial independence, and we aren’t quite there yet.
  2. My cash+bonds allocation is very safe, with extremely limited volatility
    • Mine is safer than a conventional bonds approach, with it being primarily the TSP G fund, Series EE bonds, and Premium Bonds – issued and guaranteed by the US and UK governments, with no chance of loss of capital.
    • But even if you were in 100% BND or similar, take a look at the chart and see how big the biggest drops are – absolutely tiny compared to stocks. Something like a 7% drop during the COVID drop in 2020, compared to an almost 50% drop in a US total market fund.
  3. I have good control over the non-emergency lumpy expenses. Practically, they largely come out of cashflow (via credit card float), although I’m still tracking my buckets on a spreadsheet, more for budget measurement than any sort of real concern over emergencies. They’re pretty theoretical buckets within the cash part of the bond+cash allocation, but I find them helpful to see if my budget stays realistic – since my current budget is also my expected retirement budget, it’s important that I know how much I’m spending.
  4. I have ample credit available. I’ve never needed to use it (pay off your credit cards in full every month!), but I’ve got 6+ months of normal budgeted spending available on my credit cards. Sure, not everything can go on a credit card, but combine that with the cash+bonds allocation and tightening our belts and we get to something approaching 4 years of spending before needing to touch equities.

Put that all together, and I don’t see a point in having another pot of cash labelled as an “emergency fund” anymore – that would really just tilt my asset allocation more towards bonds+cash for the purposes of semantics.

Special Considerations for Americans in the UK

Pretty much everything I said above applies whether you live in the US, UK, or almost anywhere else – only caveat being around health care expenses as a very plausible emergency in the US, but a much smaller financial impact in the UK.

A few caveats specific to Americans in the UK, though:

  • Currency risk is real, so take that into account when deciding where to put your emergency fund, if you have one, or your cash+bonds allocation.
    • It’s safest if your emergency fund is in the currency where most of your expenses are – probably GBP for most of us in the UK.
    • For the past few decades, the pound has mostly fallen relative to the dollar, so you’d actually make out to your advantage if, for example, you’d had your emergency fund in USD just before the Brexit vote dropped the value of the pound from about $1.60 to $1.20.
    • There’s no reason to think that trend has to continue though – you could easily have the pound appreciate just as your emergency happens. If that same situation were reversed and the pound climbed from $1.20 to $1.60, your USD-denominated emergency fund has dropped, in GBP terms, by a quarter. Your 6 month fund now only covers 4.5 months!
    • Personally, if I was still in the Phase 1 or maybe Phase 2 mode, I would have my dedicated emergency fund in GBP only – it’s entire purpose is to help me sleep at night, and exposing that fund to currency risk just gives you another thing to worry about. In Phase 2, if you’re starting to expose some of your e-fund to market risk, maybe it’s ok to also add some currency risk – just be aware of how much risk you’ve added!
    • In my current situation, I’m not worried that about a third of my cash+bonds allocation is in USD. Even the remaining two-thirds is still a healthy cushion, if a major currency swing were to coincide with my emergency.
  • Taxes are still inevitably complicated, although it’s not too bad for most of the kinds of accounts you’ll use for an emergency fund
    • Big picture, the UK and US both tax interest from savings accounts or bonds as income, so you’ll be taxed at whatever your marginal income tax rate is (20, 40, 60, or 45% in the UK; 10, 12, 22, 24, 32, 35, or 37% in the US). The UK has a pretty generous personal savings allowance, at £1,000 (basic rate), £500 (higher rate), phasing out at the additional 45% tax rate. So if you’re under that UK PSA, you may well owe a bit to the US if you don’t have other passive category foreign tax credits to offset it, or if you’re using the Foreign Earned Income Exclusion (since this isn’t earned income, the FEIE doesn’t help).
    • Realistically, you’re not going to make that much interest on an emergency fund today. Even a quite big e-fund – say £6,000 monthly spending and you want 12 months of spending, so £72,000 – is making you something like £720 a year at 1%, maybe £1,080 at 1.5%. Even at the highest tax brackets, that’s not a huge impact on your finances, but I know we’d all prefer to pay as little as legally feasible to HMRC & the IRS.
    • A few ways of cutting back on the tax:
      • If you’re above the PSA, you can avoid UK tax by using Premium Bonds or an ISA (Cash ISA or hold bonds/fixed income/etc. in a S&S ISA). You’ll still be subject to US tax, though.
      • You could also hold bonds/fixed income/money market/etc. in an IRA. Most practically this would be a Roth IRA, so that you can withdraw the contributions any time without penalty, although you can also use the “money is fungible” principle and sell equities in a taxable account to generate cash for spending and then sell the bonds/whatever to buy equities in an IRA – you’ve effectively taken the cash out of the IRA, just with a bit more shuffling around.
      • US Series I and Series EE bonds give you the option of deferring US tax until the bonds mature or you cash them out, or you can pay tax on an annual accrual basis. UK gilts work similarly at first glance, although they’re not one I’ve dug into deeply.
        • I don’t know for sure how the other country respects the deferment vs accrual option for bonds from the first country. For my Series EE bonds, I use the accrual basis for both my US and UK taxes, because trying to do them differently might make my head explode! (bad enough I do the accrual for two different tax calendars…). That’s one I can’t guarantee I’m doing right, but the interest is small enough I’m not going to sweat it – worst case, I’m paying HMRC slightly more and quite a few years earlier than they’d get paid otherwise.

Practical Thoughts on the New Health & Social Care Levy

By now, we’ve all heard of the new Health & Social Care levy – but what does it really mean in practical terms? I’m not going to talk about the politics, or whether the levy is actually fit for purpose to improve the NHS and social care – I’m mostly keeping this blog apolitical.

However, I think it’s worth a quick look at what the levy is and what it means for us – by “us”, I mean people saving and investing for retirement in the UK.

What is the Health & Social Care Levy?

In short, a new/increased tax from April 2022 and an increase in the dividends tax (all the gory details are in the government’s paper). For the first year starting in April 2022, it’ll show up on your payslip as an increase to your National Insurance tax, before splitting out as a separate line from April 2023 (IT changes take time!) For most employees, National Insurance is in three bands for the employee portion (your employer also pays as an employer contribution):

  • Less than about £9,568 a year: 0% – not changing
  • £9,569 to £50,270 a year: 12% – now increasing to 13.25%
  • Above £50,270 a year: 2% – now increasing to 3.25%

The increase also applies to higher income (>£9,568 a year) self-employed (Class 4) National Insurance, but not to Class 2 (lower income self-employed people) or Class 3 (voluntary contributions to fill in gaps). So it pretty much hits everyone working with income above about £9,568 a year. It also expands, from April 2023, to cover people above State Pension age who are still working – today, they don’t pay any National Insurance, but will start paying this 1.25% levy.

Since the new tax is a flat 1.25% on everything above £9,568 a year, if you want to know how much you’ll pay, just take your taxable income (after any salary sacrifice pension contributions, etc.), subtract £9,568, and multiply by 1.25%. Example: £60,000 taxable income – £9,568 = £50,724 * 1.25% = £634 extra a year.

And for dividends, the tax rate is aligned to your overall income tax rate, with a 1.25% increase on each rate:

  • Basic Rate (20%): dividend tax of 7.5%, now increasing to 8.75%
  • Higher Rate (40%): dividend tax of 32.5%, now increasing to 33.75%
  • Additional Rate (45%): dividend tax of 38.1%, now increasing to 39.35%

Dividend tax only applies above the Dividend Allowance (£2,000 a year), and of course doesn’t apply within an ISA, Pension, SIPP, IRA, 401k, etc. So very roughly, at a 2% dividend yield you’d need £100,000 of taxable dividend-paying investments before paying dividend tax, but now at a higher rate. There’s plenty of people on a FIRE (or normal retirement) path with that level of taxable investment, of course.

The other group that’s substantially affected are limited company directors who pay themselves via dividends rather than income – I won’t speak to this group in any detail, because limited companies in the UK are something I haven’t studied at all, beyond knowing that US tax law makes this a complicated area!

What do we get for our money?

Some of the extra money goes to the NHS – no actual change to anybody’s entitlement for NHS care, just try to cut down the backlog. Enough said – the proof will be in the pudding how much difference this really makes.

The bigger systematic change is in social care. Under the current system, everybody (in England at least – slightly different in the other countries) who has assets over £23,250 has to pay for their care in full. In some cases, this means selling family homes, and obviously severely impacts the ability to support children, grandchildren, charity, etc. Not passing judgment on whether that’s right or wrong, there’s a fair debate to be had as to whether end of life care is the responsibility of the individual or the state. The new system shifts the balance – it was already mixed between the individual and the state, but now the state takes more of the responsibility (although far from all!).

Huge caveat: the cap and subsidies only apply to the “social care” part of the cost of care. It doesn’t include the “hotel” or “residential” part of the cost, which can be substantial – often around 1/3 of the weekly cost of care.

To that end, the new system splits into three buckets:

  • If your assets are less than £20,000, you pay nothing towards your care from your assets, although may still pay from your income (pensions, etc.)
  • If your assets are between £20,000 and £100,000, there’s a sliding scale of means-tested support – you contribute no more than 20% of your assets a year, plus a contribution from income.
  • If your assets are over £100,000, you pay the full cost of care up to a cap of £86,000. After that, you pay nothing from your assets towards your care, although you’re still paying for the “hotel” costs.
    • If you start out a bit over £100k but the cost of care pushes you below £100k, you get some of that means-tested support from the bucket above.

I expect the vast majority of my readers plan to have more than £186,000 in assets by the time most people expect to need social care (hopefully well after State Pension age!), so will fall into the third bucket.

