I lost track of my principal- now what?

[cashflo2u2]

I like the simple idea of only taking the investment income (dividends, interest and cap gain div.) to cover the gap between annuitized income and spending. My quandry is I don't know at what point I say- this is my principal. Over the years I have had so many ins and outs to the "principal" plus reivested dividends, etc. I have no idea what my "principal" is. Should I just pick some arbitary date, say 5 years ago, or date of retirement (7 years ago), and spend a lot of time going back and try and reconstruct it? How about closing price as of yesterday? What diff does it make if any?

 

[Coach]

Well, it seems to me that your principal is what it is today, not at some arbitrary time in the past. From this point on you spend only interest and dividends. Your principal will still rise and fall, of course, assuming you have some market investments. Realized capital gains/losses and capital gains distributions? They seem like principal to me.

Coach

 

[ejman]

I live from my investment income which I define as you do as dividends, cap gains, and interest except that I only draw at present from my taxable accounts (I'm 58). Normally this amounts to between 4-5 % of principal for my particular asset distribution (50 to 60% stocks, balance bonds and cash). The pattern I've noticed is that as valuations go down, my distributions go up as a % of the portfolio. For example, distributions were 4.1% in 2007 and 4.5% in 2008. From a practical standpoint, this tends to reduce year to year volatility in my draw and within reason diminishes the importance of principal volatility.

As to actual principal amount, it doesn't really seem to matter to me as long as I'm able to do OK on the distributions. Going on 7 years now and so far so good....

 

[Rambler]

I'm not FIREd yet. Until I am, everything just builds and becomes principal. When I FIRE. I will be taking dividends and interest as distributions, but cap gains and excess distributions (unused divvies and interest income) will go back into principal. My budget calls for enough excess distributions to accrue for replacements for cars, eventual RV replacement, as well as cushion, etc. Those accruals will also go back to principal until needed and will then be withdrawn. Other than that, I hope I never have to touch the principal...at least until I'm 85 or 90. I am likely to use cap gains distributions for rebalancing, but not for day to day expenses.

The initial determination of principal for me will be the day I retire. But it will be a constantly moving target...hopefully upward most of the time. I would suggest you pick "today"as your start date, then only take the divvies and interest. If you eat the cap gains from mutual funds with high turnovers, you are eating into your principal, and will soon find that the divvies are being eroded.

R

 

[charlie]

I think your "principal" in an IRA and a taxable account are two
different things.

In an IRA, your principal is your current NAV. In a taxable account,
your princpal is the cost of your investments ...... your tax basis in
other words. If you reinvest distributions in a taxable account they
are treated like additional investments. That is why many people like
to direct the distributions to a money market account or spend them.
This helps reduce the record keeping of the tax basis of a taxable account.

Cheers,

charlie

 

[cashflo2u2]

The more I think about my question it is beginning to sound rather stupid. I agree that my "principal" starting point is the current balance, in my case I think I will use Jan. 1 of this year and only take the investment income, to the extent I need it, from that point forward.

 

[Rambler]

cashflo - never stupid. Actually thanks for asking it, because we all learn from others experiences and knowledge.

That is why we are all here, no? To learn, to share what we know, to share experiences? I thought it was a very valid question.

R

 

[audreyh1]

I guess there are two ways to think about it.

One is to pick some starting point and proclaim that as the "principal".

But I think that when many folks are trying to "preserve" the principal, they mean to take only the income generated by a given portfolio. This would means to take only interest income and ordinary dividend distributions. The capital gains distributions would have to be reinvested into the portfolio, otherwise you are taking some of the principal. In this scenario there is no comparison to any starting value of the portfolio, rather, the portfolio itself will fluctuate up or down depending on market conditions.

I guess you have to decide which is your true intent, and what you are trying to achieve by it.

Audrey

 

[ejman]

I guess there are two ways to think about it.

One is to pick some starting point and proclaim that as the "principal".

