Powerball vs. the UK Lottery

I heard this morning about a record Powerball jackpot of $500 million, which is the fourth largest jackpot ever posted by the American lottery game. So tonight, across the 44 states plus the District of Columbia, Puerto Rico, and the US Virgin Islands, people will be waiting in lines to try their luck at becoming an overnight multi-millionaire.

This in itself is not that amazing, and it happens on a fairly regular basis -- not to me, of course, but  big jackpots in the US are not uncommon. The largest Poweball jackpot was just over $590 million, which was won by a single ticket holder, in 2013. 

The amazing part is that the Britain is also having a record setting lottery draw tonight. While the National Lottery's record "Lotto" jackpot is much smaller at £50.4 million, or about $74 million, it does have a lot of benefits over America's Powerball.

 

Odds

To correctly guess the odds of Britain's Lotto, you have to get all six numbers right, which puts the odds at around 1 in 45 million. 

There is also a caveat that if the Lotto jackpot is over £50 million, someone with only five correct numbers can win if there are no winners with six numbers. This basically guarantees a winner as the odds of getting five numbers are 1 in 144,414. 

In the US, the odds of winning the Powerball are about 1 in 292 million.

 

Taxes

The British Lotto doesn't tax lottery winnings. Instead, the taxes are paid when you buy a ticket. This means that the winner, if there's only one, will claim the entire £50.4 million jackpot.

In the US, lottery winnings are subject to Federal income tax, which will take 39.6% of the lottery winnings. Additionally, many states have additional taxes and withholding, but for this thought experiment, let's disregard this. If you're very curious, or just very worried that you'll actually with the Powerball tonight and need to figure out your tax situation, you can consult some lottery tax guidelines.

Lastly, the US Powerball lets winners choose to collect their winnings a portion at a time, spaced out over many years, similar to an annuity, or to receive everything at once in a 'lump-sum.'

The first option is enticing because it would provide several hundred thousand dollars, if not millions, in income for the next several decades, which could also result in a lower tax bill and would also allow you to fully collect the entire jackpot. Except that's a bit misleading because while you'll collect the full dollar amount of the jackpot over the years, the purchasing power will have declined significantly by the time you collect everything. You also run the risk that something catastrophic happens and your money doesn't exist or simply isn't paid to you down the road. 

This is why most people choose the second option, which is the 'lump-sum' amount, also referred to as the 'cash value' of the jackpot. You get all of the money up front and you can then do whatever you want with it. However, the catch is that because you aren't allowing the lottery to self-finance the jackpot, you will receive a smaller amount than the jackpot in exchange for having it all now.

 

Comparison

So in Britain, if you won, you'd receive £50.4 million, or about $74 million.

In the US, if you won, you'd start out with a jackpot of $500 million, which would then be reduced to $306 million when you chose the 'lump-sum' option. This $306 would be subject to the US Federal Income Tax Rate of 39.6%, which would lower the payout to $189.72 million.

While winning either of these lotteries would be great, assuming there's only one winner, the British Lotto comes out ahead:

1. With odds of 1 in 45 million to win $74 million, each entry is worth $1.64.
2. With odds of 1 in 292 million to win $189.72 million, each entry is worth $0.65.

Even with the current exchange rate of $1.46 per £1, the expected return on the British Lotto is positive; with the big assumption being that there is only one winner.

Yet, the odds of 1 in 45 million or 1 in 292 million do roughly correspond to the population numbers of both countries so it's at least reasonable to say that each have a relatively equal chance at having only one winner. 

Also, each American Powerball ticket costs $2, which means that as long as there's only one winner, the relative value of a Lotto ticket at ($1.64/$1.46) $1.12 is 3.5 times higher than the relative value of a Powerball ticket at ($0.64/$2.00) $0.32.

 

Conclusion

So given the choice, playing the UK Lotto is about 3.5 times better than playing the American Powerball. Unfortunately for me, being in the US, you need to be in the UK to purchase a Lotto ticket, whether online or in person.

However, it's an interesting thought experiment, which I'm sure I'll be glad that I took the time for once I've won the Powerball tonight. And, just in case I don't, you can always reach out to us for free financial advice, whether you've won the lottery or not. 

How to Deal With Inheritance

Most people get squeamish when they start thinking about either inheriting money from their parents or setting up a way to funnel an their own money down to their their children. It's entirely natural because by making plans around inheritance, it can feel that in some way you're acknowledging the future passing of yourself or a loved one. 