Is it a good deal for us?

Again setting aside any moral arguments about the need to take care of the less fortunate in life – is this plan good value for money for those of us who invest carefully over many years in the hope of a comfortable retirement?

One way to think of this plan is as a forced purchase of long term care insurance. Since long term care insurance hasn’t been sold in the UK for a while, it gets tough to compare – I tried looking at the US as an illustration, but the cost of care is too different (much higher on average in the US). So we’ll just try to think it through with UK numbers. The government paper on social care says it typically costs £700 a week – let’s round up to £40,000 for a typical year of care. That’s just the “care” costs, not the “hotel” bit.

On average, somebody who needs care needs about two years of it, and about 70% of people need care. So that makes our expected spend £56,000, with massive variations. There’s a good chunk of people who won’t spend anything at all, but also a long tail – the people who might spend decades in care. We can look at the value in three broad buckets:

  1. Those who never need care: these people now pay an extra 1.25% and get nothing for it (aside from whatever part goes towards improving the NHS rather than social care – impossible to measure right now).
  2. Those who only need a typical amount of care: these people, assuming they have assets over £100k, will cover their entire cost of care from their assets and/or income, because the total cost is less than £86k before they die, plus the hotel costs. They also pay an extra 1.25% and get nothing for it.
  3. Those who need a lot of care: these people spend their £86k in care costs and then the government picks it up from there, plus a contribution from their income and they still need to cover the hotel costs. But it’s a significant reduction from the uncapped cost of care until your overall assets fall below £23,250.

This is a pretty classic case for insurance – when you think about home or car insurance, you put money in every year hoping that you don’t get anything back. On average, you will spend more than you ever get back, but there’s a small group of people who have very high expenses due to some kind of disaster, and they get more out than they put in. Effectively, for people with assets over £100k, the new levy is “catastrophic long term care insurance” – it won’t cover “routine” or “expected” care, but for the tail of people that need a lot of care, it puts a partial cap on your costs.

Of course, you don’t get to choose how whether or not you buy the insurance, and the price is indexed to your income rather than your risk, but that’s what we get. Given the lack of any comparable commercial insurance options, it’s really tough to say whether this is good or bad value for money, for the benefits offered by the “insurance.” There’s a case to be made that nobody besides the government could insure the long tail of protracted care needs – it might not be commercially viable.

What to do about the remainder of the cost? Realistically, unless a new “care gap insurance” springs up, our only choice is to self-insure. In most cases, people who are investing for retirement, especially early retirement, will be able to absorb an £86k cost at the end of life. Really, it becomes an estate planning problem more than a drawdown/cashflow problem.

What’s a bit more challenging to handle are the hotel costs, but hopefully those can be absorbed by your remaining cashflow, since the rest of your expenses are probably minimal once you’re in care. At something like £500 a week or £26,000 a year, you’d need £650k at a 4% withdrawal rate to cover the hotel costs indefinitely. Add in any state pension, social security, etc., and that number falls even more. So except in the leanest of FIREs, or in a case where both partners need extended care (rare but possible) we’re probably ok, even after taking an £86k hit to assets. The new plan reduces the risk of a very long care stay reducing our assets to practically nothing, albeit at a substantial cost during our working lives.

How do we minimize the cost?

There’s no major new strategies here – good tax management that worked on the “old” system works just as well or even better on the new one:

  • Salary sacrifice pension contributions are even more valuable, since they completely avoid the new 1.25% tax.
  • Keeping high-dividend investments in tax-advantaged accounts is now slightly more important. Dividend rates are still lower than income rates (which apply to bond interest) though, so the overall prioritization of tax-efficiency probably doesn’t change.
    • You could argue that currently low bond yields might push some people to put high dividend investments in a tax-advantaged account over a bond (e.g. 3% dividend taxed at 39.35% = 1.82% after-tax return, vs 1.5% bond taxed at 45% = 0.825% return), although the 1.25% dividend tax increase doesn’t change that math much.
  • There may be some nuances in drawdown and estate planning, depending on how the asset calculations work. That level of detail isn’t clear yet, but maybe you want to prioritize gifts earlier in retirement, or maybe annuities start to look more attractive if they’re not an “asset” but a pension in drawdown is? Just really don’t know yet.

It will be interesting to see what happens to wages – do employers increase them to offset the higher tax? Or do they pass on the higher NI tax that they’re paying, reducing wages (or at least reducing raises to below inflation). And if they do increase wages, whether because of the new tax or due to the tight labor market, what does that do to inflation? We’ll have to see.

What do you think? Does the new system change your approach to planning for late retirement, or your estate planning?

My Approach to Bonds (and Cash)

I wrote about my overall asset allocation a while back (Part 1 & Part 2), but have been doing a fair amount of thinking late regarding the bond part, particularly in light of some more substantial cash savings from our remortgage that are eventually planned for home improvements/extensions, but with no clear timeline (at least years, realistically). Keeping my 10% in bonds plus more than another 15% of my overall investment portfolio in cash felt too conservative, but then do I just ignore the cash because it’s sort of short term savings? But those home improvement plans are ill-defined at best, and I hate to see that much money sitting on the sidelines for potentially years, at least without a coherent plan.

After a lot of back and forth, tinkering with asset allocations, playing with how to account for cash, reading about bond tents, etc., I came to two simple conclusions:

  1. Treat bonds and cash as a single asset category
  2. Increase my bonds/cash allocation to “my age minus 15” – making it 21% now

Bonds and Cash – one category?

We’re probably all aware of the challenges facing bonds right now:

  • Yields are miserably low – 1.31% on BND, 1.41% on BNDW, 1.04% on a 30 year gilt (0.13% on a 2 year! why bother?)
  • Interest rates have almost nowhere to go but up. I’m not predicting that rates will rise soon, since they’ve really been consistently low since the 2008 crash (small ramp up leading up to the pandemic, but still historically low). Maybe they move sideways for another decade or two, but, barring going substantially negative, they can’t go down much.
    • If interest rates stay flat, bond prices don’t change – all we get is the (very low) yield
    • If interest rates rise, the prices of bonds we own today go down
  • That results in what feels like a substantial downside (risk of prices falling) without a lot of upside.
UK (Bank of England) interest rates – US and other developed country ones look similar, sometimes worse!

But it’s worth reminding ourselves of the reason for having bonds at all, instead of just 100% equities:

  • Bonds are less volatile – even when their price changes, it does so slowly. Look at the chart below, specifically 2000, 2008, and 2020 where stock prices change rapidly and bond prices move slowly.
  • There might be an inverse relationship to stock prices, through the “flight to safety”. When stocks go down, some investors get scared and move into bonds. But again, look at the chart below – the bond price increases during stock crashes are far less than the stock decreases. If you wanted to make money during the crashes, you’d need to be massively tilted towards bonds, which would leave you a lot poorer in the good times. If your crystal ball is good enough to predict the crashes, you’d make a lot more money by shorting stocks than holding bonds.
  • For those of us with investments in multiple currencies, having bonds in our “home” currency can be a tool to manage exchange rate risk.
  • We know that equities tend to have higher growth rates than bonds, over the long term, so we are deliberately choosing less growth as a tradeoff for less volatility.
  • Some day, bonds may be useful to me as a stream of income, but right now I’d just as soon the money stay invested – I’m a good ways off before I start living off my investments.
  • Bottom line: bonds reduce volatility, at the cost of lower long-run returns. I want my bonds to preserve value more than I need them to grow – that’s the job of equities.
From the excellent Portfolio Visualizer tool

Putting those two things together, and bonds start to sound a lot like cash to me, in today’s environment: low yield (a bit higher than 1% is “good”) and want them to preserve value, at least in nominal terms. So why treat them as entirely separate asset categories? Now, this wouldn’t apply if you’re interested in particularly risky bonds – emerging markets, “junk” corporate bonds, etc. Those I would consider something different and closer to equities, and they’re not something I choose to include in my portfolio. But if your bonds are developed government or high-quality corporates, they feel pretty similar.

So, at least for me, it makes sense to mentally combine my bond and cash holdings into a single asset allocation.

What bonds & cash do I hold?

Most of the bonds I hold are pretty cash-like in the first place – the chances of losing value in nominal terms are remote:

  • Premium “Bonds” (59%): I put bonds in quotes, because I consider Premium Bonds cash rather than bonds. They’re guaranteed by the UK government and have no risk of loss, plus pay out at a 1% prize rate.
    • There’s some element of luck involved here, although I have tended to average around the prize rate – this is a large enough holding that the luck starts to average out. Aside from being one of the best interest rates available for cash today (you can get marginally better if you’re willing to lock up your money for a few years), they’re a bit of fun too!
  • TSP G Fund (22%): a unique holding for the US government employee Thrift Savings Plan, this pays a US government bond long-term interest rate (1.375% as of September 2021) but without risk of loss. The interest rate varies with overall US bond rates.
    • If I was able to move more money into the G fund, I’d increase this percentage and drop the Premium Bonds allocation, but since it’s basically a 401k for a former employer, there’s no way to do that.
    • I could reduce my exposure to other TSP funds (basically US and Developed ex-US equities) in favor of the G fund, but then I’d need to move money from Premium Bonds into those equities, which is a challenge due to all the normal hoops for a US citizen in the UK (PFICs, PRIIPs, etc.). The G fund is good, but not so good that I want to start a US & UK taxable individual US stock portfolio like I’ve done with UK stocks in our ISAs! Doing the US bookkeeping and taxes for 42 stocks in our ISAs is plenty; doing both US and UK bookkeeping and taxes for more stocks makes my head hurt. Plus I’m a believer in indexing, and am pretty confident that the diversification due to indexing is worth the 0.375% difference between G fund and Premium Bonds.
  • US Series EE bonds (10% of my cash/bonds allocation): these are gifts from my parents when I was younger, slowly maturing. Because they’re relatively old, the interest rates are relatively good, plus the guarantee for EE bonds to double after 20 years means a minimum interest rate of roughly 3%. I’m not buying new ones, but won’t be selling these until they reach maturity over the next 25 years.
    • I’m not buying new ones because I’m paying income tax on the accrual basis for these (a decision made for me long ago). That’s nice, in that I don’t owe chunks of tax when the bonds mature, but also means that any more EE bonds (or I bonds) would add to my tax burden while I’m in a relatively high US and UK tax bracket today.
  • UK gilt fund in my UK pension (<1%): I’ve just started building this position from £0, and it won’t amount to much for a long time (just a couple hundred pounds a month). But of all these options, it’s the only one exposed to the risk of rising interest rates, the only “traditional” bond fund. But it’s in a tax-deferred account, practically no risk of default, and starts to slowly build an exchange-rate buffer, since effectively all my expenses are in GBP but a lot of investments are in USD.
  • Other cash accounts (9%): I include our various checking/current and savings account in my bonds+cash number. This is small stuff at paltry interest rates (0.5% is “high yield” these days), just ready spending and very short term savings, a few thousand £ & $. I could just as easily exclude it, but my spreadsheet already has it calculated. Not planning on this growing over time, it might slowly shrink as I continue to whittle away at closing old accounts.

Other bond options and why I’m not using them

The options above are not terribly traditional, and I know not everybody has access to the G fund. A few thoughts on some of the other options:

  • Standard bond index fund (BND, BNDW, BNDX, or UCITS ETF equivalents): very low yields, more downside than upside in price. Simple comparison: you can get 1% in risk-free Premium Bonds or 1.3%ish in a bond fund with risk of the price going down if interest rates go up. Is that extra 0.3% really worth it? On £100k invested, that’s about a £3k difference over 10 years – not nothing, but not going to make a huge difference compared to the risk of loss.
    • You can tilt these however you like, in terms of risk, duration, etc., but it doesn’t change the basic problem. And if you get very risky to chase yield, this starts to feel more like the risk/benefit tradeoff of an equity, not a bond.
    • For me personally, this really doesn’t make sense compared to the G fund, at the same interest rate but no risk of loss.
  • Individual bonds (UK gilts or US treasuries): a bond ladder is an interesting idea, allowing tailoring of duration to meet your goals – once upon a time I had a CD ladder, back when CD interest rates weren’t rock bottom. A few challenges though:
    • Same or even lower yields as the bond funds, even at really long durations (which add to the risk of comparative loss if interest rates rise)
    • Tax efficiency: the US and UK tax bond interest at income tax rates, which means a lot of that low yield goes right back to a government. I could put them in my wife’s name to get around that, or in a tax-advantaged account. But that would mean my ISA for gilts, which has fairly horrific transaction fees compared to the return on bonds, or my Roth IRA for treasuries. In both cases, I don’t want to use tax-free (rather than tax-deferred) space for bonds, either.
    • Fair amount of effort for the yields. Between bookkeeping for US & UK taxes and the ongoing management, this is just more hassle than its worth to me.
  • Series I bonds: these are a pretty attractive option, and definitely worth considering. 3.54% interest (as of Sep 21), balanced with some lockup periods and restrictions on how much you can buy.
    • If it weren’t for the accrual basis that I’m already locked into using for tax on the interest, I would look at these more seriously. For those of you without that restriction, this could be a nice core holding, and you could defer tax on the interest well into the future, when you might be at a lower tax rate. For me, that would knock my after-tax return down to about the same level as the G fund (pre-tax, but easier to manage those taxes later on).
    • You do have to deal with the archaic TreasuryDirect website. It’s usable, but it’s straight out of the 90s.
    • More Series EE bonds would fall in a similar bucket. Some pros and cons compared to the Series I, I think I would tend towards Series I first, but also worth looking at.
  • Very high yield savings accounts: you can get 3%ish from a savings account, that sounds great right?! Wait, but you can only contribute £50 a month and only get that rate on up to £1,000? Sure, there’s a bit of money to be made here, but if you’re managing even a moderately sized portfolio this just doesn’t help much. No harm in doing it, but it winds up being a lot of effort if you want to get any significant amount of money into these kinds of accounts.
    • Bank account switching bonuses kind of fall in the same bucket. I’m not opposed to switching to make a quick £100, but that’s more of a side hustle than an asset allocation strategy.

Why 21% in bonds/cash?

First off, there’s no right answer to this question! Bogleheads have a great primer on asset allocation, if you haven’t read it already. But the gist is that there are plenty of rules of thumb, but that’s all they are. At the end of the day, you have to pick something you’re comfortable with, and “my age minus 15 in bonds” feels good to me. 21% is enough to provide some volatility dampening without having a huge impact on the return. It’s not nearly as conservative as “my age in bonds”, nor as aggressive as “100% in equities until retirement”. It’s somewhere in the middle, and it feels right to me.

It also puts me on a path to a bond tent, helping to address sequence of returns risk in early retirement. Some people would argue it’s early to start building that bond tent, but since 21% feels about right now, building another 1% a year over the next 15 years or so feels pretty reasonable. That would have me going into early retirement with a bond allocation around 36% – might play with that and bump it up a bit in the years closer to retirement, see how the world looks by then!

There’s a lot of “feels” in the description above – this is definitely one of the fuzzier bits of FIRE or investing generally. On one hand, you’ve got people saying that 50/50 is the logical default allocation, or that “your age in bonds” is plenty aggressive. On the other, you have people holding 100% equities all the way through accumulation and retirement. Without a crystal ball, there’s no way of knowing the optimal asset allocation, so all you can do is pick something that helps you sleep at night. I’ve been very fortunate to do well so far in my accumulation, and having a bit of bond/cash ballast in my portfolio helps me sleep.

My target asset allocation, as of September 2021

Other considerations – Inflation, Mortgage, & Emergency Fund

Some of you might be screaming by now “but what about inflation!?! You’re losing money in 21% of your portfolio!” And you’re right – inflation numbers are a bit murky with the effects of the pandemic, but it’s pretty clear inflation is higher than the 1 to 1.4% or so I’m getting from anything in my bond/cash allocation. And that’s ok – it’d be nice if interest rates beat inflation, but it’s hardly uncommon for them not to. The 79% of my portfolio in equities needs to beat inflation and deliver real returns – the bonds and cash don’t. Their job is to dampen volatility.

The obvious logical inconsistency is that I’m holding bonds/cash at 1 to 1.4% and paying a substantial mortgage at 1.26%. If you look at it a certain way, we took money out in our remortgage at 1.26% just to put almost all of it in Premium Bonds at 1%ish – that doesn’t make any sense! That was a deliberate decision though – we are paying a small premium (roughly £200 a year due to the delta in interest rates) in order to have the option of using that money for a future house extension. For us, that option is worth the price, and probably cheaper than it would have been to do a shorter remortgage, not take the money out, and then do another remortgage to access that money – not to mention the hassle or the risk that mortgage rates may rise in the next few years from their current extreme lows. So there’s a method to the madness, even if there’s also a very rational argument for not holding any bonds or cash that pay less than what our mortgage costs.

The last question might be “where does your emergency fund fit into this?” The answer is that we don’t have an emergency fund, at least not in the traditional sense. I’ll expand my thoughts on emergency funds in an upcoming post, but with 21% of our portfolio in cash/bonds, that’s about 2.5 years of spending in investments that are extremely safe, so I don’t see a reason to slap the “emergency fund” name on a separate pot of cash.

So What?

That’s a lot of words to describe how I’ve wrestled with today’s bond conundrum – and sadly, I don’t think there are many universal lessons, because this is a very personal decision. I just hope that my thought process might help prompt some thoughts of your own – I’d be very interested in hearing your views on asset allocation and how you are (or aren’t) using bonds in your portfolio, including any violent disagreements 🙂

S&S ISA Experiment – September 2021

I haven’t provided an update on my S&S ISA experiment since the May 2021 update, but 3 months on I think there might be a few interesting things to note.

Very quick reminder – because of the challenges in holding index funds outside of a “pension” for Americans abroad, I’m trying a “pseudo-indexing” approach in my ISA, buying individual stocks in the hope of replicating the performance of the FTSE 100. I’m baselining my performance against a FTSE 100 ETF (CUKX, not VWRP as I mentioned before – that’s an all-world fund, so not quite a fair comparison!).

Major updates since May:

  • I was due to remortgage our house, and with interest rates so absurdly low (1.26% for our new 5 year fix), we decided to take some cash out. Some of that is earmarked for future home improvements, but I used part of it to max out both my and my wife’s ISA allowances for the year.
  • For my wife’s ISA, I picked a different 20 stocks – still all UK ones, but because I’d already picked 20 of the largest UK companies for my ISA, this means hers has quite a few smaller companies. A few of these are bordering on stock picking instead of indexing – still companies I plan to hold for the long term, but an £800 million market cap company is quite different compared to a £131 Billion one. Average market cap is £39 billion in my ISA, and £9 billion in hers. Will be interesting to see how much of a difference that makes!
  • I also opened LISAs for both of us, shortly before my wife turned 40. I don’t plan on contributing a lot to these, because my biggest concern is the gap between early retirement and pension/401k/IRA access ages, but figured it was prudent to open one before she aged out. Each of them only has about £125 in them (£100 from us, £25 from Her Majesty), with a single stock (different from the other 40 in our S&S ISAs), so not going to move the needle.

