Unintended Consequencesby moneyre5
Who will logically profit from this information? Primarily any person or persons who are, or want to be, more financially informed and who have one or more of the following:
1. A good income
2. Own a home with a market value over 100k
3. Is married
4. Has children
5. Have a retirement plan
6. Is a business owner or professional
7. Is an executive/key employee
8. Has a college education
9. Is 30 and above
10. Is retired or planning to retire soon
Everything we do with money has consequences – some build toward financial independence and some impede financial independence. Many are considered transfers of money to someone else, some intended and others not intended. This paper focuses on the unintended transfers.
The intent of this outline is to assist in the process of identifying how money is often transferred to someone else unnecessarily or unknowingly and to recognize the many ways wealth can be created and enhanced if we can stop making those transfers. The first few pages of this paper focuses on why we need to know about the transfers we make, how they happen, their impact, examples of them, and why we continue to allow them to happen. The rest of the document focuses on what the transfers are.
The goal in each of the above books is to change the way you think about money – to acquire effective methods to reduce and/or eliminate the unintended financial transfers of your wealth to others that happen every day. All of us need to stop “surface thinking” and probe a layer deeper than we have in the past in order to stop having our financial knowledge and decisions controlled by others. Keep in mind that “under the peel is where the fruit is.”
As you will see, we are creatures of habit; subdued by traditional structures imposed by Government, industry, and society. Most of us just go with the flow, we have capitulated to society; we play follow the follower on how we use banks, our complicated taxation system, credit card interest, auto financing, mortgage costs, insurance purchases, investment decisions, and our overall personal debt. This evolution of transferring your wealth away to others is based on how society/organizations/and various institutions have been able to create situations, control the outcomes, and profit from it. Eliminating (or reducing) as many of these transfers as possible can change your life. The majority of the people end up a far cry from becoming financially independent. To learn what to do we need to find out what successful people do differently so we can join them.
The Thought Process
You will not appreciate the many possibilities unless you become a scientist in thought – always trying to uncover flaws in the conventional financial wisdom (what you did yesterday with money). The flaws lie somewhere between opinion and fact; myth and reality; and truth and fiction. Please remember whoever controls how you think/what you think about, controls the outcome of your money. Unless we change where we are, we will always be where we are. It’s what we do with information and knowledge that will make a difference.
Identifying the transfers
This outline looks at the 10 most common transfers that can affect you. There are unintended consequences attached to all of them. You might readily discern how certain opinions and myths end up as profits for others, not for you. If we can recapture these transfers it should change your life – it may give you more control/freedom. Upon discovery, hopefully that defining moment will change the way you think about money!
Who is creating these transfers?
Lastly, we’ll address who is causing these transfers of wealth from the masses – who are those who create the situations, control the outcome, and profit from it. By the last couple of pages, you may find out some of the entities we faithfully follow may have profited more from our actions than we did! Their thought process may have created unintended consequences for you in the form of less wealth, higher taxes, more fees, and higher interest rates.
Every day we are bombarded by the media, bullied by some, and bewildered by the millions of things they feel we need to know to make an informed decision. On occasion, we get “paralysis of analysis” – so we either do nothing or make an emotional decision as to what to do. Most people have also found out that it is next to impossible to live on a taxable 2-3% return in today’s environment, or to actually plan for financial independence, so they do nothing. Being unemployed during 20-30 years of retirement will take a lot of money because prices go up every year. Creating adequate retirement takes time so it is urgent that we acquire more knowledge about where our money goes.
More than one return
In the past, traditional financial thinking has always emphasized the rate of return on our investments. But the faster you want/need your money to grow, the greater the risk you have to take. Understanding risk is important, but if you could acquire more wealth without taking more risk, would you pursue it?
We all have different biases in our thinking. The purpose for looking another layer deeper than you are accustomed to is not to uncover defects in your thinking, but to expand your thought processes in order to make better decisions. Once you get beyond your initial bias, things can be very different. Let’s face it, there are many companies standing in line for their “share” of your money. If you stand at the end of the line, you only get to keep what’s left. This can be changed IF we have discipline and our thought process changes.
A little more than 6000 months ago it was wildly accepted as fact that the earth was flat.
About 600 months ago our parents were told that they could retire on 2/3rds of their pre-retirement income, be in a lower tax bracket, and thus set for life.
About 160 months ago we were told there was such an enormous surplus in the federal government that society was really going to prosper from increased government programs.
All of these beliefs turned out not to be true.
What is often not explained is that tax reduction acts were designed to relieve tax burdens but they actually resulted in the government collecting record revenues from its citizens – you and I. More economic activity means more taxes. But to be fair, up until recently, Congress never said we would actually pay less tax or that there would be less revenues for government, they knew more economic activity means more tax revenues.
Social Security was started as the safety net of last resort. It wasn’t a substitute for retirement planning. Although well intended, social security was the first step of a long journey making people dependent on government which essentially means being dependent on someone else working for you and paying taxes for your benefit. Today there are less and less workers for each retiree. The 1913 income tax law was designed to only tax the very wealthy at a rate of about 0.5% in their incomes. Now the code, regs, and revenue rulings are 75,000 pages long!
Government isn’t the only player trying to make you share your wealth. For instance, Banking institutions and other financial services companies are famous for dipping into our wallets for fees and service charges. If the banks are late in doing something it’s called “process,” if you are late with them it’s called a fee.
Mortgages, credit cards, home loans, auto loans, ATM’s, checking accounts, saving accounts, and CDs all create fees. There are late fees, early withdrawal fees, minimum balance fees, debit fees, net payoff fees, and in some cases, a fee to talk to a teller. For credit cards, it seems like the goal is to make sure you are a couple days late on your payments in order to get a late payment fee. Late fees are big business, and so are charge-offs from bad debts. Even the billing cycle has been shortened, instead of sending billings out 14 days before due date, now it’s usually 10. Wouldn’t it be much better if we were our own banks? We can become our own bank.
If something you thought to be true wasn’t true…
It’s very difficult to get to the right solution when you start out with the wrong premise.
Here is an example of a false belief system: up to about 600 months ago it was believed that no human could run a 4-minute mile. They said the heart would come out of the body. Then an Englishman named Roger Bannister defeated the belief system. Now someone does it (literally) every day.
We become what we believe. Financially we often assume things about money to be true that aren’t true, simply because our friends or others do it. We follow others. We do what the “majority” does. But to become financially independent, we must think beyond the majority. Financial organizations love it when we do what the majority does because we give them the money – they profit from it. The Government and the financial organizations collaborate to create this belief system.
In 1900, life expectancy was 47.3 years. Today a 65 year old female is expected to live past 84, a male past 81. Take a wife and husband age 65 today, according to annuity actuaries, 55% of the time one will live past 92. This shows people are living much longer which also means there continues to be many more retirees. The number of people “entitled” to free government programs is growing rapidly. The national debt is rising and the baby boomers, the largest segment of our population, are just starting to retire. The GAO (Government Accounting Office) reported (starting back in 2006) that because of the country’s enormous debt, future taxes will have to be increased dramatically and there will have to be large cuts in spending/entitlement programs as well in order to keep the nation afloat. With the explosion of debt every year from 2008, our debt is the greatest worry the country has.
How would this affect you? Your adjusted gross income (AGI) determines what you can ultimately put in your pocket when you withdraw funds for retirement. Therefore future tax rates may have a huge impact on what you are doing with money today. If on the day you retire Congress increases ordinary income tax rates by 10 points, it will be too late to change the outcome because you just retired. So a very important question is: “Will your future retirement income be taxed at ordinary income tax rates; taxed at capital gains rates, or will it be tax free income?” After all our exemptions, deductions, and credits, it is our standard of living that we pay taxes on. And almost everyone wants to at least maintain their current standard of living throughout their life – most would like to improve it. If we do maintain it or improve it, at retirement we often find ourselves in a higher tax bracket because we no longer have those exemptions, deductions, and credits. If tax rates are higher in the future, does it make sense to defer taxes on a dollar today only to pay higher rates on those same dollars and all they earn, in the future? Understanding demographics is very important in your plans to avoid unintended consequences.
Of course participants in the Social Security system should be allowed to invest in the market – there should be that option. But the government doesn’t want that because they would then lose control of that portion of your money. It would not be in play for them to use and potentially, with the right planning, you might be able to keep this money from being taxed altogether. This is the opposite of what Gov’t wants. They want to control all social security money, they want to have LUC (liquidity, use, and control) cancelling the benefit of LUC to us. And when you retire, if you use the retirement plans they recommend, chances are high (as you will see) they may cause most of your social security to be taxed. Keep in mind they believe it’s their money not yours.
TSPs, 403(b)s, IRAs, and 401(k)s
Ask anyone, “can you tell me one difference, in principal, between the interest compounding on your credit card if you don’t pay off the balance and your taxes compounding on the above plans if you do not pay your taxes?” They will not be able to.
Why did the government increase the amounts (in recent years) you can put into qualified (retirement) plans like a 401(k)/IRAs? Since the Gov’t is your partner in these plans was this change initiated because they were concerned about your financial future or THEIRS? They know that as time goes on, the government will always need larger and larger pools of money to draw from so they want you to accumulate the money for them (keep in mind Congress doesn’t live by the same system we do – they have their own very generous retirement system guaranteed by the taxpayers). Instead of taxing you at the same capital gains tax rate as you pay on your private (after-tax) investments, your qualified plan will be taxed at ordinary income tax rates at your highest marginal tax bracket. Your “partner” wants your account to do well because the more it grows the more taxes they get.