However, it's necessary to have those conversations because simply avoiding them won't make them go away, and in the US, they're currently set to accelerate as baby boomers are on track to inherit an estimated $8.4 trillion.

Of that $8.4 trillion, they've already received about $2.4 trillion, with another $6 trillion yet to be distributed, according to the Center for Retirement Research at Boston College. This means that the average household will inherit about $300,000, while the wealthiest 10% of households would inherit nearly $1.5 million. 

Of course, not everyone will inherit such large sums, but still - you get the point.

So how can you set yourself up to make the most of your inheritance gift and make smart choices? 

1. Don't do anything foolish

One of my favorite anecdotes as a money manager is this: Do you know how long it takes the average person between the time when they receive their inheritance and the time when they decide to buy a new car?

The answer: 9 days.

I'm not sure of the source of that often-repeated statement, but it holds enough truth that most people can identify and relate to it. So before you do anything - just do nothing for a while.

And if you do decide to buy a new car, first pay off the loan on the old one, trade it in, and then use the money you were paying the loan down with to put towards your retirement. So rather than having an old car that you pay $400 a month for, you'll now have a new car and be investing that $400 a month into a retirement account. 

2. Make smart choices

So, what's the right course of action? First, take a look at your financial life and assess where you currently are, such as if you already have enough money for your retirement? To put your kids through college? If you aren't particularly well-off and are worried that you might spend the money too quickly, you can always look at an immediate fixed annuity, which would pay you a set amount for life, or speak to a financial advisor about your best options.

In terms of generic choices, pay down high-interest debt, like credit cards and set up a 6-month emergency fund cushion, which is kept in safe, easy-to-access investments in the event, for example, that you lose your job and need to move across the country.

3. Understand the emotional connection

If you were to look at two groups of people who had just had a large $1 million windfall, but one group won the lottery, while the other group inherited the money from their parents, you'd find that the two groups would behave very differently. The group who had won the lottery would have an easier time, in general, spending the money, whereas the other group would have a greater emotional attachment to the money.

Often, we'll see clients that will want to either: i) not touch their inheritance because they don't feel that it's their money, or ii) will want to spend the money in a way they think honors their parents.

Both of these are reasonable responses, and it's fine to do what your parents would have wanted; but it's also important to think about if it's what you want also, and if it makes financial sense to you and your family.

4. It can get complicated

Estate issues are rarely straightforward, and there are usually a lot of caveats that can accompany estate planning. For example, know that most people don't get an inheritance until the death of their surviving parent, and as many people are living into their 90s and beyond now, it's unwise to make expectations around receiving an inheritance.

Also, depending on the investment vehicle you are inheriting, there are different rules and regulations that can be applicable. For example, an IRA will make you start withdrawing money immediately, but you'll be taxed on the withdrawals. To counter this, you'll want to think about converting it into an Inherited IRA or to limit the amount you withdraw to the minimum required. If it's a Roth IRA, you'll still be required to make withdrawals from the account, but they won't be taxable as they've already been taxed.

Conclusion

As always, if you feel like you need advice on what to do with an inheritance you've received or how to structure one for your heirs, we are a fee-only, fiduciary investment advisor and would be happy to give you some free advice. You can reach us here. 

3 Reasons Why Market Timing is a Lie

A few days ago, CNBC ran a story on Bob, "the world's worst market timer." In the scenario, Bob made his first investment in 1973, right before a nearly 50% crash. Then a second investment in September 1987, right before another 34% crash. Followed by a third and forth investment in 2000 and 2007, respectively. So after 42 years of misfortune, how did the "world's worst market timer" perform? 

He had an annualized return of nearly 9%. The key was that Bob never sold his holdings, and instead relied on capitalism to carry his savings higher.

I wanted to look into this story further and see what else we could learn from Bob.

1. Liquidity is key.

We've preached to clients for years that the key to being successful in the long-run has to do with staying invested. In fact, here's a chart that we often show in client meetings showing the impact of jumping in and out of the market.

Just missing the top 25 days in a 45-year period lowers your return by over 400%! And, those 25 days probably came during the scariest, most volatile times.

So having a proper asset allocation so that you're able to withstand market fluctuations without trying to time the market is key because it lets you stay invested and liquid. If he would have needed that money for something else, it would have gone terribly.

2. Inaction is still action.

Many people don't invest because they think the market is on the brink of collapse. And while they're sometimes right, the overall effect is devastating on a portfolio. 