Performance Update

Big picture, there’s not much difference to be seen between our ISAs and the FTSE 100, although, to be fair, most of the change in value is driven by ongoing contributions. It will be interesting to see any difference between now and the next contributions in April 2022.

Break it down some more, and there is a rather more obvious difference in the monthly growth figures, although they wind up averaging out to pretty much the same:

And when you break it into the individual stocks, the differences between them are particularly striking. As a prime example, we bought M&S in my wife’s ISA only a few days before the price spiked – pure good luck, rather than any foresight on my part!

After expenses, both for purchase and predicted expenses for sale, we’re up a total of not quite £300 on a £40,500 investment. Hardly life-changing, but, by pure luck, it’s about £700 better than we’d be doing in a FTSE 100 tracker fund. Since this is replacing a chunk of UK exposure in my overall asset allocation, I’m happy with that.


Hargreaves Lansdown, my ISA brokerage, puts out a lot of articles. Most of these are shilling for active funds that I can’t buy and wouldn’t even if I could, but occasionally there’s something interesting. In particular, one on the evolution of the FTSE 100 index caught my eye, especially this graphic:

It’s obvious that Materials (mostly mining) and Financials (mostly banks) are a huge part of the FTSE 100 – 36.6% to be exact. But I’ve chosen to skip the largest players in these sectors, so my “pseudo-index” is missing around a third of the actual index. I do have some exposure to those sectors: CRH is a construction materials company, Croda in chemicals, and we have a few companies around the financials space (Aviva for insurance, Experian in mostly credit rating, the London Stock Exchange itself, and a merchant bank in Close Brothers). But we’re missing the obvious big names: no HSBC, Rio Tinto, BHP, Glencore, Anglo American, Barclays, Lloyds, and so on.

In a way, it’s remarkable how closely my ISA is performing compared to the index despite this discrepancy, at least so far. I haven’t changed my opinion on these sectors – the extractive materials companies in the FTSE are borderline (or beyond!) exploitative while the banks aren’t much better, plus I expect them to struggle in this extremely low interest rate environment. You can get a higher interest rate from Premium Bonds than on some mortgages!

So, I’m not changing the allocation of my ISA – the high transaction fees (about £24 to sell one and buy another) put me off anyway. But if something dramatic happens to either the Materials or Financials sectors, it wouldn’t be surprising if my performance diverges from the index.

Overall, I’d say the experiment is going well – I’m generally tracking the index, no major concerns there, and the mechanics are manageable. I do have ongoing Excel sheets for both dividends and basis tracking, so I’m not expecting US taxes to be anything too terrible, but we’ll see. So far, so good!

Buying Index Funds – 2 More Options

In the last few weeks, I’ve run across two more options for buying index funds, the key building blocks of my portfolio (and of anybody taking a passive, buy-and-hold, Bogleheads-ish approach). I haven’t implemented either of them yet, but wanted to share what I’ve found and I’d be very interested to hear if any of you have tried one or both.

While this blog is mostly about American citizens in the UK, these options likely apply to Americans in the EU as well.

In short, they are 1. Exercising options and 2. Buying PFICs in an IRA

Quick Background

One of the hurdles for US citizens living in the UK or the EU is the catch-22 of buying ETFs and mutual funds:

  • The US will happily allow you to buy non-US mutual funds or ETFs, but will impose horrific penalties and filing requirements because it’s a PFIC.
  • The UK/EU governments, via the MiFiD/PRIPS rules, will not allow you to buy US mutual funds or ETFs because they don’t give you, the consumer, enough information – they don’t have a Key Information Document.
    • Apparently, US funds can’t provide a KID even if they wanted to – some kind of clash between SEC and EU/UK rules on forward-looking statements.
  • If you, as a UK resident and taxpayer, do manage to actually buy a US fund, as long as it’s on HMRC’s reporting funds list, all is good.
    • I’m not familiar enough with the tax regimes of the 27 EU countries to speak about any parallels they have for PFICs, reporting funds, or any other kind of offshore/foreign investment vehicles.
    • If it’s not on the list, the punishment isn’t as bad as PFICs, but you do pay for any gains at income rates, not the lower capital gains rates.
    • It’s fine to buy stuff not on the list inside a treaty-protected “pension” (e.g. 401k, IRA, etc.).

So how to get around this? There were four options that I was aware of until recently, when I added two more:

  1. Buy within a UK pension (or other treaty-protected “pension”), so that PFIC rules don’t apply
    • Simplest option, probably the core part of the portfolio of most Americans in the UK since you get auto-enrolled, employer match, etc.
    • But there are contribution limits (with some questions around exceeding employer contributions making it a foreign grantor trust), pensions are relatively inflexible vehicles with almost no provisions for early access, and you may or may not have good investment options in your pension – high fees, etc.
  2. Don’t let a US brokerage know that you live outside the US – use a US address (friend, family, etc.)
    • This definitely works and has the least restrictions of anything. I do wonder how sustainable it is for the long term, and you need to decide for yourself if you’re happy lying to your brokerage.
  3. Become an accredited investor, with 2 of:
    • €500k+ to invest
    • A track record of investing, like 10+ decent sized trades a quarter
    • Professional experience in finance
    • This one also definitely works, but not many of us qualify. You can pay an accredited investor to manage your money for you, but I’d rather not pay somebody to do something I can do myself just as well.
  4. Give up on index funds and buy individual stocks
    • This is exactly what I’m doing in my ISA
    • But you lose out on the benefits of indexing – for an ISA’s tax advantages, I’m ok with that. But I’d rather not do it more than I have to, for an IRA or taxable account
  5. New: Buy US ETFs via options
  6. New: Buy EU (mostly Irish) ETFs within a US IRA

In all of these cases, we’re just trying to buy boring, broad index funds – nothing especially complicated, although if you were wanting to buy a triple-leveraged ETF focused on underwater basket-weaving companies, the same processes would work. Sadly, because of the silly interactions of US and UK/EU laws, we’re jumping through hoops to try to buy the simplest world all-cap or S&P 500 index funds.

Option 5: Buying US ETFs via Options

Some warnings before we start:

  1. I’m not trying to make money with options trading – they’re purely a way around the PRIIPS/KID hurdles that prevent UK/EU residents from buying ETFs. I’m not an advocate of options trading for “normal” investors.
  2. You need to make sure that anything you buy in a taxable brokerage account via this method is HMRC reporting. Bogleheads has a useful list of Vanguard ETFs that are also HMRC reporting – I’m not aware of any other good index ETFs that are HMRC reporting (I’ve checked for Schwab, Fidelity, & others, no luck)
  3. Interactive Brokers is not the world’s simplest platform for investing – be careful you know what you’re doing! Spend some time paper trading first.

The basic idea of this option (as described on the Bogleheads forum) is:

  1. Open an account at a US brokerage that has options trading, using your legitimate non-US address. The only brokerage I know of that definitely meets these criteria is Interactive Brokers; Schwab International might as well but I’m not certain.
  2. Shortly (a day or two) before option expiration on the third Friday of every month, buy 1 or more call option contract on the ETF you want to buy – trying to minimize the premium and strike price costs.
  3. Exercise the call option, typically at 16:00 Eastern time on the Friday.
  4. Now you own 100 shares of the ETF per call option.

The big advantage: PRIPS/MiFiD prevents you buying the US ETF directly, but doesn’t prevent you buying options on the US ETF. That’s absurd policy (why is the EU protecting individuals from buying vanilla ETFs but not potentially riskier options on those same ETFs?), but it works. Note that the restriction is only on buying; you should be able to sell the ETF normally, no messing about with options.

A couple disadvantages:

  • Only works once a month – not a huge deal for long-term investing, but a bit annoying
  • You can only buy ETFs in lots of 100 shares. That’s a pretty big chunk of money – VT (world all-cap) is around $100 a share, so you’re investing in $10,000ish increments. The lowest priced HMRC-reporting Vanguard ETF I could find is VEA (Developed Markets excluding US), at about $50 a share, so still in $5,000 chunks.

You can also do a similar transaction by selling put options – slightly lower cost but slightly more uncertainty because you depend on the other party to decide whether or not to exercise the option.

I’ve tried the call option version on Interactive Brokers paper trading and it worked without a hitch – their interface is far from the simplest, but it works (really intended for much more advanced trading than what I want to do!). If I’m fortunate to have excess funds beyond what I invest via my UK pension, ISAs, and IRAs, I’d try this in a taxable account – don’t think I’ll be so lucky anytime soon!

Option 6: Buy EU ETFs in an IRA

By now, many of us probably have “PFICS=bad” pretty much engrained in our mind, with the exception of pensions. But there are really two parts of PFICs that are so bad:

  1. Tax: tax rates can be very punitive – sometimes even exceeding 100% of the gain
  2. Tax returns: the filing requirements are extremely onerous, taking a lot of time and/or money to prepare. Hours and hours per holding per year.

However, holding a PFIC in an IRA prevents both of these – none of this is dependent on the tax treaty, just US law:

  1. Tax: IRAs are tax-deferred (Traditional) or tax-free (Roth) – there’s no tax due on any capital gains, etc. Even for Traditional, you’ll just pay income rates when you eventually withdraw. PFICs don’t create any additional tax inside an IRA.
  2. Tax returns: PFICs inside an IRA don’t require all the painful filings. This is also true for 401k and other tax-advantaged accounts, although finding a 401k that offers a PFIC is pretty unlikely!

So this is a pretty simple option – just open an IRA at a brokerage, using your non-US address, that will allow you to buy non-US funds. Again, Interactive Brokers allows this, possibly Schwab International as well.