When participants in 401(k)s are surveyed, you will find that most believe “tax deferred” means they get to pay the tax, on the dollar they deferred today, at some later date. And they believe that during all those years they continue to defer the tax, they will be earning a return on the government’s tax money! Unfortunately, nothing could be farther from the truth. Most participants don’t realize that all the earnings on the taxes they deferred today will not only be taxed but they will be taxed at the ordinary income rates that are in force at the time you take the money out! They do not realize that the taxes they owe on that deferred dollar is compounding at exactly the same rate their 401(k) account is compounding and they will pay ordinary income tax on both the dollar they deferred plus all that which has compounded. (Wait until you see the demographics).
Assume that by the time you retire you will need $100,000 to live on to keep your commitments and your standard of living, and that you are in a 35% (combined Federal, State, and Local) tax bracket. When you “gross up” the $100,000 to cover the taxes, you would have to take out nearly $154,000 from your plan, and pay $54,000 in taxes, in order to have the $100,000 you need. Would a $154,000 withdrawal put you in a higher tax bracket? Will you like writing a check for $54,000 in order to have $100,000? See how this works for the Gov’t?
Therefore it is understandable that the government doesn’t want you to earn for your own private social security account the same rate that you can on your qualified plan. The reason is that if you did, you would get to keep all the money and not have to pay any taxes on your social security income (unless you are over the maximum income limit as calculated today). The politicians couldn’t commingle your social security investment account with the general account – it would be separate. But inside your 401(k), taxes are compounding to the politicians benefit and if they expect rates to be much higher in the future, they want those accounts to grow as large as possible.
Should you fire your advisors? Have they told you these things?
In 1965 a family could have a new 3-bed room home, a new car, and live well on $400/month. Today, 45+ years later, a 2-income household would need about $75,000 of joint income to have the same standard of living. Say you sat down with a planner 45 years ago and developed a plan to create a $400 a month income but today you would need $75,000/year to keep your standard of living, would you be happy with his performance? What is your planner doing for you today? Could this same increase happen in the next 45 years of your life? How would you cope? Is your planner helping you plan for your retirement based on today’s income or on what your income might be in the future? In the final analysis, should you expect to live for 45 more years, shouldn’t your Advisor be planning for a continuous increase in the cost of living over the next 40 years? Have they told you what your number is – (the amount of assets you will need) in order to create a lifetime of income?
We need to remember that it is your income, net after taxes, that defines our living standard. While you are working, many/most of your employment expenses are deductible; other expenses will continue throughout your lifetime. You take your exemptions (children); you take any tax credits due (such as education credits); and you take all your other deductions such as retirement contributions and interest on your mortgage. With few exceptions your AGI (adjusted gross income) is what you pay taxes on and the net, after paying your taxes, is essentially your standard of living-all the stuff in your life that you spend money on. It is very productive to go through this exercise, see what you are/would be spending money on if you retired tomorrow and then ask yourself what part of your present standard of living are you looking forward to giving up when you retire? None right? (And don’t forget to add some expense for the grand children, maybe more travel, and increased health care cost!
If you hear from your advisors what Congress and the financial institutions want you to believe: “that you will be able to retire on 75-80% of your pre-retirement income, and thus be in a lower tax bracket,” perhaps firing him may be doing yourself a favor. First, after we take out our taxes, credits, deductions, and exemptions (which will mostly go away after retirement), we are already living on a net 75-80% of our gross income so using that percentage is meaningless.
Secondly, as you have just seen, our standard of living today is what we have left after all those deductions and taxes. With most of our deductions gone once we retire, how can we live comfortably, and maintain our standard of living on 75% of an amount we are having difficulty living on today? Most people say they have difficulty living on 100% of their net income today. What are you going to give up or go without? Is this what we want for OUR retirement?
Thirdly, if we haven’t projected what our cost of living will be by retirement (and what it will be 20 years after retirement for that matter), how can we know what our number is (the amount of assets we will need to fund our retirement)? Almost no one knows this number. How can we hit a target if we don’t have one or even know what it is?
Fourthly, prices go up every year, so what we will need the 10th, 20th, or 30th year of retirement will be dramatically more than what we will need the first year of retirement. If you are planning to maintain today’s standard of living throughout retirement, is your Advisor doing his job if he hasn’t shown you what you can expect in the future?
And, fifthly, any number is meaningless IF our retirement will be taxable and we do not know what the tax rates will be by the time we retire or if they will change during our retirement. And further, most people will earn more/have a higher standard of living by the time they retire than they have today. It’s like the Gov’t is telling us to keep quiet – “we’ll tell you how much you have to pay in tax after you retire.” Would you borrow money from a bank if you didn’t know how much interest they were going to charge you or when you had to pay it back? Of course not, but do you know what “interest” rate (tax) you will have to pay on your retirement income?
Could your advisors be showing you a fixed retirement income because it is much easier for them to illustrate? Or are they doing so because it is much easier to fund a retirement that does not increase throughout your lifetime? Is that fair to you? A betting person will probably bet on both the cost of living and taxes being higher in the future. In either case, taxes are definitely waiting for you because there will be fewer workers, more retirees, and a greater increase in government social programs and spending.
By the way, what is your number – the amount of money you will need by the time you retire so that it will last your lifetime and your income will increase every year? Want us to calculate it for you? That is a very important number don’t you agree?
Google “total public debt’. There may be several sites. Some update DAILY the amount of the public debt of our government. Not only has our debt gone up considerably every single year but carefully look at the years when we had huge surpluses (2003/4) – you’ll see debt continued to go up then too. It has gone up 6 Trillion since 2009!
2013 – 16,765,000,000,000
2004 – 7,379,051,696,330.32
2003 – 6,783,231,062,743.62
Before January 2013 the public debt will be over $17,000,000,000,000. How can anyone looking at this increasing debt, and understanding the changing demographics (less people working), conclude that future taxation will be lower???
Remember who you are
REMEMBER: The government sees you as a taxpayer; the banks see you as a borrower; wire houses and attorneys/accountants/advisors see you as a fee payer, and retail outlets see you as a profit center.
We must learn how to lessen the burdens of dealing with all of them. We must learn how to pay ourselves first and the others last. This may seem irrational from a humane point of view, but from a financial point of view, we must because your family’s financial outcome is of little consequence to them.
Knowing how to use money and when it will be taxed is generally more important than the vehicle you put it in. Retirement plans and homes are illiquid so they “tie-up” your assets – you do not have liquidity or use of the equity – and they are not really in your control. Your own “banks” which you can learn how to create for yourself, should give you LUC. you may then create more wealth or an improved lifestyle. You can make it a habit to reduce the fees or interest you pay others; you can reduce taxation; you can reduce payments; how to turn bad debt to good debt; and how to make future purchases from your bank and pay yourself back, not pay others. After this becomes habit, pass it on to your children/grandchildren.
Lost Opportunity Cost (LOC)
Liquidity, Use, and Control (LUC)
What is the definition of LOC? If you spend a dollar needlessly, not only do you lose that dollar, but you also lose the ability to earn money from the dollar – for the rest of your life! Just think how much that would be if you saved a few thousand today and it compounded the rest of your life!
There is magic in the rule of 72. If you earned a 10% return, divide 72 by the rate of return (10%) and you will find that your money will double every 7.2 years. This is a fun example. Consider the long term cost (the opportunity cost) of a $20,000 wedding assuming you could earn a 10% return on that money if you did not spend it on the wedding. If you start at age 25, the cost or the wedding doubles every 7.2 years so by age 68 (actually age 68.2), the real cost of the wedding was $1,280,000! So if we spend that kind of the money on the wedding, the long term impact on your wealth is $1,280,000 by the time you get to be age 68.2 years old. Amazing huh? Every dollar that you spend during your lifetime that you cannot get back, be it taxes, higher interest rates, fees, café mocha, etc., all create LOC. It is easy to see the impact of opportunity cost in so many things in our life that may be avoided.
But to maximize the return on your dollar – to be able to use it for other things that will create wealth – you also need to have LUC (liquidity, use and control) of your money. Liquidity means you can access the account whenever you want without penalties or fees (and ideally, without taxes). Use of your money means you can use it anyway you wish. Control means no 3rd party controls your money, you do. LUC is critical because it translates to capital.
That’s an Ugly Baby
In a cute way, we have all probably seen a baby that appeared “ugly” to us. But it will never be ugly to its Mom. Our view is only our opinion. Our view is like the “Mom.” Our view, our opinion, or our method of doing so many things in life often outweighs the facts. So often in our lives we are reluctant to give up the way we do things (our ugly baby) because we have done them that way for so long we feel it must be right. Only after a lot of encouragement, and after we have been shown many examples, do we finally concede and do it differently. But once we are converted we are really converted and readily see the advantage of doing it differently. It then becomes fact for us and we may even wonder why it took so long to “see” it.
Give me a shovel
In today’s society, we are swamped with so much info it is nearly impossible to decipher between opinion and fact. Enormous amounts of misinformation has been passed on to us, or passed down, or advertised, that may not be fact or the full truth. Misinformation or half truths may lead us down a path towards unintended consequences. In this paper we will dig below the surface, at least one layer deeper. By using common sense and knowledge we must learn to think a layer deeper in everything we do in order to separate opinion from fact and myth from reality. Lack of knowledge is your greatest wealth transfer.
You need to know
How often have we said, “I thought something wasn’t quite right but I just didn’t know what it was.” It’s hard to get the right solution when we start out with the wrong premise. Have you ever seen a public service announcement on how you are transferring wealth away to others unknowingly and unnecessarily? Have you ever seen an ad from VISA suggesting ways in which you can avoid overuse of credit cards? No? Why not?