Like Bob, consider the story of Sad Suzy, who invested $2,000 a year for 20 years between 1993 and 2012. The only difference is that Suzy invested her $2,000 each year on the highest day of the year. While Suzy is not only willing to invest in the market, she's also very unfortunate to pick the worst day each year to begin investing. Now, contrast her to Scared Sam, who keeps all of his money in cash because he's either afraid of a market crash or waiting for the 'next big thing.' 

Over that 20 year period, Sad Suzy with her terrible market timing will still end up with nearly $72,500, which represents a nearly 50% higher return than Scared Sam, who will have about $51,300 in his portfolio.

3. The fallacy of being perfect.

Now, consider two other people Perfect Paul and Immediate Ida. Perfect Paul takes his $2,000 a year and invests it at the lowest point of the year for 20 years. That means Paul is able to perfectly time markets to the month for 20 years - an impossible task. On the other hand, Ida invests her $2,000 as soon as she gets it. This means that Ida will invest in January of every year, while Paul may wait until August, if that's the lowest month of the year, and this means that Paul should earn a superior return to Ida at almost every turn.

Well, after 20 years, you find that Paul's portfolio comes out to $87,000 while Ida's is at $81,650. So Paul's portfolio outperformed Ida's by about 7% after 20 years of being able to predict the future. Personally, we don't find this $5,000 out-performance to be all that impressive.

The lesson we took from this? Unless you know the future, you should just invest your money into the stock market whenever you can, and not only will you bypass a lot of the emotional stress of the market, you'll achieve a similar return to someone with nearly-perfect timing. 

What did we learn?

The quote about "just showing up is 90% of the job" is true in investing too. While it would be ideal to have a crystal ball, you can avoid all of the emotional turmoil of market timing by just investing regularly. For us, we love to see our client's succeed, and we see this most often when they make regular contributions into their investment accounts.

This concept is often referred to as 'dollar cost averaging,' which we've talked about before. Short of that, investing immediately is a great solution for most investors. The key is to work with a good financial advisor that understands your liquidity needs and your time horizon for investing. 

Harvard, Class of 2035

Like most grandparents, my parents and in-laws are convinced my 20-month-old son is a child prodigy. Every new word and new motor skill is followed by exclamations of ‘he’s so smart’ and ‘what a genius’ and they're ready to enroll him at Harvard or MIT next semester. While all this is perfectly normal ‘grandparent-tinted glasses,’ it did get me thinking about our college saving plan and what that might mean for someone entering college in 2033. I am fortunate enough to have graduated without accumulating any student debt thanks to my parents, which left me free to start working toward other financial goals like a down payment on a house and saving for my retirement, but will my children be as lucky? It was time to look at the numbers.

Now, there is every chance my son might actually be a prodigy and either get a full ride scholarship to whatever school he chooses or he could become a billionaire before he hits 18, but my wife and I have seen him try to eat out of the dog bowl and feel we could all benefit from a backup plan. 

What will college cost for my children?

So let’s look at three cost predictions, one for private universities, one for in state residents at public schools, and lastly out-of-state residents attending public-colleges.

According to the College Board, the average cost of tuition and fees for the 2014-2015 school year was $31,231 at private colleges, $9,139 for state residents at public colleges, and $22,958  for out-of-state residents attending public universities.

Let’s assume that tuition rates continue to rise at an average of 5% per year, which is the 10-year historical average rate of increase according to The College Board(R). This table shows what college costs will look like in 18 years.

Private

State resident public

Out-of-state resident public

One Year

$80,988

$23,699

$59,535

Four Years

$349,068

$102,146

$256,603

Now, before you look at these numbers and declare your children ‘need not apply’ to anywhere out of state let alone a private school, it’s worth remembering that many students qualify for financial aid and/or receive scholarships which can have a substantial impact on these numbers.

When should I start saving for college?

So what does this all mean for your savings plan? Let’s say you have a 5 years old, and you’re ready to start putting aside some money each month for college. That gives you roughly 13 years of savings to prepare. If you commit to putting in $200 per month, every month, and you invest that money at an average market return of 7% per year by the time your little one enrolls in advanced astrophysics or the history of underwater basket weaving, your savings will have grown to over $50,000.