There are a few considerations:

  • You’ll probably be primarily looking at EU, mostly Irish, ETFs. These tend to have higher costs than similar US funds, and often track less diverse indices, resulting in less diversity across your portfolio. For example, the US VT ETF (Vanguard Total World Stock) has 9,074 stocks across large, mid, & small caps, for a 0.08% expense ratio. The similar Irish VWRD (Vanguard All World) has 3,618 stocks, only mid and large cap, for a 0.22% expense ratio.
    • You can build an equally diverse portfolio using specialized geographic and/or capitalization-based funds, but it will cost you more. Especially getting into regional small caps the ER goes up considerably – replicating the European part of VT likely takes 3 funds, with the small cap part having a 0.58% ER.
  • If you can help it, you probably want to keep US holdings in US-based funds, to avoid US dividend withholding tax (which I can’t figure out a way to get back, even though we have to file US tax returns!). This is 30% by default, although in Irish ETFs the US/Ireland tax treaty reduces it to 15%.
    • This isn’t a massive effect – if we assume a roughly 2% dividend yield for US stocks, this is 15% of 2%, or about 0.3% for a US-only fund. That said, if we were choosing between two identical index funds and one had an ER of 0.1% and the other 0.4%, I know which one I’d pick!
    • If you still have a 401k or similar, this is a good place for your US holdings. Also, if you have existing US ETFs/mutual funds in an IRA or taxable brokerage, you should be able to continue to hold them, even if you tell your brokerage you’re now living in the UK/EU (as long as they don’t close your account), you just can’t buy any more.
  • Since the investments are inside a treaty-protected IRA, you technically don’t need them to be HMRC reporting, although you’d struggle to find many Irish ETFs that aren’t HMRC reporting even if you tried.

I do find this a really interesting option – there’s no skirting around any rules, you’re being completely open with your brokerage, HMRC, and IRS. The drawbacks of using Irish instead of US ETFs are real but fairly small, and no worse than a non-US citizen resident of the UK/EU faces for their own investments.

Just as an example, moving most of the non-US portion of my overall portfolio to Irish ETFs, with my current asset allocation, would change my overall expense ratio from 0.088% to 0.112%, with little to no impact on diversification. That’s a real impact – 27% more fees! – but it’s still well within what most people would call low fee, and still less than the lowest fees in my relatively good UK pension (0.29% at the cheapest).

I’m planning on trying this with my 2022 IRA contributions, just to make sure it all works smoothly, then may think about moving my IRAs over to Interactive Brokers and doing this completely. There’s no huge rush – using a US address is working fine at my existing brokerage – but it still doesn’t feel like it will work forever and I don’t love the workaround.


While the whole catch-22 situation remains completely absurd and pretty pointless, it’s good to have a few more choices! Have you tried the options or EU ETFs in an IRA routes? How did they work for you? Is there a seventh choice I haven’t found yet?

I’ll report back when I try the Irish ETF path early next year, and if I ever do the options way I’ll write a post on that, too. In the meantime, my UK pension is on autopilot and my IRA and ISA contributions are done for the year, so it’s pretty quiet on the investing front until 2022.

Tax Management in Traditional Retirement (Phase 3)

This is Part 3c of our Retirement Withdrawal Strategies series.

Quick summary so far:

Today, we’ll look at “Traditional Retirement” or Phase 3 in more detail. Reminder of the phases:

I’ll eventually follow this up with Part 4, looking at a few scenarios and how it can all work in practice. If you have any particular scenarios you think I should model, I’d welcome your input in the comments – I’ll definitely do one that roughly matches my situation (move to the UK in mid-career, so balancing both US and UK retirement accounts), but happy to do a few more that might help my readers!

Phase 3: Traditional Retirement

Phase 3 is retirement for the masses, as well as those who retired early. You already have access to all your retirement accounts in Phase 2, and now you start picking up income streams. On one hand, this is great – more money, and it’s mostly guaranteed money (State Pension and Social Security), so your chances of running completely out of money drop to zero, although you could still run out of savings and be eating cat food on the monthly payments…hopefully not! On the other hand, the fact that you now have income that you can’t control once you start receiving it means that your tax situation can become more challenging.

Here’s what you’re likely dealing with:

  • Age 62 to 70: US Social Security – you get to pick when you start taking this, and that’s a complicated subject all on it’s own. My post on Estimating Social Security can help you get started.
  • Age 65: HSA for non-health expenses – this is conceptually a better fit in Phase 2, since it’s basically a Traditional IRA at this point, but the age cutoff is after the earliest Social Security option.
  • Age 65-68ish: UK State Pension (you can check your specific age on – you don’t get to pick as much as Social Security, although you can delay it if you want
  • Age 72: Required Minimum Distributions from your Traditional 401k/IRA/etc.
  • Age 75: Final Lifetime Allowance Benefits Crystallisation Event (BCE) in your UK workplace pension or SIPP

Three main objectives for Phase 3, carrying on from Phase 2 or even if you start retirement in Phase 3:

  1. Ensure you have enough money plus income from Social Security and/or State Pension to last the rest of your life
  2. Execute your plan for Phase 3, managing your tax liabilities and planning for the future. Three key considerations:
    • Required Minimum Distributions
    • Lifetime Allowance penalties
    • Estate planning
  3. Continue enjoying retirement!

The universe of accounts doesn’t change a whole lot in Phase 3, but now we’ve got everything on the chart that we ever will:

Goal 1: Don’t Run Out of Money Before You Die

And we’d still rather not pay more tax than we have to along the way!

If you retired significantly before Phase 3, you’ve handled any sequence of returns risks – they might even be decades in the past. Hopefully your Safe Withdrawal Rate and withdrawal planning have stood the test of time, and you’ve still got a comfortable nest egg to carry you through Phase 3, bolstered by State Pension and Social Security. Very likely, at least based on most past returns, you have significantly more money than you started with.

You now also have a pretty good idea of how much you’ll be getting from your State Pension and Social Security, and have decided when you’ll start drawing Social Security. Any changes to these plans now are likely tweaks around the edges – how do they change with inflation, does the UK triple lock survive, etc. But you aren’t in the situation you might be at age 25, wondering if the programs will even survive long enough for you to get anything.

You’ve probably also got a pretty good idea of how much you spend in retirement. Sure, your spending will continue to change over time – a 92 year old is probably spending differently from a 62 year old – but most of these are likely to be reductions, not increases in spending. The big caveat there is nursing home care, which you may need to plan for specifically, depending on your health and family situation and if the Government ever finds a way to address the issue.

Knowing the State Pension and Social Security pieces plus your spending so far in retirement, it’s worth reviewing your withdrawal planning again. If things have gone well, you might choose some one-off expenses (renew your wedding vows somewhere tropical? Pay for grandchildren’s university or house deposit?), increases in your spending, or start putting a gifting strategy in place. If things are more challenging, you can adjust as needed, incorporating your new income streams.

And once you know how much you need to withdraw, you’ll want to figure out how to fill your tax-free and lower tax buckets. The strategy changes a bit compared to Phase 2 though, because now you have these income streams.

Starting with UK taxes:

  • Personal Allowance (£12,570 per person – all numbers are for 2021).
    • First off, you don’t get any choice to fill some or all of this:
      • State Pension: about £9,500 a year if you have the full 35 qualifying years, reduced proportionately if less.
      • Social Security: the amount will depend on your number of years and Social Security income history and could vary significantly. For most people who left the US in mid-career (say 10-20 years of earning history), you’re looking at something close to or more than $10,000 a year – call it £7,000+.
      • Required Minimum Distributions: These will also vary massively, and might only start a decade after you start getting Social Security, if you start as early as possible. But these can be very significant – for illustration, on a £100k Traditional balance, they start at £3,906 at age 72, and climb with age.
      • Put those three together, and you can easily have filled your Personal Allowance, so that anything above it is taxable. You might even get pushed into the 20% bracket just from these three.
  • Capital Gains, Dividends, & Interest don’t really change from Phase 2, but as a reminder:
    • Capital Gains Annual Exempt Amount (£12,300 per person). This is all from your taxable brokerage/general investment account, plus an HSA if you have one (just a taxable account to HMRC). It makes sense to fill this exemption even if you don’t need the money – capital gains harvesting, so you sell one investment, buy another one slightly different, and your basis increases without paying any tax.
      • Caveat: be careful of your US capital gains tax as well! You could wind up in the 15% US capital gains bracket while still under the UK annual exempt amount.
    • There are also tax-free buckets for savings interest (up to £6,000) and dividends (£2,000). These are a bit harder to manage proactively, since you’re just getting paid interest and dividends on your holdings in a taxable account, but worth considering.
  • If you’re still in need of more money for spending once you’ve accepted State Pension, Social Security, and RMDs, plus taken advantage of capital gains and any other tax free buckets, you’re into the realm of paying tax on income, capital gains, and/or dividends, or drawing from tax-free accounts like ISAs and Roth IRA. If you’ve been doing Roth conversions through Phases 1 and 2, your Roth IRA may be quite a healthy balance, allowing you to minimize income that spills over the tax-free buckets.
    • It’s not really possible to give generic guidance at this point – you’ll need to weigh up what is important to you and what options you have based on your investments.
    • This also ties into your estate planning – you may not want to draw from your UK Pension because it’s excluded from your estate, for example.