The government professes to have your best interest at heart. But if they did, don’t you think they would sponsor infomercials on how to greatly reduce taxes or avoid the long-term consequences of some of their programs? They could do that if they wanted to but why should they? They are in the business of collecting taxes. So do they really have your best interest in mind? Do 75,000 pages of tax code/regs/rulings impact your ability to know?
Do banks sponsor infomercials on how to save on the interest or fees they charge you? No. Does your accountant or your lawyer or your financial advisors spend hours and hours teaching you how to be more efficient with money? No. Why don’t these advisory groups help you do this? Is it because it would be extremely expensive for anyone to acquire knowledge this way; or the advisors simply could not pay their overhead if they didn’t charge you for their time? If they taught us how to reduce our transfers, would that impact their business? And don’t you have some responsibility too? After all whose future are you supposed to be financing – yours or someone else’s? You must learn this quickly because experience can be expensive!
Dumb and Dumber
Public education is centered around what to think, rather than how to think. This “dumbs down” the public. Do you know of any courses that teach students how to use money as a tool to reach their financial goals? With money, the less we know the more exposed we are to misinformation. All the financial info available today has created some wealth but it also has created a debt-ridden society as well as record numbers of bankruptcies. Isn’t it obvious we should be doing something different?
Yes there are some great planners out there that are doing a great job informing the public but there are many, many more “wanna-bees” – people who just call themselves financial advisors or financial planners – but have no 3rd party certification that they have passed the requisite courses. These planners allow the conventional investment wisdom of bankers, auto dealers, accountants, lawyers, insurance agents, or investment sales reps to pass for actual wisdom. Some planners run fancy 15-100 page reports full of numbers, assumptions, and projections which contain no knowledge. No differences will be shown between opinion and fact. So the first step in getting a grasp on your finances is to understand there are only 3 kinds of money – lifestyle money, accumulated money, and transferred money.
This is the amount of money needed to maintain your standard of living – the house you live in, food you eat, clothes you buy, cars you drive, vacations you take, country clubs, and other comforts you desire or are accustomed to. All financial decisions are based around lifestyle money and most people would like to improve their lifestyle for themselves/family before they retire. If you live above your standard of living, you run the risk of overbearing debt and some future unintended consequence.
This is the money you have in savings, insurance, mutual funds, retirement plans and others. Confusion reigns supreme here as everyone who considers themselves a financial wizard – magazines, news articles, TV commentators and gurus, brokers, bankers, and financial planners – are active in this area. Trying to separate opinions from fact, myth from reality, or truth from fiction, is nearly impossible.
Transferred money (LOC)
Transferred money includes expenditures on things like taxes, interest on deposit versus loan interest, service fees, finance charges, markups or the spread between wholesale and retail, maintenance fees, management fees etc. Those who receive our transferred money are the government, retailers, banks, finance companies, mortgage companies, and insurance/investment companies. Understanding this type of money is the secret. While all vendors focus on accumulated money, the answers to increasing your wealth often lay hidden in your transfers, especially taxes. In many cases you can create wealth without spending an additional dime.
Few people understand how transfers impact how much they are paid at work. To examine how your income is affected by transfers, you really have to think several layers deeper. First you have to decide on a career/job. Your services or labor must have value to your employer in order for you to be compensated for your work. The employer knows how much he can afford to pay you and how much work you must do in order for him to keep paying you – for you to keep your job. Jobs can only come from someone’s savings, investments, or profit. There must first be profit or the employer could not hire, pay, or retain employees (the Gov’t only receives tax revenues if there are profits in the private sector). The determination of how much you will be paid comes after a lot of analysis, but the single most important consideration affecting your pay scale is how much of the company’s gross income is transferred to others. Profits are determined after all expenses are paid. Expenses include not only the cost of labor and the raw materials/inventory, but also corporate taxes, payroll taxes, the health insurance tax, vacation pay, the huge cost of government regulations, government fees, property taxes, fuel taxes, unemployment taxes, workmen’s compensation taxes, gross receipts taxes, all the business licenses, all the utilities and their “taxes” on the operation of a business such as water, power and sewer, and the cost to remove/dispose of waste. Of course the company you work for, like all others, must pass all these costs, fees, and taxation on to you and me, the customer, by raising the price of everything they sell. Then of course, when prices rise, less is purchased! Have you ever noticed that the people who are critical of businesses are the ones that generally have never run one – or have ever made a payroll – in order to know how difficult it is?
As soon as you get your first paycheck at your first job, federal, state, and local governments have their hand out to take some of your work effort; banks take interest for your new car loan; mortgage interest and real estate taxes are due on your condo; the water/sewer guys want a deposit as well; the gas and electric people say their fees and taxes are due; when you cash your check – yep, perhaps a check cashing fee; then the government wants taxes on your savings account too; and there is a fee for your drivers license. There are many other taxes not mentioned but you get the idea. When you get a layer or two deeper in understanding wealth transfers, always ask yourself who will profit from all the transfers and why you get paid last! This paper focuses on 11 major ways we all transfer wealth to others and how we do so, in many instances, unknowingly and unnecessarily.
THESE ARE THE TRANSFERS
Taxes Tax Refunds
Qualified Retirement Plans Owning a Home
Financial Planning Life Insurance
Disability Purchasing Cars
Credit Cards Investments
#1 TAXES – The Largest Transfer of Wealth
Start by asking yourself, whose future do you primarily want to finance, yours or the Government’s?
Here is a definition of taxes: “It is a payment in support of government, required from persons, groups, businesses within the domain of that government; a burdensome or excessive demand; a strain.”
The only power an elective official has is his ability to spend money – your money – through laws and regulations, by taking from one person and giving it to another, without the work effort of the latter. A gov’t almost always spends more than it collects so they spend a majority of its time focusing on how to raise more money through fees and taxes. Over forty (40%) percent of your income now goes to some form of tax which is more than the average family spends on food, clothing & housing. Overall, we are now taxed at a higher rate than when we threw tea into the Boston harbor. Unlike all other States in the US, on Guam our Gov’t gets to keep all your income tax, all the corporate income tax, and all the Section 30 money and not have to send it to Washington! Every State would like to switch with us.
When we understand the demographics of our nation, we know people are living much longer which requires more money to be spent to take care of them. That light at the end of the tunnel is not a ray of sunshine, it’s a train coming our way. This problem can only get bigger. Translated that means we may be paying much higher taxes in the future. According to the Family Research Council, over the past 10 years, state and local taxes of all kinds have increased 168% faster than national incomes.
Directly or indirectly we pay so many taxes it is nearly impossible to list them all. We are confronted with a host of taxes on a daily basis. Consider all the taxes paid on every single item we buy, at every level of production/every time a product is touched, from the raw materials, its manufacturing, transportation, warehousing, stocking and retailing it. (If you would really like to understand this process, google “I, Pencil” and read that essay. You will not regret knowing the details. Many of the following taxes/fees, at some point in the process of production, are either included in the cost, or added on to the cost, or taken from the producer:
FEDERAL INCOME TAXES; SOCIAL SECURITY TAXES; STATE/TERRITORIAL TAXES; CITY TAXES; PROPERTY TAXES; SALES TAX; LONG TERM CAPITAL GAINS TAX; SHORT TERM CAPITAL GAINS TAX; REAL ESTATE TAX; ACCOUNTS RECIEVABLE TAX; ESTATE TAX; FEDERAL GASOLINE TAX (42 CENTS/GALLON); WATER TAX; SEWER TAX; POWER TAX; TAX ON ENERGY-GAS; TAX ON MEDICAL EQUIPMENT DEVELOPERS; ELECTRICIY; HEATING OIL; GROSS RECEIPTS TAX; USE TAX; BUSINESS LICENSE TAX; TRASH TAX; STREET LIGHT TAX; ABANDON VEHICLE TAX; AIRPORT TAX; TELEPHONE TAX; LICENSE PLATE TAX; HOTEL TAX; CABLE TV TAX; USER FEES/TAX; UNEMPLOYMENT TAX; WORKERS COMPENSATION TAX; CIGARETTE TAX; 100s OF REGULATORY FEES; CORPORATE INCOME TAX; INHERITANCE TAX; INVENTORY TAX; MARRIAGE LICENSE TAX; LIQUOR TAX; BUILDING PERMIT TAX; MEDICARE TAX; FISHING/HUNTING LICENSE TAX; REAL ESTATE TAX; FUEL PERMIT TAX; ROAD USAGE TAX; LUXURY TAX; RECEATIONAL VEHICLE TAX; SEPTIC TANK PERMIT TAX; WELL PERMIT TAX; ROAD TOLL TAX; VEHICLES SALES TAX; TRAILER REGISTRATION TAX; WATERCRAFT REGISTRATION TAX; FEDERAL EXCISE TAXES (MANY KINDS); UNIVERSAL SERVICE FEE TAX.
It is safe to say not a single one of these taxes existed 100 years ago – when our country was the most prosperous in the world! Today, if something is not taxed it must be considered illegal such as drugs, prostitution, theft, gambling, money laundering, etc. If the government did away with all taxes and sent us one bill for everything each month, there may be another revolution like the Boston Tea Party!
But No One Told Me
If it was brought to your attention that you were unknowingly & unnecessarily paying a tax you didn’t have to, would you continue to pay it? Or, if you were told you had to pay a certain amount of tax, would you purposely over-pay the amount due? If you could legally recapture or keep some of the money you pay in taxes, would you?
