Escrow 2.0 – Become Your Own Escrow in a Brokerage Account
by FI Designer
Pay for future vehicles, major home repairs, or a child’s wedding with earnings from a brokerage account while reducing your tax bill in retirement.
In a previous post titled “Become Your Own Escrow,” I outlined a process for amortizing yearly lump sum payments such as property taxes and insurance payments using a high-yield online savings account. In essence, you are creating your own escrow account and pocketing the interest shed by the funds. Although the interest accumulation was quite meager, the greatest realized benefit was how it normalized expenditures during the year and nearly eliminated the cash flow sting of an “expensive” month.
I was so pleased with how the escrow/amortization of yearly expenses simplified our life that I began to consider how the concept could be modified to address larger expenses that happen every 10 to 15 years, or possibly once in a lifetime as is the case for a child’s wedding. With at least a 10-year time horizon that money can be invested in a regular taxable brokerage account instead of saved. This was the genesis of a new experiment that I am calling “Escrow 2.0”.
This concept may sound extremely aggressive, but it is not unlike a 529 college savings account that also invests in equities. In our personal situation, we are managing the market risk by holding enough cash in savings to cover any one of these infrequent expenses if they happen to occur during a down market. Another way we are considering to manage market risk is to move a portion of the funds into the brokerage account’s money market settlement fund as we get closer to the time we need to make a particular purchase. That does have an opportunity cost and seems much like just holding the money in a savings account.
Power of Compounding
The benefit of Escrow 2.0 is that you are letting compounding do some of the saving/earning for you. Here are some approximate numbers to illustrate the effect of compounding.
- Option A, No Compounding: Compute a $10,000 expense into a monthly payment over 10 years with a 0% ROR.
- $83/month = $10,000/(10yr * 12mo/yr)
- $10,000 = Amount invested
- Option B, With Compounding: Compute a $10,000 expense into a monthly payment over 10 years with a 6% ROR.
- $61/month = PMT(0.06/12,10*12,0,10000,0) in an Excel function
- $7,320 = Amount invested
- Option C, Buy Now & Finance Later: Compute a $10,000 expense into a monthly payment over 10 years with a 6% APR.
- $111/month = PMT(0.06/12,10*12,10000,0,0) in an Excel function
- $13,320 = Amount paid to principal & interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”Albert Einstein
Note that I am running this analysis in today’s dollars, not future-inflated dollars. The result is the same for the time value of money, but running the analysis in today’s dollars simplifies the analysis. For this analysis run in today’s dollars, the inflation-adjusted “real” rate of return is used. Inflation-adjusted average returns for the S&P 500 have been between 5% and 8% over a few selected 30-year periods. The bottom line is that using a rate of return of 6% or 7% is reasonable for longer time horizons.
Retirement Tax Benefits
Escrow 2.0 has a big tax benefit in retirement. Amortizing significant expenses that occur once every 10 to 15 years will help avoid large tax bills that could occur had you pulled the funds from a pre-tax account in the year you made the purchase. And because the funds are held within a regular taxable brokerage account, the long-term realized capital gains are subject to a substantially lower tax rate than ordinary income according to the article titled Income Tax vs. Capital Gains Tax by Investopedia. Long-term capital gains can also be tax-free in some cases according to the article titled Capital Gains Tax 101 by Investopedia. Income tax could be avoided altogether by making a large one-time purchase with funds from a post-tax Roth account, but that is beyond the scope of this post.
Why Only VTSAX?
At this time our funds for Escrow 2.0 are invested entirely in the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX). I considered investing in the Fidelity ZERO Total Market Index Fund (FZROX) because it tracked nearly the same index, had a $0 minimum investment amount, and a 0% expense ratio. However, I ultimately chose VTSAX which has a $3,000 minimum investment amount and a 0.04% expense ratio primarily for these reasons.
- FZROX can only be held within Fidelity. The Fidelity Zero funds are a Loss Leader, and if Fidelity ever decides to charge an expense the only way to get out will be to sell and realize the capital gains.
- VTSAX is slightly more tax efficient than FZROX because it has less turnover. Turnover is buying and selling which forces the fund to incur expenses that can hurt the performance of the fund and result in more taxes for the investor who holds the fund in a regular taxable brokerage account. For more information on this topic see the article titled FZROX vs VTSAX by Money the Simple Way.
Why Not VTI?
You may be asking yourself what about the Vanguard Total Stock Market Index Fund ETF (VTI)? An ETF is an Exchange-Traded Fund. VTI is generally considered better than VTSAX because it is slightly more tax efficient, has a $0 minimum investment, and has a 0.03% expense ratio. For more information on the topic see the article titled VTI vs VTSAX by White Coat Investor. I chose VTSAX because my monthly contributions would likely be small, around $200, and an ETF must be purchased in whole share increments on the Vanguard platform. Vanguard is not a platform that allows fractional shares. VTSAX on the other hand is a mutual fund and may be purchased in any increment. The ETF would be causing me to leave money each month sitting in a money market settlement fund instead of being invested. I will save the full analysis of this opportunity cost for a future post.
Tips for Tracking
Tracking the procedure for Escrow 2.0 can be fairly cumbersome. I created a spreadsheet to automate the framework and to take my brain out of it. The spreadsheet logs the transactions similar to a savings account register book. Each transaction is broken down into a prorated amount for each future expense. At any given time you can see a subtotal of how much you have allocated for each future expense. The spreadsheet can be seen in the image below.
Call to Action
Please don’t stop here. Consider if some variation of this system could work for you. And if not, ask yourself what steps can you take to optimize around the margins. If this does interest you, download the free Excel template below.
Escrow 2.0 v2022.11