And then thinking about US taxes:

  • Standard Deduction ($24,800 for married filing jointly). Much like the UK, this will get filled up somewhat by State Pension and RMDs (not by Social Security, at least – the US/UK tax treaty gives only the UK the right to tax Social Security as long as you’re resident in the UK). Depending on the size of your Traditional balance and your taxable income situation, you might consider continuing Roth conversions, or you might have more than enough! At this point, Roth conversions aren’t helping you get money early, but you’re choosing to have the conversions taxed only by the US, instead of Traditional withdrawals or RMDs that get taxed first by the UK, usually at a higher rate. You can also fill this from tax deferred accounts, like UK pension or US 401k.
  • Capital Gains 0% rate ($80,000, but wage income counts against it as well as capital gains). No change here from Phase 2 – it’s the same idea as UK, but also need to add in any capital gains or qualified dividends in your ISA, since the US considers those as simply standard taxable accounts.
    • You can harvest capital gains in your ISA that won’t show up on your UK taxes at all, and can take advantage of the potentially larger US 0% rate. However, if you’ve got Social Security, State Pension, RMDs, and/or Roth conversions as well, that may not leave much space.
  • The US doesn’t have a different bucket for interest and ordinary dividends, they just get taxed like wage income.
  • Just like the UK, you may find that your tax-free buckets are overflowing, so you’ll need to consider whether you need more money for spending, and if so whether you’ll accept paying some taxes on it or draw from your Roth IRA tax-free.

Goal 2: Execute Your Phase 3 Plan

In Phase 2, you should have made a plan for Phase 3 and done what you could to prepare. This would include how you’re going to manage Required Minimum Distributions, Lifetime Allowance and any penalties there, and estate planning. As you enter Phase 3, it’s a good idea to see how you’ve done preparing and put in place any modifications.

This part does get really specific to individual situations – some people may have RMDs that are more than enough to pay for all their spending and then some. Others may not being worried about RMDs but are pushing to avoid Lifetime Allowance penalties from taking too big of a bite. And estate planning is very personal – are you making gifts now, trying to preserve a legacy, donating to charities, and so on.

If you want to modify that plan based on how Phase 2 actually turned out, that’s fine, just update your plan, check how it affects your taxes, and put it on autopilot.

Goal 3: Continue Enjoying Retirement

Hopefully, you’re in a pretty comfortable place now. You’ve got access to all your money, you’re collecting your State Pension/Social Security, and can pretty much put your finances on autopilot. The more you can keep things simple, the better – at some point, you may need help with your finances, so if a spouse, child, or other trusted person can make sense of your plan instead of it only working in your head, all the better!

Estimating Social Security for Americans in the UK

I’m back after a short break – a week on holiday in Cornwall, and another week just catching up. I’ll continue my withdrawal strategies series in due course, but this is another quick aside, which is related but not central to that series.

A lot of people in the FIRE community, especially on the younger side, tend to ignore Social Security completely in their planning. On one hand, I get that, and I do the same to some extent – I discount both programs by 50% in my planning. The fact that both of those will very likely exist in some form in another 3ish decades gives me some backup in case things go very wrong, and I think 50% is probably plenty conservative.

I do think it’s worth everybody having some sense of how much Social Security could be – even if not for spending planning, it’s worth considering for tax purposes, because for many people it will fill all or most of your Personal Allowance, especially when combined with any State Pension. But there are some complications that apply especially to Americans living outside the US:

  • Many of us won’t have the full 35 years of earnings
  • If you qualify for the UK State Pension (or other similar scheme), you’ll probably be subject to the Windfall Elimination Provision, reducing your Social Security payments.

So, I’ll walk through the three steps I’ve taken in order to estimate my own Social Security payments – I welcome any feedback on other ways of doing this, because it does get slightly long winded 🙂

If you haven’t read my intro to Social Security and State Pension for Americans in the UK, it’s probably worth glancing over that before diving into this post.

Step 1: Your Social Security Earnings Record

This one is pretty easy. First, log into your mySocialSecurity account (create one if you don’t have one yet). Annoyingly, the website is only open for part of each day – why a website can’t be open almost 24/7 is beyond me, but just plan around it.

When you get in, click on “Review your full earnings record now”:

Copy your record – we’ll paste it into a calculator in the next step. You may want to store your record in Excel or Google Sheets for easy future reference, especially if you want to do any planning when the Social Security website is closed.

My earnings are $0 because I live and work in the UK now – no need to pay Social Security taxes due to the totalization agreement, but I also don’t accrue any earnings history. My US earnings history is in earlier years, but didn’t want to post that!

For illustration, I’ll use an example earnings record. Let’s say that Jill earned $60,000 a year from 2010 to 2019, then moved to the UK in 2020 with zero earnings, and Jill is married to Jack, who earned $40,000 a year over the same time period. They were both born on 02 January 1985, and plan on working for another 20 years in the UK, qualifying for 57% (20/35) of the new State Pension.

Step 2: Your Primary Insurance Amount

Once you’ve got your Social Security earnings record, I recommend using the very useful Social Security calculator at Note that this isn’t an official US government website, but I find it very useful and the security is such that I’m not worried about pasting my earnings record in, because it stays entirely on your computer (not that your earnings record is SUPER confidential, but probably not something you want out in the open).

Open up and click the big green “Get Started” button. The instructions on the site are pretty clear – you just need to paste your earnings history into the box. Here it is with our sample data for Jill:

Double check the numbers look good and press Yes. Put in your birthdate and then it brings up the report.

I recommend spending some time looking through this report – it does a great job of explaining how Social Security works, how future SS earnings would affect you (if you have any – you probably won’t live if you’re living in the UK, with a small caveat for self-employment).

Once you’ve had a look through, jot down your Primary Insurance Amount. If you’re married, repeat the process for your spouse.

In our example, Jill’s PIA is $1,103.10, Jack’s is $927.70.

Quick Aside – Social Security Bend Points

You may have noticed that Jill made 50% more than Jack every year, but her PIA is only 19% more than Jack’s. That’s because Social Security is intentionally tilted towards replacing a larger percentage of the income of lower income workers compared to higher ones. has a nice chart illustrating this, here’s Jack in green and Jill (almost) in blue:

There’s a more detailed explanation on the site, but the key is that “bend point” between 90% and 32%. That’s saying that both Jack & Jill get 90% of their “Average Indexed Monthly Earnings” up to a threshold (currently $996), but only 32% above that (and only 15% above $6,002 – that would mean about $72k in Social Security earnings over 35 years, or maxing out your SS earnings above about $142k for 18 years). So there are quickly diminishing returns to earning beyond the bend points.

This is actually a pretty good thing for many people who work in the US for 10 or so years before moving to the UK – you’ve gotten the most bang for your buck by filling up the 90% portion, even with only 10 years of work at a fairly modest wage ($40,000 is around the 34th percentile of US income, although would have been higher back in 2010).

Step 3: The Impact of State Pension & WEP

I really like the calculator, but one thing it doesn’t model is the impact of also receiving the UK State Pension. This triggers a Social Security clause called the Windfall Elimination Provision. There is another open-source calculator, Open Social Security, that handles WEP, and also has some nifty guides to help explore possibilities of when to start taking Social Security.

Bring up Open Social Security, and you’ll want to click the somewhat unobtrusive box at the top for special situations:

Then let’s fill out the form with Jill and Jack’s information – there’s a couple of things we’ll need to calculate first:

  • State Pension amount: The full State Pension is £179.60 per week, but Jack & Jill will only get 57% (20/35) of that, since they only work 20 of the 35 years required for full benefits. Assuming a $1.40 to £1 exchange rate, that comes out to $622/month each.
  • State Pension age: Check on the quick UK government calculator – for Jack and Jill, their State Pension age is 68, so they’ll start collecting State Pension in January 2053
    • There is an option to delay taking the State Pension, we’ll look at that in a bit
  • Your WEP-reduced Primary Insurance Amount. Two ways of calculating this:
    • Simple Way: If you don’t have any more Social Security earnings planned in your life, the WEP is just half of the State Pension, so $622/2 = $311. Subtract that from your non-WEP PIA – for Jill, that’s $1,103 – $311 = $792, for Jack it’s $927 – $311 = $616
    • Official Way: Use the official WEP calculator. Use your full retirement age (67 if you’re born in 1960 or later). Re-enter your earnings record, your State Pension amount from above, and it’ll spit out “Your monthly retirement benefit” – that’s your Primary Insurance Amount, reduced by WEP.

Now transcribe all that into Open Social Security:

The calculator then spits out a few different, interesting things:

  • A recommended strategy for when to start collecting Social Security, including a table showing the various amounts by year.
    • From playing around with it, this tends to be for the spouse with the lower PIA to file early, collecting their full benefit from age 62, then a WEP-reduced benefit when State Pension kicks in at 68, and for the spouse with the higher PIA to file as late as possible, collecting their WEP-reduced benefit from age 70.
    • If the difference is large enough that the higher PIA spouse has a PIA more than twice the lower PIA spouse, the lower PIA spouse will get bumped up to 50% of the higher PIA as a spousal benefit, once the higher PIA spouse starts collecting.

For Jack & Jill, we see an initial annual benefit at 62 of $7,787 from just Jack, dropping to $5,174 when he starts getting the State Pension (although Jack and Jill each start getting $7,464 from the State Pension), and finally $11,785 from Jill when she start’s getting Social Security at age 70. From age 70, that means the couple is collecting $31,887 across Social and State Pension – a good chunk of change!

  • The calculator also spits out a chart, showing how the benefits would change with alternative claiming strategies:

This is useful for seeing how big a difference it can make to claim earlier or later.

The calculator also let’s you explore some other variables. Here are two I think are particularly interesting:

What about cuts to Social Security?

As you’re likely aware, Social Security is not fully funded, and something will need to be done in the future to sustain it. That could be higher taxes, cuts to benefits, means testing, cancel the entire program and let seniors starve on the streets, etc. The actual choice is up to the politicians – without a crystal ball, I have no idea.