The people who write the tax code assume you will take all the advantages that are created within any new law. If none of your Advisors have taught you how you could or should take advantage of tax reduction techniques when you can, that is truly unfortunate. And few people make an effort to find out. For instance, the most common belief is that using QRPs (qualified retirement plans) is the best way to reduce taxation. This is what you are told to believe isn’t it? Don’t be surprised to find out that this is not necessarily true. The tax savings above is not about pouring more into your 401(k) or other qualified plan – it may be quite the opposite. This will be discussed in greater detail in “Transfer #3.” One might hear, “I will be spending a lot less money when I retire than I am now.” When asked why they will explain the reason is they are putting the maximum into their retirement plan now. This means their contributions are not taxed today and their taxable income is what they spend. They never stop to think that contributions to a QRP today is above the line (AGI – adjusted gross income) and that the taxes they pay today is what they spend for lifestyle which will be about the same amount at retirement so their taxable income does not change after retirement! (The same goes for business deductions, education credits and home interest deductions – they are deductible today but one expects the children will be educated and the home almost paid off at retirement).
It’s Only Temporary
In1913 the 16th Amendment was passed, it allowed the imposition of income taxes. It was only going to be temporary. Only 5% of the people paid any tax at all and the highest rate was 7% on incomes of $500,000. Indexed to a cost of living of 3%, this amounts to the equivalent of having an income of $7,813,253 today!
Understanding the Math
All the talk about lower tax rates is fraught with misunderstanding and faulty math. If you could look at a tax return in 1960, you would see the highest federal marginal tax rate was 87%. However, there were a multitude of deductions which could bring your net realized tax rate to around 12% on most returns.
Twenty five years later the margin tax bracket was 28% but there were very few deductions. Instead of a tax deduction of 59% (from 87% to 28%) it amounted to a tax increase of over 130%!! (from a net 12% to 28%). Very clever isn’t it?
In the 80’s the government professed to give the people one of the lowest federal tax brackets in the history of the country. On the surface, or numerically, they did, but they quietly took away most of the deductions. Did you know that in all tax legislation, especially when there is a tax cut, when the whole Bill is finished being drafted the minimum objective is to make sure the income to the government was at least as much as the previous year – that revenues do not go down? The lowering of the tax rates supposedly created one of the largest windfalls in the government’s history. The politicians told us we enjoyed lower taxes while we actually paid more. But before long, subsequent Presidents/Congress had raised the marginal rate from 28 to 39%. Check your math – is that an 11% increase? Of course not, it is a 40% increase!! Today we are back to 39.6%.
Keep in mind, even with the record revenues being collected, the country’s debt continues to grow. Does anyone really believe taxes will go down in real terms (the amount you actually pay) in the future? But to be accurate, there are lots of people who pay less taxes when they retire. Why is that? Because they don’t have enough income to maintain their standard of living – all those who failed to save/invest enough to maintain their standard of living at retirement, end up being disproportionately poor! If this is true for you, you should get the needed help now because costs go up every single year, even when you are retired.
If you are one that believes exactly what the government and industry tells you about its retirement plans and deferring taxes to a later date, often times many years later, you should again study the demographics of the country. The government’s main objective is to thrive and survive. Politicians need more and more revenue to get elected – to give people things. We, the producers, on the other hand must play by different rules and we are the only ones pulling the wagon. Every time you earn a dollar, spend a dollar, or save a dollar you face possible taxation. Any attempt by you to thrive or survive will be taxed. In addition they get to change the rules anytime it suits (or profits) them. This is kind of like building a home on quicksand. Again, ask yourself a logical question: is the government’s primary goal to finance their future or yours?
TRANSFER #2 – TAX REFUNDS-
Sit Doggy Sit
Ever watch a dog try to catch its tail? At first it’s funny but when the dog keeps on until he is weary, you feel sorry for him and want to tell him “sit doggy sit”. You think to yourself what would he do if he caught it? What was the point?
The dog catching its tail is in some ways like trying to get a tax refund. You spend a lot of time going round and round, only to find out it was your money in the first place.
Avoiding tax Exuberance
Ever been around someone who just received a tax refund and is excited about it? They act like they won something when actually they lost – they had given the government an interest free loan and all they got back was their own money. The government used their money the first year for free, and in the process you may have had to pay someone to help you get it back! Instead of paying too much, all we have to do is adjust our withholdings. Would you do the same thing in any other part of your life? If you went to a store and bought a $110 dollar jacket, would you logically give the store $200 and allow them to send you the change a year later?
There are many types of government sponsored tax-deferred savings plans. The reason you don’t pay taxes on your contributions to these plans is because of something called “constructive receipt” of the funds. Since you did not actually get the money, you don’t have to pay taxes on them. Some plans, such as define benefit (DB) and (a few) profit sharing plans, now require the employee to make contributions to these plans because they are becoming very costly for companies to maintain. In the past they were a great benefit to the employee because then the employee wasn’t required to contribute. New DB plans are rare – in today’s world companies can’t afford them.
The second type of plan enables both the employer and the employee to contribute to the plan – with restrictions of course. Sometimes this is called a plan with or without a match. Employers could match stamp-collecting if it chose so while an employer can match any benefit they choose, whenever they choose, (for some reason some people think they can only get a match with a 401k), matching is an option by the employer. And since they pick up the administration costs, some do not match.
The key in all analysis of these plans is what you do with your money – the money you put in the plan that exceeds the match. This requires you to think one layer deeper, beyond majority/surface thinking. It also requires you to think about who is encouraging the use of these plans and why.
It’s almost like a carnival. “Step right up, come one and all, to the greatest disappearing act ever performed.” Then you watch in amazement as the master of deception makes things disappear with the help of his assistants. In some ways, taxes are a bit like the carnival. Not only do fortunes vanish into thin air – your participation is mandatory. Welcome to the greatest show on earth!
Here is how it works. The government creates the plans, financial professionals deliver them, and you turn over all the money to the financial institutions. Could we assume all three parties just might be on the same side? With little or no questioning, many believe life can not exist without a government savings/retirement plan. They are marketed and/or recommended by the financial services industry – banks, brokerage firms, accountants, lawyers, insurance, and Mutual Funds/investment companies. All of these entities promote these savings programs – it is natural, they profit from the revenues that flow into them. It would also be logical that Gov’t, who created them, would also profit. The popularity of these programs is based on blind faith – as evidenced by how little most people know about them. It is assumed that if the government and all these professionals support these programs, then they must be good. Companies even offer them as an entitlement (couched as a “benefit”) to the employees, promoting them as great savings tools for retirement. But when you get to retirement, HOCUS POCUS POOF! Once you must “gross up” for taxes to net the amount you need, taking more out each year to account for the increase in the cost of living, a whole lot of your money seems to quickly disappear, along with the magician and the assistants! It is your job to learn all the ins and outs so you know precisely what to expect. Then you can make an informed choice.
TRANSFER # 3: QUALIFIED RETIREMENT PLANS (QRPs) – Are they incentives or entitlements?
Incentives or Entitlements
Sales people go to businesses without a retirement plan and say something like, “do you know your competitor has a retirement plan benefit for his employees? He is going to hire your very best people from you because he has this benefit!” A lot of businesses buy plans based on this threat. They cannot afford to lose their best people so they are anxious to sign on the dotted line as quickly as possible. Never does it dawn on him to ask the second question: “If I start a plan like my competitor, there would no longer be an incentive to stay with me because they can go to either company and have the same benefit and the only thing both of us have done is increased our cost of doing business! That is no longer an incentive to the employee, it becomes an entitlement – the opposite of what I intended. Can you show me a plan that is a real incentive, where there is a huge benefit to the employee for staying but not a huge loss to me should he leave – something that will make me keep the employee and something that would make the employee want to stay with me, kinda like golden handcuffs??? Of course this is the only thing that makes sense and can easily be set up, but it would be a subject of a different paper.
Now we must think a layer deeper and go beyond how the majority thinks
In addition to them not being a true incentive, some people have come to believe QRPs are not all they profess to be, especially when they realize they have given up liquidity, use, and control (LUC) of their money and can’t leverage it to buy an asset or to reduce interest charges. The rules are ever-changing, complicated and, invariably, once all the costs are known, they can turn out to be very costly (for instance, most people believe there is no charge to invest their money or to manage it – because they don’t see it, almost no one understands they pay some type of asset management fee that can easily be 1.5% a year in addition to sales charges, administration, and compliance fees.) Those who think a layer deeper realize that QRPs serve the purpose of forcing some people to save, especially when there is a good company match. However, when the truth is known, the employer and the employee can create the same discipline by matching many other products/programs. Those who think deeper do not believe all the rhetoric about the tax savings of QRPs. First there is no tax savings because these plans are tax deferred plans not tax-savings plans – at some point you will pay the taxes on the contributions, in fact those taxes compound every year you defer paying them by the same rate of return your program earns and then you pay taxes on the entire amount (at ordinary income tax rates). No one seems to be able to point out one single difference in principle between charging on your credit cards and letting the interest compound the amount your owe and a QRP where you compound your taxes (the amount your owe) and not paying them off. In addition, if you do not pay those taxes while you are alive, then your heirs will pay them after you pass. The question is, at what tax rate? Will taxes be higher tomorrow?
