Understand that you should make this calculation every year, so that if the following year the price of a new water heater becomes $1,050, due to annual inflation of 5 percent, your annual contribution should be $105 and the amount in your reserve after four years should be $420.
If you had invested the $300 at an after-tax return equal to inflation, you should have $315 by the end of year three, so your contribution of $105 at the end of the fourth year would bring the total up to the necessary $420. Although using this strategy helps you combat the effects of inflation on the price of goods and services, you still have to deal with the uncertainty of not knowing exactly how long the item you're planning to replace will actually last. It could be shorter or longer than you plan. If some of your items last longer -- great! You can use part of the reserve to offset other shorter-lived items.
The theory behind this replacement-reserve calculation
is based on getting an after-tax return at least
equal to inflation. The after-tax return equals
the before-tax return times one minus the tax
rate. So if you would get a 5 percent before-tax
return and you're in the 25 percent tax bracket,
the after-tax return would be almost 4 percent
(0.05 x 0.75 = 0.0375). As a practical matter,
being a little under or over isn't going to make
a lot of difference because you are going to make
a new calculation every year.
The savings should not be in tax-deferred retirement accounts such as an IRA or 401(k) unless you are over age 59½ and can make withdrawals without penalties. If you are already retired and must use tax-deferred accounts, increase the amounts in these calculations to account for taxes by dividing the goals by one minus your tax rate. For example, if your tax rate is 25 percent, your annual savings for the water heater would have to be $133 ($100 divided by 0.75 = $133). Your reserve after three years would be $400 ($300 divided by 0.75 = $400).
Unless you specifically establish an account to be used only for replacement reserves, the reserves will be a theoretical part of your total investments. I make this point because most retirement planning programs simply ask you to enter the total of your investments. In fact, you should not enter the amount you have planned for replacement reserves. Doing so will overstate the amount you can spend after you retire.
These days a young person cannot possibly buy
a car for cash unless he has rich and generous
parents or buys a cheap wreck and somehow finds
ways to keep it running at a low cost. But over
your lifetime, it's important to work toward being
able to buy an automobile with cash instead of
credit because the gains are so large.