I think it is worth considering the possibility that benefits of current workers won’t be as high as they are today. There’s another option up top called “Possible Future Cut in Social Security benefits” – tick that box. If you scroll down to the bottom of the calculation input screen, there’s now an option to reduce the benefit by a percentage, starting in a specific year. Let’s look at Jack & Jill using the default of a 23% cut in 2034.

The calculator spits out the same kind of results, now just reduced by 23%:

Even at this reduced level, we’re still talking about more than $13k/year, plus whatever they get from the State Pension – enough to be worth considering.

How about delaying the State Pension?

This one isn’t built into the calculator, but isn’t too hard to do. There’s an option to defer taking the State Pension, which increases the benefit by about 5.8% for every year. So if Jack & Jill delay by 2 years to age 70, they’d get about $8,363 a year each instead of $7,464 (7,464*1.058*1.058). But, this bigger amount means their WEP goes up as well. Let’s recalculate that:

  • Recalculate WEP and the after-WEP PIA
    • Simple Way: Same as before, WEP is half of the State Pension. That’s $697 per month State Pension divided by 2 = $349.
      • Jill’s WEP-adjusted PIA is now $1,103 – 349 = $754
      • Jack’s WEP-adjusted PIA is now $927 – 349 = $578
    • Or re-do the official WEP calculator with the deferred State Pension amounts.
  • Update the PIA’s on Open Social Security, change the month and year in which the State Pension will begin, and submit.
  • The calculator spits out new results. For Jack & Jill, the key results don’t change too much, and the overall recommendation is the same:
    • Initial benefit on just Jack’s Social Security is the same at $7,787 – there’s no impact until State Pension kicks in.
    • Now that State Pension is delayed to age 70, the same age Jill starts collecting Social Security, there’s no intermediate stage – at age 70, Jill starts collecting $11,220 in Social Security, Jack’s drops to $4,855 due to WEP, plus they each get $8,363 in State Pension.
    • That’s now a total of $32,801 a year from age 70, compared to $31,877 if they’d taken State Pension at age 68. About $1,000 more a year, but not getting any State Pension at all for 2 years – I won’t do the present value calculations, but in Jack and Jill’s case, that doesn’t sound like a huge benefit.
      • Conceptually, this makes sense – State Pension increases at 5.8% a year, but for every extra dollar they get of State Pension, they lose 50 cents of Social Security, so you’re really looking at only 2.9% increases. That’s not very attractive, at least to me.
      • Obviously, Jack & Jill is a hypothetical, and this is not a universal outcome – try out your own numbers.

So what do I do with this information?

Three key takeaways for me:

  1. If you have 10 years of US Social Security earnings at most full-time wage levels, you’re looking at a pretty significant benefit – often something north of $1,000 a month.
    • If you don’t have 10 years of Social Security credits but you’re reasonably close, it may be worth thinking about how to get them. That might be delaying a move slightly (depending on your overall picture), using the totalization agreement, or maybe you want to do some self-employment in the UK and not elect out of paying Social Security taxes.
  2. Even if you don’t include this income in your retirement income planning, it’s worth keeping in mind for tax planning, especially when combined with State Pension.
    • Even for Jack, with the lower income history and taking Social Security early, he’s looking at $7,787 in Social Security plus $7,464 in State Pension every year. That’s something close to £11k, which doesn’t leave much tax-free space in the £12,300 Personal Allowance for withdrawals from pensions, 401(k), etc.
    • Jill would be over the Personal Allowance just with her $11,785 SS and $7,464 State Pension (about £13,750 in income).
    • Throw in some Required Minimum Distributions, and you’re very quickly well into the UK 20% basic rate, maybe pushing into the 40% higher rate income tax.
  3. The timing of when to take Social Security gets complicated, especially for a couple with a mix of Social Security and National Insurance records. There’s no one answer, but it’s worth looking into more closely when you get close to it.

How are you accounting for Social Security in your plans? I’m curious to hear your perspectives.

Tax on UK Pension Withdrawals

A relatively quick one today, on a topic I’ve been trying to nail down for a while. Disclosure up front – as always, I’m not a professional. This topic is particularly complex, and I invite discussion and disagreement; I’ll happily update this post if anybody finds any inaccuracies and call out any alternative viewpoints. Just leave a comment and we can talk 🙂

I’ll also caveat that this is a high-level, conceptual discussion. I’ve summarized about 134 pages of IRS publications in just over 1,300 words – there are many details and caveats that you’d need to research before relying on this.

The focus for today is taxation of withdrawals from your UK pension. I’m mostly considering defined contribution pensions – both workplace and a SIPP – although the same concepts generally apply for defined benefit. We’ll consider all three main withdrawal types: flexi-access drawdown, lump sum (UFPLS), and annuity.

Quick summary: the UK tax situation is clear, the US one not quite so much but still reasonable. Key takeaway is that the method of your withdrawals (periodic vs nonperiodic) has an interesting effect on how the US taxes you, something we might be able to use to our advantage (or at least need to consider in our planning). Also, it looks like it’s usually best to include pension contributions in your taxable income while you’re working.

UK Tax

The UK side is the easy part: 25% of your pension is tax-free, 75% is taxable income. You can take the 25% up front or as part of later withdrawals – for most US citizens, you won’t want that big lump sum that’s UK tax-free but probably US taxable, because you likely won’t have enough Foreign Tax Credits to fully offset the US tax, resulting in you paying real dollars to the IRS.

Today, I’m not going to discuss any further whether the US respects the tax-free status of that 25%. That’s a knotty treaty question, and not one I’m 100% convinced about. If I had to say, I find it more convincing that the US will tax all of the pension, not just 75% of it, but that’s far from a certainty.

US Tax

The US approach to tax on a UK pension depends significantly on whether you take the withdrawals as periodic payments or nonperiodic payments, so we’ll treat them separately.

Periodic Payments

This would obviously include a traditional annuity, but also if you set up a flexi-access drawdown to pay you automatically on a periodic basis – for example, if you want a pre-set monthly income. The IRS just requires that the periodic payments be paid at regular intervals (weekly, monthly, annually, etc.) for a period of time greater than 1 year.

All the details are in IRS Publication 939, and is called the “General Rule” (which is confusing, because the “Simplified Rule” seems to be actually more common for most Americans, since it applies to 401(k)s and the like, but go with it). Grab a strong cup of coffee before you dig into that one, but in a nutshell:

  • In general, the portion of each payment that can be attributed to contributions to the pension is tax-free, while the part coming from gains is taxable.
    • This assumes that the contributions were subject to income tax when they were contributed, both employer and employee contributions. If they were excluded, they don’t count as cost (makes sense – you now have to “pay” income tax on withdrawal since you didn’t “pay” when earned).
  • Because it’s a periodic series of payments, every payment includes both tax-free and taxable portions, in proportion to the overall ratio of contributions to gains.
  • Figuring the cost of the pension is mostly as simple as totaling up all the contributions – there are some subtractions for refunded premiums, unrepaid loans, and so on, but these are probably rare. The most likely would be any contributions that were previously withdrawn as a nonperiodic payment
  • Then there’s some calculations to do:
    • For an actual annuity, take a look at Pub 939, because there are specific cases for different types of annuities.
    • For periodic payments other than an annuity, you use an actuarial table to look up how many payments you expect to get. For example, if you’re 65, the IRS expects you to live another 20 years. Then, you divide the cost of the pension by the expected number of payments. For example, if you are 65 and have £120,000 of cost in the pension, you divide £120,000 by 20 to get £6,000 tax-free for each annual payment.
      • This part is a little tough to read in the pub, because it talks so much about annuities and not much about non-annuity periodic payments. If somebody else reads this section and comes to a different conclusion, I’d love to hear it!

Nonperiodic Payments

This would apply to lump sums (UFPLS) as well as nonperiodic flexi-access drawdowns. This is discussed in IRS Publication 575, which mostly covers the “Simplified Rule” that applies to qualified US plans, but also throws in this nonperiodic part.

There’s two sub-options here:

  1. If you take the payment before starting periodic payments (most likely), the payment is first allocated to gains in the pension and are fully taxable, until you’ve withdrawn all the gains. Then the payments are allocated to the cost of the pension, and are tax free.
    • Like with periodic payments, the cost of the pension is the sum of all the contributions that were included in taxable income, with some potential adjustments and caveats.
    • In practice, I think this means that all of your “early” nonperiodic payments would be fully US taxable until you’ve withdrawn all the gains, then all your “late” periodic payments would be US tax free.
  2. If you take the payment at the same time you start periodic payments or after they start (as in, you’ve got periodic flexi-access drawdown going but then you take a lump sum), the entire payment is taxable, unless the subsequent periodic payments will be reduced because of the nonperiodic payment. In that case, a portion of the payment will be non-taxable, in proportion to the reduction in future payments (there’s a slightly complex calculation involved).

So What?