But I think that when many folks are trying to "preserve" the principal, they mean to take only the income generated by a given portfolio. This would means to take only interest income and ordinary dividend distributions. The capital gains distributions would have to be reinvested into the portfolio, otherwise you are taking some of the principal. In this scenario there is no comparison to any starting value of the portfolio, rather, the portfolio itself will fluctuate up or down depending on market conditions.

I guess you have to decide which is your true intent, and what you are trying to achieve by it.

Audrey

Why is utilizing capital gains distributions considered taking the principal? If I buy an asset for $100k (my principal) goes up in value to $125, I sell $25k don't I still have my $100k "principal" Although there are a variety of definitions of principal, the one I generally follow is "original amount invested"

 

[W2R]

Why is utilizing capital gains distributions considered taking the principal? If I buy an asset for $100k (my principal) goes up in value to $125, I sell $25k don't I still have my $100k "principal" Although there are a variety of definitions of principal, the one I generally follow is "original amount invested"

I suppose you can make all sorts of arguments as to what you think is principal, but conventionally capital gains distributions are considered to be part of the principal and dividends are not. So, if you want to leave your principal untouched, regarding principal in the conventional sense, then just re-invest your capital gains and take the dividends.

Personally I am going to do that but I might re-invest some of my dividends as well, depending on their size from year to year.

 

[kaneohe]

Why is utilizing capital gains distributions considered taking the principal? If I buy an asset for $100k (my principal) goes up in value to $125, I sell $25k don't I still have my $100k "principal" Although there are a variety of definitions of principal, the one I generally follow is "original amount invested"

Perhaps there is a difference between a capital gain and a capital gain distribution. In your example, if you buy something directly and then sell it for a gain, perhaps it is ok to think of the 100K as principal.

However if you bought 100K of a mutual fund, it is possible that the fund may have had e.g.
50K of unrealized gains when you bought it. If those gains were then realized and distributed after you bought it, it is possible that the value of your fund including the distribution may not have changed (100K). However, if you spent that
50K distribution, you would be eating into principal. In this example, you had a capital gains distribution but no capital gains.

 

[Alan]

Interesting thread and FWIW, here are my plans come January.

I'll be 55 and RE'ing and don't want to withdraw from IRA's until 60 so they will continue to re-invest. The taxable accounts I intend to re-direct the dividends to a MMF for spending and the capital gains distributions will re-invest as they do now.

I expect this will leave me short by 15 - 25K which will come from existing cash. (CD's, I-Bonds, Bank Savings A/C etc)

 

[dbr]

I think the fundamental definition of principal is original amount invested. But it can also be the current amount invested so that principal amount is a function of time that has an initial value and a sequence of time values. Note that in the simple original concept of loans and debts there is a very straightforward delineation between initial (and constant) amount of loan or debt and the separate issue of interest payments. Hence it is possible, for example, to talk without ambiguity about payment of principal on a debt and payment of interest on a debt. In the cases of capital investments that are valued in a market, I think definitions are not as simple.

The present balance of an investment is original amount invested + return + further investment (contributions) - further disinvestment (withdrawals). The present balance is also the principal for a new period going forward.

For investments that pay interest or dividends return can be further subdivided as "earnings" = interest and dividends and capital changes.

My view is that any money paid out from an investment is a withdrawal, otherwise known as a disinvestment. Whether or not there are mechanics to set the amount of the withdrawal exactly equal to some interest or dividends earned by the investment is entirely immaterial. In that sense taking a payout of dividends or interest is an "invasion" of principal, but perhaps more palatably stated as a "disinvestment." If money is paid out from some kind of mechanics related to capital changes in component investments in a fund, that is also disinvestment, which is not fundamentally distinct from a withdrawal of a dividend or interest related amount.

It is also true that none of the above forms of withdrawal are different in any financially significant way than selling shares in the fund to finance a withdrawal. In this sense selling "original" shares and failing to reinvest dividends to buy new shares are equivalent invasions of principal simply referenced to different points in time. This is all based in the principle of fungability of money.