A VERY IMPORTANT NOTE FOR THOSE BORN OR NATURALIZED ON GUAM – Most people who were born/naturalized on Guam (Organic Act citizens) believe there is no federal estate tax on their estates when they pass away. Actually there is none, as long as the assets are on Guam. However, what constitutes a Guam situs asset? The following is an actual case:
An Organic Act citizen had a qualified retirement plan with $374,818.00 in it when he died. Since retirement plans invest in companies in the US, and since the plan was with a US company, it was considered a US situs asset and not a Guam situs asset. The first thing that happened was that income taxes had to be paid on the $374,818.00. This amount put the account in the 35% tax bracket (without considering State and Local income taxes). By taking 35% of $374,818, income taxes would equal $132,586.30. Income taxes are due no matter if the plan is here or on the mainland. But in addition to the income taxes, because it was a US asset, estate/gift taxes were also due in the amount of $115,790 (including penalties and interest). This means taxes, of one kind or another, cost this program around $248,378. The total value was only $374,818. This translates to a loss of over 66% to taxes. Is this a asset you want to own at death? Perhaps a better question, is this a great plan for your employees? Which is followed by the question, “if I am an employer, what legal ramifications do I have as the sponsor (fiduciary) of the plan if my employees were not told about this potential tax time bomb?” Wouldn’t this be a material fact if you were sued? These are very important and very serious questions.
Stocks you own through your brokerage firm are also subject to US federal estate taxes. Exempted from the estate taxes are deposits in banks and life insurance policies, plus physical assets on Guam.
Tax Savings: Real or Imaginary?
So many people buy QRPs because they think it “saves them taxes” and “they will earn a return on the taxes they save.” Neither is true. Here is a good example. Let’s say you are 45, you put $5,000 into an IRA, you are now in a 25% tax bracket and you can earn 10% on the account (meaning the $5,000 doubles every 7.2 years). What would your tax savings be? Most would say you saved $1,250 because the math seems right and they will earn money on the taxes they saved. Now let’s say someone said they would give you $100 if you could tell them what that tax savings would have grown to 21.6 years later. What would your answer be?
Is the savings real or imaginary? Your $5,000 grew to $40,000 but your tax obligation grew from $1,250 to $10,000, assuming there were no tax increases over 20 years! This is the consequence of just one $5,000 deposit earning 10% per year over 22 years.
Age Value of the account Tax Savings
45 $5,000 $1,250
52 $10,000 $2,500
59 $20,000 $5,000
67 $40,000 $10,000
The reality is your tax obligation is compounding every year just as fast as your account is growing. Unfortunately, there is NO tax saving. So the tax due on the $40,000 would be $10,000, exactly what we thought was saved in the tax saving account. So the answer is: the tax savings is zero. And if taxes increase to 30% during these years, you lose money because you would then have to pay $12,000!
In this case a person thinks they really have $40,000. But because you must pay taxes on it, they really only have $30,000! Here is some real irony people never stop to think about. A before-tax dollar that accumulates tax deferred but is taxable upon withdrawal is exactly the same amount as an after-tax dollar that grows tax deferred and comes out tax free!! So if the same person did not put the money in an IRA and had it in some other non-deductible, tax-deferred account, they would have to start with $3,750 because they would have to pay the $1,250 in taxes first. But the irony is that the remaining $3,750 compounded at 10% would end up with the exact same amount – $30,000 in the same amount of time BUT they would NOT have to give up liquidity, use, and control of the money. Should future Congresses decide to convert all qualified plans to a Federal plan, you would lose all control and flexibility!
But because of the demographics of the nation (lots of older people), along with our huge debt, it appears inevitable that we will be paying higher taxes in the future. That would mean you deferred at a lower rate and will pay tax at a higher rate when you take the money out. What would your taxes be then if you liquidated your account at 66 and were in a 35% or a 40% total income tax rate?
30% tax bracket = $12,000
35% tax bracket = $14,000
40% tax bracket = $16,000
Hocus Pocus, Poof! The plan is disappearing! No one argues with the calculation but many still will not change because they are conditioned to do what the government sponsors. Congratulations, you have just become the perfect taxpayer!
Is this a failure to communicate?
Did your advisors tell you about the following disadvantages? There are other complications with QRPs that you might want to consider. We are so indoctrinated by the government and the financial services industry that when we actually consider alternatives, the only parameters we are prepared to consider are those determined by QRPs. For instance, what if you are worried the market will go down about the time you’re your retirement, can you have a guaranteed return on your basis in the plan even if the market goes down? No, you would have to buy another product. QRPs limit the amounts that can be contributed. What if you want to put in more than the rules allow? You can’t. Wouldn’t it be better to have a plan where you could contribute much more if you had the money and a big goal? What if you wanted a plan just for yourself and one or two others instead of the whole company? Wouldn’t that be a good thing? You can’t. Few people know the entire amount of a QRP is taxable at your death (if the beneficiary needs the money). Would you want to overcome those taxes if you could? You can’t with a QRP. What if you would rather retire any time you want, or not be forced take the income at age 70½? You can’t without penalties and taxes. If when you retire you want a guaranteed lifetime income it does not give you that; you would have to buy an annuity to get a guaranteed lifetime income. What if you were concerned about nursing home care – a QRP has no provisions for that; again you would have to buy a product that gives that benefit. What if you become disabled, does the QRP have a provision you can add to it that will fund your retirement even when you are disabled and not able to work? No. Would that be important? If these items are important to you, maybe you should check to see how you can overcome these disadvantages.
For many people the most disconcerting restriction of QRPs is that they cannot be used as collateral for a loan or other financial needs (without paying all the taxes and penalties). The wealthy generally became wealthy by using leverage. This requires the use of liquidity but QRPs suffer from the lack of liquidity, use, and control (LUC) of the money in the account. QRPs restrict access to your money. For many this is their only real source, or at least their largest single source of savings. If this is true, they might need to consider diversifying into non-qualified plans or diversifying your taxes – some taxable, some tax deferred, some exempt, and as much as possible tax free! Limiting your access to your money severely limits your options and opportunities in the future.
Think about this. When you and your company contribute to your QRP, both of you give up your right to access this money for any future use. Would it be better if you both could access your proportionate interest from time to time, without taxes, to acquire other assets, pay it back, keep all or nearly all of the interest, and have the assets available for the next opportunity? For example, say that you could access your money to buy a car with cash. If you could, then you could pay into your own account the same payment you would have had to pay the bank every month and in the end you not only have your car, but you would also have all the interest that would have gone to the bank – you would have eliminated the LOC and the wealth transfer, in this case.
If you need to use $10,000 from your plan before 59½, most tax professionals will recommend this might not be wise to do. If you are in a 28% tax bracket, you would have to take out 15,278, pay the 28% tax plus a 10% penalty to have $10,000 left! This is called “grossing up for taxes” to have a net amount of $10,000. This is a high price to pay so it is usually not recommended by accountants.
The same process applies to retirement, it requires you to “gross up” your needed income in order to end up with the amount you need. The number one fear at retirement is running out of money and therefore, for some, this grossing up can push you in a higher tax bracket in addition to draining your qualified plan more rapidly. For example, if you needed $50,000 a year to live on, in a 28% tax bracket you would have to withdraw almost $70,000, pay $20,000 in taxes, in order to net $50,000 dollars (40% more!). Thus, these excess required withdrawals, in order to end up with a given amount, eats up these plans quickly – and the grossing up could also push you into a higher tax bracket.
Again, remember demographics and the national debt. If your tax rates went from 28% to 38%, which most people see as “only” a 10% increase in taxes, you can now see that in order to increase 28 to 38 you actually have to increase 28 by 36% in order to get 38. That’s a huge increase in taxes.
Seed or the Harvest?
One idea is to always consider what you are planning to do from the point of “will I pay tax on the seed, the harvest or both?” Pretend you are a farmer. You are getting ready to plant. The IRS comes out and asks if you know there are 2 ways to do this – you can pay the tax on the money you buy the seed with, harvest the crop year after year, and then consume the crop over the rest of your life without paying any more tax. OR you don’t have to pay the tax on the cost of the seed, you harvest it year after year, but when you finally consume the harvest, you must pay tax on the whole thing as you consume it. If the tax man asked you if you wanted to pay the tax on only the seed or the entire harvest, which would you want to pay tax on? Obviously, everyone says the seed. But the harvest are QRPs!
Did They Tell You How To Avoid The Penalty?
Most people know about the penalty for early withdrawal but they don’t know about the four ways to withdraw from an IRA without a penalty (Section 72(t). You can use the following distribution methods:
A. Life expectancy – Take the account balance and divide by the table the IRS has and that will be the (taxable) amount you can take out without penalty every year regardless of your age.
B. Amortization – by using a “reasonable” rate of return, you can withdraw amounts based on that projection – the amount it might earn over your lifetime.
C. Annuitization – The IRS also allows withdrawals based on life insurance mortality tables and a “reasonable” interest rate assumption.
D. Conversion to a Roth – Currently you can avoid all future taxation for life if you convert an IRA, an old 401k, or do “an in-service rollover of part of your current 401k”, and pay the taxes due by April 15th.
As you can see there are ways around the 10% penalty. Did your financial professional tell you this? Isn’t this important for you to know? It is possible to avoid the 10% penalty.
Remember, aside from worrying about the market going down, the real concern for most people is that taxes might go up when they can least afford it. When you start working you deposit money while you are in the 10%-15% bracket. But as you acquire skills and get promotions at your job, your living standard goes up and so does your tax rate. So when you must pay 28%-31%-35% or maybe higher when you withdraw money, you have a hugely losing strategy. Run the numbers and you will be amazed what taxes could cost you in the long term. Just a point (1%) increase in tax rates sometime in the future can make a huge difference in how long your money will last and the amount a person can withdraw from any retirement asset, unless they are in accounts where withdrawals may be tax free. Again, if you need calculations on these figures, let us know.
TRANSFER #4: MORTGAGES
Owning You Own Home: The Most Misunderstood American Dream
Next to taxes, one of the largest transfers one will ever encounter is in purchasing a home. Our goal is to try to obtain the maximum home with the minimum price. When you find the perfect home there is a lot of excitement in the air. But you are now entering the twilight zone of the banking industry. It’s called a mortgage.