Two key takeaways for me:

  • It is likely to most people’s benefit to include employer and employee pension contributions in your US taxable income while you’re working.
    • Under the US/UK tax treaty, you do have the option to exclude these contributions. Because UK income tax rates are higher than US ones, you’ll build up Foreign Tax Credits more quickly if you have less US taxable income, and potentially could use those FTCs if you start pension withdrawals within the next 10 years. That’s good, because if you don’t include these contributions, you probably won’t have any cost basis in your pension – effectively all of your withdrawals will be US taxable.
      • If nothing big changes from now, that still probably doesn’t matter much – the UK taxes on 75% of a withdrawals are still mostly more than US taxes on 100%, so FTCs wipe out any US tax owed. But that’s a pretty close calculation today, and could easily change over the years with tax updates, exchange rate movements, etc.
    • If you don’t exclude the contributions from your taxable income, you “pay” US tax in the year the contributions are made (probably, you just use FTCs and don’t actually owe anything), and build up the cost basis in your pension. In withdrawal, that means a big chunk of your pension is tax-free, and you only need to worry about US tax on the gains.
  • The differing US tax treatment of periodic vs nonperiodic withdrawals might open some interesting opportunities in retirement. For example:
    • If you’ve living off periodic payments from your UK pension in the first few years of “middle retirement” (Phase 2), the fact that only part of the withdrawal is US taxable could give you more space in the low/no tax brackets for Roth conversions
    • Since nonperiodic (lump sum) withdrawals start as taxable and then switch to tax-free once you’ve gone through all your gains, there might be an opportunity to take advantage of that switch, potentially with a substantial US and UK tax-free lump sum. There are definitely drawbacks here too, but something to think about.
    • At the very least, the two different regimes bear including in your planning, even if you wind up with a simple approach.

Any other thoughts? Ideas for how this might help or hinder you? Leave a note in the comments.

There won’t be a post next week, but I’m slowly working on wrapping up my withdrawal planning series – hopefully done by the end of June!

Tax Management in Middle Retirement (Phase 2)

This is Part 3b of our Retirement Withdrawal Strategies series.

Quick summary so far:

Today, we’ll look at “Middle Retirement” or Phase 2 in more detail. Reminder of the phases:

We’ll follow this up with Part 3c on Traditional Retirement (Phase 3), and finally Part 4 looking at a few scenarios and how it can all work in practice.

Phase 2: Middle Retirement

If you’ve made it to Phase 2, you’ve survived Phase 1, with some amount of money left (even if you’re just skidding into it by the skin of your teeth!). That’s ok, because Phase 2 is where you get access to the rest of your money:

  • Age 55: UK Pensions & SIPPs (there’s an ongoing conversation about changing this to age 57, it’s not clear yet if existing plans will be grandfathered in)
  • Age 59.5: All US retirement accounts – Traditional and Roth, 401(k), 403(b), TSP, IRA, etc.
  • Age 60: UK Lifetime ISA
  • Age 65: HSA for non-health expenses
    • This is probably in Phase 3, but conceptually fits here. I won’t go into any detail – it’s basically the same idea as a Traditional IRA unless you can use it for health expenses (even carried forward from previous years/decades!), in which case it’s more like a Roth IRA.

Three main objectives for Phase 2, carrying on from Phase 1:

  1. Ensure you have enough money to last the rest of your life without paying too much in taxes, with the boost from Social Security and/or State Pension in Phase 3.
  2. Continue setting yourself up for success in Phase 3. Three key considerations:
    • Required Minimum Distributions
    • Lifetime Allowance penalties
    • Estate planning
  3. Continue enjoying retirement!

Now that we’ve got access to all this money, with a wide variety of tax treatments, the considerations get somewhat more complicated – the “new” accounts in Phase 2 are in bold

Goal 1: Don’t Run Out of Money Before You Die

And try not to pay any more tax than you have to, along the way!

By Phase 2, you’ve likely weathered any sequence of returns risks – if you’re unlucky, your portfolio may be somewhat diminished from the beginning of Phase 1, but as long as you’ve had a sensible Safe Withdrawal Rate and maybe adjusted spending a bit, you should be ok (barring an unprecedented market collapse). If you’re more typically lucky, you’ve come out with more money than you started.

Either way, this is a good time to revisit your withdrawal plans and incorporate any updates in your plan moving forward. Maybe you’re comfortable increasing spending a bit. Maybe you’re getting a better picture of your life expectancy in light of any health issues that may or (hopefully!) may not be appearing. Maybe you want to start gifting to children or grandchildren, while they’re still young enough that it makes a big difference to their lives. And so on – it’s your call.

Once you’ve reviewed and adjusted your spending needs, if necessary, you want to start thinking about how to fill your tax-free and lower tax buckets to provide for that spending.

Starting with UK taxes:

  • Personal Allowance (£12,570 per person – all numbers are for 2021). Fill this from your tax deferred accounts:
    • US Traditional balances (IRA, 401(k), etc.)
    • UK Employer Pension/SIPP – you get to withdraw 25% tax free without counting against your Personal Allowance, so you can actually withdraw up to £16,760 if you don’t have any other wage income before you pay tax.
    • We’ll talk about which of these you want to focus on in Goal #2 – it’s all about RMDs and Lifetime Allowance – you may wind up not using much of this at all, depending on your Traditional vs Pension split.
  • Capital Gains Annual Exempt Amount (£12,300 per person). This is all from your taxable brokerage/general investment account, plus an HSA if you have one (just a taxable account to HMRC). It makes sense to fill this exemption even if you don’t need the money – capital gains harvesting, sell one investment, buy another one slightly different, and your basis increases without paying any tax.
    • Caveat: be careful of your US capital gains tax as well! You could wind up in the 15% US capital gains bracket while still under the UK annual exempt amount, especially if you have a lot of Roth conversions.
  • There are also tax-free buckets for savings interest (up to £6,000) and dividends (£2,000). These are a bit harder to manage proactively, since you’re just getting paid interest and dividends on your holdings in a taxable account, but worth considering.

And then thinking about US taxes:

  • Standard Deduction ($24,800 for married filing jointly). You can fill this from tax deferred accounts, similarly to the UK (although 100% of your UK pension will be taxable). But, you can also use Roth conversions here, which are probably not UK taxable. If you have a significant Traditional balance, you’ll probably want to focus on Roth conversions over Traditional balances, and then take out the conversions US & UK tax free after 5 years.
  • Capital Gains 0% rate ($80,000, but wage income counts against it as well as capital gains). Same idea as UK, but also need to add in any capital gains or qualified dividends in your ISA, since the US considers those as simply standard taxable accounts.
    • You can harvest capital gains in your ISA that won’t show up on your UK taxes at all, and can take advantage of the potentially larger US 0% rate. However, if you’ve got lots of Roth conversions as well, that may not leave much space.
  • The US doesn’t have a different bucket for interest and ordinary dividends, they just get taxed like wage income.

Let’s look at Goal 2 before deciding how to fill the buckets.

Goal 2: Set Up for Success

Hopefully, you’re already well on your way to managing Required Minimum Distributions, but it’s worth rechecking how you’re doing. If you’ve had more growth in your Traditional balances than you were projecting, there may be a need to readjust. Conversely, if you’ve suffered with less growth than you hoped for, there’s a small silver lining that it helps with RMDs.

You’re now also in a position to do something more active about the Lifetime Allowance for your UK Pension/SIPP, beyond just “don’t contribute so much” and “put your bond allocation here (or in a Traditional balance).” Basically, if you start to withdraw aggressively from your pension as soon as you can, you can reduce the growth of your pension and avoid going over the LTA, or at least reducing how much you go over, and thus how much attracts the 25% penalty.

There are three main drawbacks:

  1. You have to pay taxes on your pension withdrawals. Typically, 75% of the withdrawal will be UK taxable and 100% is US taxable. Very roughly, Foreign Tax Credits will usually mean the UK tax on the 75% offsets the US tax so you only owe HMRC, not the IRS. If you withdraw aggressively, it’s not hard to get into the UK 20% or even 40% brackets. Paying 40% now to escape 25% penalty and 20% income tax later is a wash at best.
  2. There are downsides to wherever you move the money you don’t spend – you can put £20k a year in an ISA, but it’ll need to be individual stocks to avoid PFIC pain, plus it’s US taxable. Your only real option is a fully taxable account, so you lose the tax deferral of the pension.
  3. Your pension isn’t part of your estate when you die, so it isn’t subject to inheritance tax. Anywhere you move that money to will be part of your estate, so could be taxed at 40% on your death. Not a big deal if you’re not expecting to leave much to your heirs, but if you’ve been fortunate and expect to have a sizable portfolio at death, it’s worth considering leaving as much of it as possible in your pension.

There’s no single clear answer on how to approach RMDs vs the LTA, but you should consider them both and come up with a plan that makes sense for you. It might be a balance of Roth conversions and pension withdrawals, might be a focus on one or the other, or you might realize that neither RMDs nor the LTA are a big deal for your particular situation – those are all valid options.

The other thing to consider here is revisiting your estate planning. Have a will up to date, start considering any gifting strategies, that kind of thing. If you’ve got a complicated situation with accounts in two countries, it’s probably worth consulting a professional, even if it’s just a one-off review, get wills and such signed, etc.

Goal 3: Continue Enjoying Retirement

You’ve now got access to all your hard-earned money, you can spend according to your plan and hopefully put most of your finances on autopilot. You’ll just need a bit of attention for withdrawals, Roth conversions, that kind of thing – hopefully something you can do with a cup of tea once a month.

Transition to Phase 3

You get to pick when you move from Phase 2 to Phase 3 – it could be anywhere as soon as 62 to as late as 70, depending when you choose to start Social Security payments. State Pension can’t be brought earlier than your State Pension age (probably between 66 and 68 for anybody reading this, may well get delayed further for some of the younger readers). The calculations can get pretty detailed – might be something I look at in a future post – but in general, the longer you wait, the more you get paid every month, but the fewer months you have remaining.

You might want to take a stab at planning out Phase 3 at the same time you revisit your plans for Phase 2, probably sometime before you get access to your pension (maybe around age 54 or 56, if you get access at 55 or 57). You’ll know your working history and can get a good idea of your Social Security and State Pension payments. We’ll talk through it in the next part, covering Traditional Retirement.