In the case of mutual funds dividends, interest, and capital gain distributions have importance due to rules regarding how funds must handle these entities. Funds must distribute return originating from what is defined by law or tax code as dividend or interest payments of underlying investments. Funds must also distribute realized net capital gains from sales of underlying investments, but do not distribute realized losses. Tax code has its own concerns about how to define these distributions relative to individual income tax. Life can become complicated when distributions originate in what tax code classifies as return of capital.

 

[ejman]

Interesting thread and FWIW, here are my plans come January.

I'll be 55 and RE'ing and don't want to withdraw from IRA's until 60 so they will continue to re-invest. The taxable accounts I intend to re-direct the dividends to a MMF for spending and the capital gains distributions will re-invest as they do now.

I expect this will leave me short by 15 - 25K which will come from existing cash. (CD's, I-Bonds, Bank Savings A/C etc)

My initial thoughts when I ER'd 7 years ago were along the same basis i.e. don't touch the "principal" and reinvest capital gains, that being the prevailing wisdom and common advice.

I quickly realized however, as DBR points out that all fund distributions regardless of the terminology are money and money is fungible. It followed for me then that it made little sense to pay taxes on my capital gains distributions (obviously talking about my taxable accounts here), reinvest them and then take money out of somewhere else to cover my living expenses (dividends by themselves unfortunately not enough for me to live on).

So now, I consider all taxable fund distributions as a withdrawal pot regardless of the technical definition (dividends, LTCG, STCG - whatever). If I'm ever in the happy position of having more distributions than I need from my taxable accounts then of course I'll reinvest some of it, guided by whatever the prevailing tax winds are at that time.

 

[dbr]

The most tax efficient way to manage withdrawals from a taxable account is to have no interest, no dividends, and no distributions and to withdraw by selling shares that have no capital appreciation. It is certainly very important to avoid large capital gains distributions in taxable accounts, at a maximum when one does not even want the money but also when one does. A good way to avoid large distributions is to invest in passive rather than active funds and in total market funds rather than slice and dice asset allocation -- in taxable.

As with all things tax individual circumstances trump rules of thumb.

 

[ejman]

The most tax efficient way to manage withdrawals from a taxable account is to have no interest, no dividends, and no distributions and to withdraw by selling shares that have no capital appreciation. It is certainly very important to avoid large capital gains distributions in taxable accounts, at a maximum when one does not even want the money but also when one does. A good way to avoid large distributions is to invest in passive rather than active funds and in total market funds rather than slice and dice asset allocation -- in taxable.

As with all things tax individual circumstances trump rules of thumb.

Very true. I remember looking at BRK back in 79 or so and wondering should I do it or not....

 

[Alan]

The most tax efficient way to manage withdrawals from a taxable account is to have no interest, no dividends, and no distributions and to withdraw by selling shares that have no capital appreciation. It is certainly very important to avoid large capital gains distributions in taxable accounts, at a maximum when one does not even want the money but also when one does. A good way to avoid large distributions is to invest in passive rather than active funds and in total market funds rather than slice and dice asset allocation -- in taxable.

As with all things tax individual circumstances trump rules of thumb.

This is fine in the accumulation phase but I don't see how it works in the withdrawal phase (that I am about to enter). Unless the withdrawals come from money stuffed in the mattress or from equities with both gains and losses so you can balance them out you are going to have to pay taxes.

I'm sure if you can manage this then you'll pay no taxes, but I am more simple minded and prefer the easier route of dividend paying funds, interest bearing CD's etc.

 

[dbr]

For investors in withdrawal phase that have a significant tax burden, tax efficiency is just as important as it is in accumulation. How can it not be worth avoiding significant tax costs if they exist, or at least to note where they exist and what might be done to manage them?

Realistically a person with accumulated wealth in taxable accounts will most likely have unrealized gain in the equity in those accounts, but a withdrawal is only taxed (at LTCG) on the fraction of the withdrawal that is gain, while all of a dividend is taxed.

No one is arguing that dividends are a bad thing, but tax cost is tax cost and may well be worth attending to.

It is, however, a maxim that one should not allow the tax tail to wag the investment dog.