Hello, I’m New on the Planet
You’ve worked hard, saved your money for the down payment, and found the house you want to buy. The next step is to get a loan from the bank. Banks are always friendly but you will learn right away they play their game with discipline and you are at their mercy, so to speak. They will need your income statements, tax returns, lines of credit, and your credit score. Of course they didn’t ask you any of those questions when you opened a savings account and made a deposit, nor did they explain interest rate risk, tax rate risk and inflation rate risk and how they impact your savings deposit. But now that you wish to borrow, they want to make sure you aren’t a credit risk. That is why on every application you are presumed to be a bad risk until you can prove beyond a doubt that you aren’t – that you can afford the fees, the interest rate on the loan and all the other details they are going to require. And by the end of the first meeting you will sign an agreement allowing them to do this.
By the time you leave they have started the wheels turning which will make sure the process won’t be easy – they will be checking on your entire past, they will find out any financial problems you might have had, old or new, big or small. They will be focused on the idea of finding out about all financial activities you have ever had. No matter how many credit lines you have, how long the relationship, or when they made the last appraisal, they will do it all over on any new loan or refinance.
You should also know about credit scores. They may get a number of different scores. And they don’t normally take the best or even the average, it is to their advantage to analyze from the lowest scores.
What Flavor Would You Like
Now here’s where you’ll develop perspective. Buying a home is an emotional experience, and as mentioned before, emotions are sometimes based on opinions not fact.
The market provides many kinds of mortgages and there are many ways to “sell” a package. Since the demographics show an aging population, this will mean a lot of large houses will be on the market as seniors move out of them and down size. Banks, and the government, will find a way to put you in them. Banks may go to a 40-year (or longer) mortgage and since the government also wants the tax revenues from the appraised value of the house, they both want you to buy. It isn’t the price of the house that makes the difference; it is the affordability of the monthly payment the banks are interested in. They are naturally interested only in your ability to pay.
The more common methods are to get either a 15 or 30-year mortgage, or to pay cash. No matter which you choose, transfers will occur – if you have a mortgage you will pay interest; if you pay cash, not only do you lose the use of the money that you paid for the house, but also the ability to earn more money from that cash payment (LOC). Which is best? The myth of the decades has been “if you can pay off your house quickly, do so.” But is that good for you?
What If Something You Thought To Be True, Wasn’t True…
We’ve already discussed Lost Opportunity Cost (LOC) and Liquidity, Use & Control (LUC) several times. They really come into play when you pay cash. You really need to analyze what it means to you.
Watch the Money Grow? Paying Cash
Say you paid cash for a $150,000 (150k) house in an area where values grew. You bought it 6 years ago and now it’s worth 200K. Obviously this 50K gain amounts to an increase of over 30%. While it looks good, when you spread that over a 6 year period, the rate of return is only 4.91% per year. In addition, you made other expenditures over that 6 year period – you may have put in new carpets, did a lot of painting, new drapes/window dressing, perhaps a new A/C, a roof, or a furnace, possibly new windows or doors were installed in order for it to be considered “green” and to increase its value.
While you lived there 6 years you may have paid $2,000 a year in property taxes and maybe another 12K in improvements, insurance and maintenance – that totals 24K. Now the compounded rate of return is only 2.35%. How does that compare to other investments available to you? In a good market that sounds puny right? However, most everyone will still be impressed with your $50,000 gain. Were you?
No More Payments???
When considering paying cash for a house, one must think much deeper than you ever have before. You must apply the lessons of lost opportunity cost (LOC), liquidity, use, control (LUC), and the Rule of 72.
The first myth is that people think they will save on interest payments by not having a mortgage. Yes, you won’t pay interest to the bank but the first problem is that when you pay cash, the cash is now locked up in your house so you certainly cannot invest that same money elsewhere! The cash in the house earns nothing so you are losing earnings that you could have made on the money if it was invested elsewhere. In addition, when paying cash for the house, you forfeit the tax benefits on the interest deduction! By using the tax benefits from the interest deduction, you can recapture dollars which you can’t do by paying cash.
This example uses a higher than current market interest rate to make a point in order to understand the opportunity cost is much larger than you expect whether you pay cash or finance the house. To use an example, let’s assume you have a mortgage of $150,000 at 7% for 30 years (360 months). The monthly payment will be $997.95. If you invested $997.95 at the end of every month for 30 years @ 7% per annum, compounded monthly, the total at the end of 30 years would be $1,217,470. If you invested $150,000 at 7%, you would also have $1,217.470 at the end of 30 years.
Some people say they want to save on interest. But $997.95 a month means they will make total payments of only $359,363 in 30 years – much less than investing the payment and earning 7% on it ($1,217,470). So the bottom line in our example is that $150,000 has an opportunity cost of $1,217,470 whether you pay cash or finance it.
But there is a major difference. The interest on a mortgage is deductible if you itemize. If you are only in a 25% tax bracket the interest at 7% is really 5.25% net after taxes. In a 35% bracket the net cost of a mortgage is only 4.55%. And it doesn’t stop there. One would assume that if you invest money you would earn more than the mortgage interest rates (otherwise no one would invest in anything else!). In other words, in the above example you may expect (but there are no guarantees) that should you invest for growth, you may earn a 10% return (both current returns and mortgage rates are lower than what we are using in the example). You might also expect that someone with a 30-year mortgage also has something in excess of a 12-15 year investment horizon so investing for growth may be a logical investment for that person!
So if we assumed a 10% return, the $150,000 would grow to over $2.5 million if it was invested for 30 years and not used to pay cash for the home. The reality is that we do need a home. If we will only consider taking the $150,000, invest it in diversified portfolios that meets your risk tolerance, and if needed, take the mortgage payment from the account using a withdrawal plan, there may be a big difference in terms of results. More accurately, calculate how much interest you will pay the first year of the loan; then use your tax bracket to calculate the amount of taxes you’ll save; and lastly reduce the amount you withdraw from your investment account by the amount of taxes you’ll save because you’ll get it back anyway. This will have the net effect of allowing the investment account to have more growth potential. But make sure you understand the details before you do this.
If the mortgage is on investment/rental properties then you have the option of using the rental income to make the mortgage payment and keeping your investment account in tact. The whole idea is, provided you understand it all and have the discipline to do it, is to recapture some of the transfers and keep them yourself.
15 vs. 30
The most common mortgages sold today are a 15-year and a 30-year mortgage. Here again, misinformation clouds the choice between the two. First the buyers figure that since they pay for a shorter time, they will pay less. Secondly, they assume they will save interest payments. Let’s check that out.
If person “A” got a $150,000 mortgage for 30 years at 6.5%, s/he would pay $948.10 a month. The same mortgage for 15 years would be $1,306.66. If “A” invested the savings of $358.56/month into an account at 6.5% return, this will grow to $396,630 in 30 years. Now if person “B” pays his mortgage for 15 years and then invests the entire $1,306.66 at 6.5% for the remaining 15 years, it grows to just about the exact same amount. But if they both could earn an 8% return on their investment, then A would have $534,382 and B would only have $452,155.
All of this is before considering the greater tax advantages A has over B because more interest would be paid – so A would have greater write-offs. Keep in mind there are more tax deductions during the first 15 years of the 30 year mortgage than during the entire 15-year mortgage. Better deal? Here’s another thing most people don’t think about. Say you paid your home off in 15 years. Instead of investing the same amount they generally SPEND the money or they re-mortgage the house – but what will the rates be then? The guy with a 30 year mortgage at least knows what the rate will be 30 years into the future. That could be quite a comfort zone.
But get this. If A had invested the difference (between a 15 year and a 30 year loan) during the first 14.5 years, the 16th year she would already have accumulated $124,075 and could pay off her mortgage if she wanted to. Or, she could leave her investment in the market and let it grow while taking interest deductions. Isn’t that amazing?
Person A has more control, options, and opportunities. S/he also has retained some liquidity, use and control of her money while being able to maximize the tax deductions – recapturing your money through tax deductions is good! And perhaps by deducting your interest you may be in a lower tax bracket.
Banks need to “turn” their money – the faster they can turn over loans the better. A 15 year loan is not an interest saving technique. When a bank tells you a 15-year loan would be better because you will save on interest, as you have just seen this may not be true – but it does help the bank to “turn” the money faster.
Mortgages are a Bank’s most lucrative product. Interest only mortgages are fairly new. This is where you pay no principal, only interest. Here is how the idea works. If you had a $200,000 loan for 30 years at 7% interest, you would pay, and deduct from your income, $14,000 a year. The end of the 30th year you would owe the bank $200,000. But as you know, the bank needs additional security so let’s say they required 12½% or $25,000 of security. If you assign it to them and your savings/investment earns 7.2%, in 30 years the $25,000 will equal exactly $200,000, the amount you need to pay off the loan. Keep in mind there are no “interest only” loans on Guam at this time and with such an idea both you and the bank would want a “safe” account.
The key here is you have control of the money in the sense that you get to invest it. While there are no guarantees, one would hope to earn more than a 7.2% return. If it earned a 10% return the amount would be $436,000 in 30 years! In this case the $25,000 investment on the side could almost get your after-tax interest payments back AND pay for the house! (Ignoring that the investment would probably earn capital gains so your taxes would be much less).
Insuring the Bank
If you can’t get the interest only loan (above) and you have to put down the standard 20%, it is almost like an “up front failure fee” – they have equity of 20% before you start. With every payment you make they get more equity/safety and you have more risk if you default. With you however, with every payment you have less interest deductions so you must earn more, and pay the tax, in order to make the payment.
