June 26, 2022


Business Update Blog

Can Your Lifestyle Inflation Keep Up With Investment Inflation?

Making sure lifestyle inflation never gets ahead of our income and wealth inflation is a core fundamental in personal finance. Ideally, we want to widen that gap between income and expenses so that we can one day live free.

However, what if you are already living free? Or what if your investment returns are so strong that you end up dying with too much? Dying with too much money is as suboptimal a situation as never having enough money to retire comfortably.

Therefore, for disciplined investors, I thought it would be worthwhile to discuss whether your lifestyle inflation can keep up with your investment inflation. I’ve noticed that a lot more people are now concerned about how to properly spend down their wealth.

Let’s go through a quick example.

Tether Your Lifestyle Inflation To Your Investment Inflation

If you decide to take investment risk, you should definitely reap the investment reward. Don’t let people who were too scared to buy real estate, stocks, alternative investments, and cryptocurrencies tell you otherwise.

There is rarely ever a free lunch unless you are relying on the government for everything. If you spend hours cooking your meal, you sure as heck should get to eat it! And if you sometimes slice your finger, then all the more reason to savor the results.

Let’s say you spend $100,000 a year on average and you have a $2,000,000 investment portfolio. For the past 10 years, you’ve logically tied your spending to your income gains. For every $1 more you earned after taxes, you spent 20 more cents.

However, after a difficult year due to the pandemic, you decide to live it up a little. Your investment portfolio gains have been much higher than you expected at this stage. So you decide to tether your spending increase to your portfolio increase by a 1:1 ratio. In other words, if your portfolio went up 30%, you get to spend 30% more money.

Over the next 12 months, your portfolio increases by 10% to $2,200,000. Therefore, you give yourself permission to raise your spending by 10% to $110,000. But you soon realize that your 1:1 tethering is too conservative.

$200,000 in gross gains equals a $150,000 gain after paying a 25% tax rate. $150,000 minus $10,000 in after-tax spending still leaves $140,000 in net worth gains. Therefore, so long as your larger investment portfolio is generating greater absolute gains than your spending, your lifestyle inflation will always be falling behind.

What is a disciplined investor who wants to live their best life now supposed to do? Adapt.

Controlling Lifestyle Inflation Should Be Easy For Investors

The one thing I know about aggressive savers and investors is that most of us have a difficult time spending more money as our wealth grows. We are so used to being frugal that spending money on unnecessary things sometimes feels like a crime!

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Before buying anything, we rightly calculate how much gross income we need to earn to pay for something in after-tax dollars. We also always think about opportunity cost if we spend money now.

In my mind, I believe that whatever money I don’t spend, I can double it in 7-10 years based on historical return averages. Heck, I just shared a 5-year structured note example that returned 150%. Therefore, expecting a doubling of your money every 10 years is not that farfetched.

But eventually, you will get to an age where you may start to doubt being able to benefit from the future returns given you may not live long enough. This doubt has started to creep in my mind this year because two people I know passed.

Now, I’m not so sure I want to invest as much money in the next private fund with a 7-10-year lockup period because I might never enjoy the rewards. Instead of investing $500,000 in a fund, perhaps it would be better to invest $300,000 in the fund and spend the $200,000 today.

Example Of Super Frugality And Minimum Lifestyle Inflation

Here’s a comment from a reader named Joseph on my Roth IRA conversion post.

My income is $250K, which is middle class at best in Northern CA. I have an IRA worth $20 million from 30 years of saving and sound investing.

Proposed IRA legislation would trigger 50% RMD for IRAs over $10 million if income exceeds $400K. I was planning on selling my house, and moving after retiring, which would generate capital gains easily surpassing $400K and trigger a $5 million IRA RMD.

This seems punitive, in fact draconian; am I missing something?

What I think Joseph is missing is spending more or giving more of his money away while alive! Having $20 million in an IRA alone is massive. Joseph is also probably in his late 50s or early 60s.

Given he makes $250K a year, he is spending at most $187,500 a year if he spends 100% of his after-tax income assuming a 25% effective tax rate. With a net worth of at least 106X his annual spending and at least 80X his gross income, Joseph will more than likely pass with too much.

Remember, my recommended net worth target before declaring financial independence is 20X your average annual gross income. Joseph is at 80X, if not more!

Why Not Spend More Money?

When I asked Joseph why not spend more, he responded,

Spending a lot of money doesn’t make me feel good for very long. In fact the most rewarding things I do don’t cost any money, e.g. a new personal record on my bike, a good tennis match, or the first scent of the cool ocean breeze on a hot smoggy day.

This is a great response. The best things in life are often free. There are only so many bike accessories you can buy and professional sports matches you can watch. There’s no way to go through even a quarter of the $20 million in Joseph’s lifetime on simple things.