The most significant way that this number changes isn’t down to how much you save each month. It mainly comes down to time due to the magic of compound interest. Lets say Junior takes a long time to stop eating the paste and you wonder if he will ever go to college. Fast forward 10 years and his award winning science fair project is a nutritiously dense paste that will end third world hunger. Time to start saving. By now you have a 12-year-old and just six years to save. The same $200 per month will only get you to $18,000. However, if you start from day one, and save for a total of 18 years, your contributions will get you over $86,000, nearly enough to cover the entire bill of a state school.

So what have we learned?

So my overall thoughts after doing this research? I should have started saving from the day we found out we were expecting and maybe even a year or two earlier if my wife’s desires for 4 kids actually come to fruition. But, as my genius child is yet to invent a time machine, I’m just going to have to start saving from today. It seems the rule for college saving is much like the rule for retirement saving, if you didn’t start yesterday, start today. 

Is maxing out my Roth IRA each year enough to retire on?

Often when I hang out with friends in their 20's, they don't think about retirement because they are either putting money into their 401K plan through work or a Roth IRA.

This got me thinking about how much a person needs to retire, and if they only put money into their Roth IRA, how would that work out for them?

What is a Roth IRA?

A Roth IRA is a US retirement plan that is generally not taxed, as long as certain conditions are met. The main difference between a Roth and a regular IRA is that a Roth doesn't grant a tax break for placing money into the account but rather the tax break is granted on the money withdrawn from the plan during retirement. 

How much to save?

A good rule of thumb is that if you're taking the traditional path and planning to retire in your 60's, you should save around 15% of your income for retirement. The earlier you start doing this, the easier it's going to be for you in the future. 

So let's take a hypothetical 25 year old, who makes $40,000 a year, and as such, is able to save the maximum of $5,500 into a Roth IRA every year, as it only represents a little under 14% of her annual income. She'll continue putting in $5,500 every year into her Roth, until she is 50, when she will start contributing $6,500, which is the maximum contribution for people over the age of 50. Now, let's assume a 7% annual return.

When she retires at 65, she'll have around $1.3 million in her Roth IRA, which is completely tax-free when she withdraws it from her account to live on. That's an amazing sum to have amassed just through a Roth IRA! 

And to highlight the importance of starting early, if she had started at 30 instead of 25, she'd have just over $900,000 in her Roth IRA, nearly $400,000 less because she waited just 5 years!

So she retired at 65 with $1.3 million. Now what?

For most people, $1,300,000 is a lot of money - I mean, just look at all those zeroes! But, when you start thinking about that representing all of your financial wealth, and needing to make it last for 25+ years of retirement, it can get a little scary. After all, people are already living longer than they used to, who knows what the average life expectancy could be in another 30 or 40 years!

I've known people in their 20's that get a six-figure windfall from a relative passing away, and within a few years, it's all gone. I didn't even look hard, and two of the top stories on reddit's r/personalfinance are of people who have gone through savings in just a few years. So careful planning is needed to make sure that this money will last through her retirement, and if possible, leave something behind for her children or an important charity for her.

This means that the responsible thing to do is to have a sustainable withdrawal strategy, where she only withdraws what the portfolio can replace. Using the average market return of around 7% a year (remember, that's how much we assumed her account would grow every year), her account should grow on average by 7% a year. However, inflation averages 3% a year, and because we need to preserve her purchasing power through retirement, we have to remove inflation from the 7% market return. This leaves her with a sustainable withdrawal rate of 4% a year.

This leaves us with an income of $52,000 a year, adjusted for inflation. She may also be eligible for Social Security benefits at the end of this too, which will also help her through retirement.

Conclusion

As a baseline, $52,000 a year is a great income from just a maxed Roth IRA, and if she were also able to continue saving through an additional investment account as her pay increased over time, this income number would be even higher.

The main lesson is that it's better to be consistent with your savings and to start early. You can see how waiting just a few years really impacts the account value and the resulting income number. For example, if she had retired at 60 instead of 65 or if she had just started 5 years later, her Roth would be worth around $900,000, which would instead result in $36,000 a year in income!  

Further, if both of those circumstances had happened - she had started investing at 30 and retired at 60, she would have cut off 10 years of investing time, and as a result,  she would only have around $600,000 in her Roth IRA by the time she retired. This would leave her with just $24,000 a year in income - less than half of the original amount!

So, if you get started early and save prudently, your Roth IRA will be enough to afford a modest retirement, but if you start saving late or become accustomed to a higher standard of living before you retire, you'll need to think about saving more money through additional investment accounts.

As the Chinese proverb goes, "the best time to plant a tree was 20 years ago, the second best time is now."