Black Hole in Space
Where does that deposit you make for your new home go? What is your rate of return on that money? Think hard! It’s ZERO! It will be zero forever. Can you borrow the $30,000 (20% of $150,000 = $30,000) from the bank as part of your loan? No. Why not? It’s not part of the mortgage. The banks will argue it lowered your monthly payments. On the surface that may be true, but what did the bank get out of the deal? Instead of loaning you a full $150,000 they have the use of the extra $30,000 (to make other loans) for the next 30 years. At only a 7.2% of return, that $30,000 would grow to $240,000 in 30 years for the bank. Just from the down payment they have doubled the amount they financed ($150,000-$30,000 = $120,000 borrowed). Can you deduct your down payment on your taxes? No. Can someone please tell me why I should want this? This is an incredible deal for the bank. Remember, the bank is telling you the more you put down, the more you will save. If you get nothing more in the process, part of your solution to this problem is to demand that all of your down payment money be accessible to you through an equity line of credit. OR, use other assets as collateral so you can effectively obtain a 100% loan.
Hitting the Jackpot!?
This is not an uncommon experience. Assume you have just bought a home for $150,000 from someone. You’ve just signed a whole bunch of documents, most of which were not explained to you in detail, nor did you read or understand them, before you signed. The people you bought the house from share their story. They paid $39,000 for it 33 years ago. They remember how low the real estate taxes were then but how they have grown over the years as the house appreciated. They point out the additions they added to the house which totaled $20,000. They feel it was their greatest investment ever. After all, they made $111,000 on it! ($150,000 – 39,000 = $111,000).
But when you take a closer look, the compound rate of return was only 4.17%. But is that what really happened? When we subtract the taxes and the improvements, which was $53,000 (without calculating or adding on the LOC each year as they paid the taxes or made the improvements), we have $150K – 39K – $53K or a gain of $58.000. That is a whooping 1.49% per year! In this case the Sellers had the entire house paid for at the end of the 30th year and owned it free and clear for 3 years. However they earned nothing on the 150K sale price during those last 3 years. If they could have earned just 7% on the $150K they would have had $10,500 a year in income! This means they lost another $31,500 in LOC! (By now you might be saying “Wow.”
Who is really in control of the equity in your house? How much do you earn on it? (ZERO). And when you pay down your mortgage and have $70,000 of equity in the house, I bet the bank sends you a big dividend right? WRONG! Sorry, the equity earns nothing. Some say their house increased in value and therefore their equity went up. Nope! Whether you have only $1 or $70,000 of equity, your property would have gone up anyway. And when values go down, would you rather loose $1 or $70,000 of equity? What if you were looking for a safe place to park your money, would you want a place that gives you no return, no tax advantage, no guarantees, and no access to your money – no liquidity, use, or control of your money? Of course you wouldn’t consciously do that but that is what happens with equity. So before you take it for granted that your home is a safe place to park your money, we should really make an effort to understand this.
Who Is In Control?
Alternatives allow you to have LUC – but that doesn’t mean the savings can be used for gambling, spending foolishly, or other “fetish” spending. These alternatives are only for people who have discipline and who are serious about their financial independence. If you are going to be in control of the money then you must also be responsible in using it wisely. You must create as much extra money as you can in order to create greater wealth.
Be the Bank
If your accountant says you can deduct the interest on your credit line, use your credit line at the bank to pay off things that hurt you financially. For instance if you have a $5,000 credit card balance at 18%, pay it off by converting it to a 6% loan from your credit line and deduct the interest, then throw that card away! Or, say you owe $12,000 on your car loan @350/mo, maybe you could pay $250/mo on the credit line and deduct the interest and invest the $100/mo savings. Wouldn’t it be better for you to get the extra $100 a month than the credit card company? There are many ways to reduce transfers.
The equity in a home is “tax free”. Of course if it doesn’t grow, it would be tax free – it is the same as being buried in the ground. But what happens to the equity when your neighbor decides to work on car engines next door? Property values (your equity) can disappear. Or what if they have a lot of animals, dogs that bark all the time for instance? Or what if the Federal Reserve raises interest rates – high interest means housing values go down and there goes your equity. And the “tax free” equity may become taxable if both spouses passed away. Rule: if you are breathing it is tax free; if you are not, it may be taxable.
Not dead, just disabled
Without LUC you could face another problem. Say both spouse are working and one spouse becomes disabled (or the breadwinner becomes disabled). You have $70,000 equity but the medical insurance doesn’t cover the ongoing therapy so you need to tap the equity. You go to your banker and ask for it. Chances are they will say that the loan was based on two wage earners not one so they can’t give the equity to you. “We don’t think you have the ability to pay back (YOUR) tax-free equity to us so we are sorry we cannot give you the loan. Good luck!” But instead of putting money into your equity (paying down your mortgage) you could put it into a separate account. Then you would have LUC and you could get the money anytime you wished.
And if you are sued?
What if you had a very unfortunate accident, you are at fault, you lose the court case, and the plaintiff is awarded a large settlement. Would the lawyers most likely go after a home with 5% equity or one with 50% equity? Hurricane Katrina settled that question. There were many cases where the people with a lot of equity were foreclosed on when their houses were blown away. But if you have next to no equity in your home, the bank will offer many solutions to the problem if you will rebuild your house. Of course this presupposes you either have your other financial assets in vehicles exempt to creditor attachments (ask us) or they were in an asset protected trust (or similar) so that your other assets were protected from lawsuits. (File your home as a “homestead” – on Guam it is protected from creditors.
If you have an account where you have LUC, where it grows without tax and can be used without a taxable event, then if you want to buy a $25,000 car, you can borrow from yourself and pay yourself the monthly amount. When it is “paid off”, you get to keep all the interest because it was paid to yourself. You’ll feel great being your own bank. Remember, a car is a depreciating asset. Paying cash up front on something that will lose money is a losing strategy!
TRANSFER #5 FINANCIAL PLANNING
Banks, wire houses, investment companies, insurance companies, money managers, brokers, financial advisors, lawyers, and accountants, all want your attention. All have solutions. Most try to convince you that the competition is inept, incompetent, and incomplete. There are a lot of highly skilled professionals out there but their skills are often in a narrow area of expertise. Few can provide educational information beyond their own industry.
As we have seen, the person best for you may be the one who can point out where you are transferring some of your wealth. Without this information you are only funding their projects/programs, and the only objective then is to take more risk to get a higher rate of return. When choosing higher rates of return, all the risk will be yours. But by focusing on the reduction of transfers, you make money regardless what the market does. This is called internal savings (IS). The real benefit of internal savings (IS) is that all the savings from the reduction in transfers you had been unknowingly and unnecessarily making every day are not taxed nor are there fees or charges. It is simply money you are no longer giving to others. Plus, because you are reducing transfers, it means the savings are guaranteed.
Your goal would be to reduce transfers equal to 1% (or more) of your gross income. If you normally saved $5,000 a year and your gross joint income was $100,000, a reduction of 1% ($1,000) would mean a 20% increase in savings on the $5,000. This would be guaranteed year after year. It may also increase your LUC as well as tax savings. It will be a defining moment in the way you think about money.
Is your savings in your 401(k) real or apparent? Perhaps by now it may be obvious that it is apparent. Is it real or apparent that paying down your mortgage is a good idea? We know it is only apparent because equity earns a zero rate of return and it does not have LUC.
Consider this. Say you have 15 years left on your mortgage and could refinance at a lower rate. If you took the balance of your mortgage, and refinance it, the payment should be much lower. Say you had a $120,000 loan at 7%. The payments would be $997.95/mo. If you now had a balance of 60k and you refinanced it at 6.5%, payments would be $380/mo or a difference of $620! Wouldn’t it be great to have an extra $620 a month to save or invest in a safe account? Also look at the possibility (with your accountant) of using an equity line of credit to pay off credit card debt and a car loan by lowering the monthly amount and making the interest deductible (because it is coming from the house loan).
If we do NOT acquire the knowledge it takes to change the dynamics of our personal wealth and either stop or reduce wealth transfers, all the institutions and companies will be there to take the money we willingly give them. Solutions based on knowledge, not products, means we must depart from the get rich quick mentality. Planning for poverty takes no time, no effort and the results are guaranteed (but will vary with luck).
TRANSFER # 6 – INSURANCE
How would you describe a person that lived near you who in the middle of the night walked out on his wife and family, leaving them with no means of support and a lot of debt? Would you have a term for him?
What would you call someone, who in the middle of the night died and left his wife & family in the same situation? The circumstances may be a bit different, but the results would be exactly the same.
Now how would you describe this person if he/she left a large life insurance policy which was designed to pay off the debt and sustain an income to the family, exactly as he wished? Would you say he was a loving husband and father? That would be a wonderful gift of love wouldn’t it? Would that gift of love mean he had a commitment to the family that didn’t end when he took his last breath because the gift lived on into the future? This is an important subject, one where we must think a layer deeper.
How you buy life insurance might be just as important as getting it. Buying life insurance based on price is flawed. It is not a “thing,” such as a TV, it is a program of financial security and understanding how it works is quite important. Cheaper is NOT better in most cases. If cheaper was better and you followed that philosophy for everything you buy, you’d end up with a house full of junk! Competition should be based on the provisions of the insurance contract.
There are a lot of policies and a lot of differences in those policies so one should talk to representatives who will provide you with a complete educational process so you understand the policy. The decision you make as to whether you buy term insurance with cash value or term insurance by itself could be a costly one. For instance, if you could recapture all the money you pay in premiums, is that something you would want to do?