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Therefore, if he can’t spend it on himself, then the logical decision is to spend more money on others. There are plenty of people and organizations who could use the money. Super funding multiple 529 plans is one idea. A 529 plan is one of the best ways to pass down wealth in a tax-efficient manner.

But Joseph doesn’t mention family or issues he cares about, so I’m not sure what he’ll end up doing. And the reality is, it’s his money. He is free to do whatever he darn pleases.

I’m assuming most of us don’t want to die with tens of millions of dollars in the bank. Dying with even $3-$5 million might feel like a waste, depending on your retirement philosophy. If the estate tax threshold gets lowered under the Biden administration, all the more reason to spend or give our money away.

Therefore, let me propose some solutions to ensure that our lifestyle inflation keeps up with our investment inflation. Frankly, I’m having a difficult time coming up with a framework that works. So I could sure use some of your ideas.

Ways To Ensure Lifestyle Inflation Keeps Up With Investment Inflation

For those of you who are financially independent or very close to financial independence, here are ways to let your spending inflate responsibly.

  • If you are bullish, spend an amount equivalent to 50% – 100% of your investment gains each year after adjusting for estimated taxes. For example, if your $3 million portfolio returns $300,000, after applying a phantom tax, spend $150,000 – $300,000 on whatever you want.
  • If you are uncertain about the economic outlook, spend an amount equivalent to a quarter of your investment gains adjusting for estimated taxes. Consider the remaining 75% of gains you don’t spend as a buffer in case things turn sour.
  • If you are bearish, keep spending the same. If you are wrong after 12 months, spend an amount equivalent to half your investment gains adjusting for phantom taxes.
  • Alternatively, if you are bearish, take at least 10% off the table and spend half the gains. It’s much better to enjoy your money than lose it in some nebulous market.
  • At least once a year, tally up your net worth and trailing 12-month spending. The difference will likely be even greater than the difference between your investment gains and spending. Donate a quarter of it to charity.

More Spending Suggestions For Those Still Focused On Growing Wealth

Here are some spending suggestions for those still on their financial independence journey. You are someone who maxes out your tax-advantageous retirement accounts and saves and invests another 20% or more.

  • If you are bullish, increase your percentage spending by the percentage return of your investments each year. In other words, if your investments go up 10%, increase your spending by 10%. If your investments go down 20% one year, cut spending by 20%.
  • Don’t buy anything you don’t need until you generate returns equivalent to 10X what you want to buy. This is my 10X consumption rule that helps create an “invest first, spend later” mindset.
  • Start a side hustle. After one year, designate your side hustle income for your wants. This way, the more you want something, the harder you will try at your side hustle. Here are 20 side hustle ideas.
  • Tether an amount you want to spend to a particular exercise activity. For example, for every 1 mile you run you get to spend $10. Therefore, if you see a $100 pair of shoes you want to buy, you must first run 10 miles. Gamifying your spending through exercise is a win-win. We should be risk-averse when it comes to our health so we can increase our chances of living longer.
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My Favorite Spending Strategy

Out of all these responsible spending suggestions, my favorite is tying spending to a side hustle. With this method of spending, you are never losing! Making money on your own is often more rewarding that making money from a job.

For example, my newsletter could be considered my side hustle to my regular posting on Financial Samurai. This past weekend, we were hit with a “bomb cyclone,” which caused water to leak into my chimney. As a result, I stayed up from 12 midnight to 6 am Sunday wringing out sponges and towels every hour.

I didn’t want to write a newsletter Sunday morning because I wanted to sleep. But I told myself that if I really wanted to send my son to a language immersion school, which costs a lot of money, I needed to write one. So I did and took a nap after.

Commit not to quit!

Spending money on things you don’t need when you’re still trying to build your capital is not ideal. At the same time, you’ve also got to live a little to make all that hard work and risk-taking worth it.

More Focused Spending Going Forward

Personally, I’m going to review my investment gains at the end of each year and carve out 20% to be spent on whatever the hell I want. If I end up losing money, then I will try and cut expenses by 10%.

For so long, I’ve felt guilty about spending it up because I either didn’t have a day job or I wanted to ensure my kids have more opportunities. But now that I’m middle-aged, I’m much more focused on spending down my wealth.

To me, the most important group that can use our support is the ~15% of the population that has a disability. Some are minor, some are major. Whichever the case may be, I think it’s important we help level the playing field for them.

Readers, do you have a system for increasing your spending as your net worth grows to ensure you don’t die with too much? Do you have any other responsible ways to tether spending to investment or net worth growth? Ever though of letting lifestyle inflation far surpass your increases in wealth? If you were 60 with a $20 million IRA, what would you do with the money?