How Much Is Enough?
Say you had a $100,000 policy and you thought that was enough. But one day you were walking through a store and a condenser blew up, there was a huge explosion and you and everything else was all over. You were gone. Your family then hires an attorney and sues the store. How much do you think they should ask the court to award your family in compensation for losing the breadwinner prematurely? Say the court determined the economic loss to the family to be a couple of million. Now that would mean there is quite a spread between the 100K and a couple million – the amount you thought your life was worth compared to what the court thought it was. Wouldn’t your family be happier with the courts determination as to your economic value rather than yours? Of course all of us think we are invincible and nothing could ever happen to us – we are going to live forever so it is so easy to underestimate what our needs are. But as you will see, there is another reason to purchase as much coverage as the insurance company will allow you to buy.
Buy Term & Invest the Difference
A common marketing ploy says: buy term insurance by itself (rather than term with savings or investment) and invest the difference. If that was sound advice, why not apply this wisdom in everything we do? Here are some very obvious comparisons.
We could buy folding chairs instead of a couch and invest the difference.
We could buy push mowers, rather than a power mower & invest the difference.
We could buy a bicycle, not a car and invest the difference.
We could buy a shovel instead of renting a tractor and invest the difference.
We could buy a pet, not have kids and invest the difference.
We could buy a scissors, cut your own hair and invest the difference.
We could buy an aspirin, not a prescription and invest the difference.
We could stay at home, don’t eat out and invest the difference.
We could visit the mall, don’t take vacations and invest the difference.
If the philosophy really works, simply extract its value & invest the difference.
Here are some term insurance facts. Less than 1 policy in ten survives the term for which it was written (i.e. 10 or 20 years); the average life span of a term policy before it is cancelled is 2 years; 45% are terminated or converted the 1st year, 72% within 3 years; but one of the most glaring statistic of all is that less than 1% end up paying a death claim, the only reason you had the coverage! Carefully consider these findings and what this means. This means the odds are 100 to 1 against term insurance ever being a death claim! And for those who keep their policy for the full 10-20 years it was issued for, they usually drop them when it comes time for renewal and they find out the premium has increased dramatically. If so few policies survive, doesn’t this seem like a good deal for the insurance company?
When would be the best possible time to own a term-by-itself policy? If you guessed “the day you die” you weren’t even close. It is the very first day you own it. If you received the policy today, paid the premium, and died in a car crash on the way home, financially it doesn’t get better than that. The benefit only decreases from then on because there is no recovery of the premium. However, it’s hard to get people excited about that concept, or to volunteer to make it work!
No cost recovery and taxes
Here is some more logic on buying term and investing the difference. When we invest in something, our number one concern is the return of your dollar. This is called “cost recovery.” Of course you’d like to get a return on your dollar too but most important is not to lose your original dollar. Term insurance by itself has no cost recovery – you never get the premiums back and so you have the cost of lost opportunity compounding against you the rest of your life and that cost far exceeds the death benefit at some point if you live to your life expectancy.
On the investment side, if we buy term and invest the difference, the investment will be taxable and taxes have opportunity cost (LOC) that compounds against your wealth for the rest of your life. Ask a responsible representative to run an illustration showing, for instance, any Mutual Fund over past 20 year investment period comparing the before tax and after tax results. It is amazing the difference after deducting taxes. This is an eye opener and a harsh reality.
Finally, if you purchase an investment oriented life insurance policy (which requires a prospectus and other disclosures) and literally wrap your investments (the portfolios of the policy) with the term insurance death benefit, you can overcome both problems. When you take money out of the contract, you get to take the total cost of the life insurance and the investment, tax free – the cost recovery problem and the tax problem are both solved. Now obviously there are many other things you should know before you do anything, including using the policy in this way.
If there is money to be made
The people who only invest your money for you, and charge a fee, want you to also buy term. This makes sense to them, they are in the investment business and want you to spend less on everything else so you can invest more with them. Today many investment advisors collect a fee based on your account balance every single year so the bigger the account the better. Banks also push term – it means more can be put into their accounts. Is it now easier to see why there is such a ground swell of support for this concept? But one layer deeper is the question, “is it for their profit or yours?”
Let’s do some more math
Wouldn’t it be reasonable to say that you would pay less by renting a house or an apartment than buying a home where you must also pay upkeep, taxes, and insurance? On the surface that may be correct but over the long term, say 20 years, the house should have a lot of value where the rental unit will have no return. Suppose you rented a house for $1,000 a month for 20 years versus buying a $150,000 house. It is easy to see that you would pay $240,000 in rent over 20 years if the rent never went up. But if you could earn just a 5% return on the home, in 20 years the house would have appreciated to nearly $400,000! So instead of a negative $240,000 by renting, you could have a huge positive plus you would write off all the interest each year! This does not take into account that rents go up every so often which makes the rental option worse. Rents go up but the mortgage payment will still be the same so, all things being equal, the first year paying a mortgage is the most difficult.
Term insurance is like renting, it gets more expensive with each renewal and you can only renew it if you stay healthy. When you talk to representatives who have sold term policies, and are still around when the term expires (when its time for renewal), they will tell you that many do not pass the required physical so they can’t continue the coverage. In addition, not only will the insured (most likely) have forgotten that the premium will double or triple (depends on the age at renewal), they will be mad at the agent for selling a policy that increases in premium when they can’t afford it (i.e. they just retired). But if the insured is no longer insurable, they will really be angry because you caused his family/business/heirs to be without the security of the coverage. The payment for the cash value (CV) policy on the other hand stays the same while accumulating more value each year. With the term policy, at some point in time you will not be in good health; the policy will not allow another renewal; or you will not be able to pay the premium. One or more of these events will take place before you reach your life expectancy, leaving you without coverage. Furthermore, because you will never get anything back, the lost opportunity cost on all the premiums paid, like the rent on a house (above), gets bigger and bigger every year for the rest of your life.
Term vs. Cash Value
Let’s assume a 46 year old bought the most expensive whole life policy he could find (interest based not investment based) and compared it to a 10-year term. An annual premium for $250,000 face/death benefit would be around $5,718.00 a year. The ten year term starts out at about $345/year for the first 10 years; about double the second 10 years; and then those premiums nearly triple the 3rd ten years at which time (age 76) the policy cannot be renewed again for a ten year period and converts to an annual renewable term policy. In addition, he would have had to be in good health at age 56 and 66 in order to continue the coverage.
A ten year term insurance policy at age 46 initially looks much more attractive. However the expensive whole life does not change even if/when his health changes. Also, the CV policy builds up equity or cash value. Under current values/interest rates (subject to change), at age 65 he would have paid $108,642 in premiums over the 19 years but the cash values would be so large he could stop paying at age 65, be insured for life, and those values would continue to grow. (Remember this is the worse case scenario for life insurance).
By comparison, the total premiums for the term insurance would only be $68,125 at age 80 so there would still be a difference of $40,517. However, the cash values at 81 would be $357,908. Subtracting the $40,517 CV would mean you netted $317,391! Those values have grown tax-deferred and can be taken out of the policy tax-free by borrowing your cash values or withdrawing to the basis (meaning you can take out the total amount you contributed for both the cost of the death benefit and the savings element in the contract before borrowing). How much money would be required in a 401(k) to net $357,000 after taxes. It would take more than $500,000 if you were in a 30% tax bracket? Financially, the permanent life policy, the cash value policy, is a much better buy. Not only that but you would have tax-free access to its values during this entire period to be used as leverage if you wanted or needed to. You would not have access to qualified plan money without penalty, taxes, and possible restrictions to future participation in the plan.
Here is another major consideration. If the guy died before his 81st birthday, the term policy would have paid out $250,000 to his beneficiaries but the whole life would have paid out $485,000 – that is $235,000 more! So which was the better buy. At age 80, to have a $458,000 term insurance death benefit would require you to pay a premium of $43,500 just for that one year alone!
So, is it or isn’t it?
Is term insurance cheaper over your lifetime compared to CV insurance? In addition to the previous 2 paragraphs, you can add the following: Outside of the death benefit, does term by itself offer any additional benefits? NO. Can cash value policies be a financial tool? YES. Do investment people and insurance companies recommend term insurance by itself? YES. Is that because it will be profitable to you? NO. Is it profitable to them? YES. See how easy it is to make your own assessment?
The whole life policy used above for comparison just happened to be the most expensive permanent policy, but by no means does this suggest that it is the most efficient or the preferred permanent type of policy – there are several others both interest sensitive and investment based that should be considered. In any permanent policy there is a term insurance component as well as an accumulation benefit. But the death benefit has a cost and must be paid. The cost of a stand alone term insurance policy cannot be recovered so it creates lost opportunity cost for life. In the above example the cost of the term to age 80 was $68,125. It assumes you are unable to continue the extremely high premiums after age 80. Say you lived to age 90. At that time, without considering the opportunity cost from age 45 to 80, the lost opportunity, just for the last 10 years between 80 and 90 would be another $68,125 and you would not even have any death benefit because the premiums would be way too high. Remember the demographics – people are going to live longer than they think and when they run out of money because they live too long, the death benefit will be very important to the survivor/heirs – both to live on and to pay the bills that will accumulate. With the whole life/permanent policy, you can recapture those dollars through withdrawals, loans, or in the death benefit.
With permanent life insurance you have access to these values throughout your lifetime. They grow without taxes while the policy is in force. Those values, up to the total contributions you have paid, including the cost of the death benefit, can be withdrawn, surrendered, or borrowed tax free. Loans from the policy are tax-free and in a modern policy they may be made on a zero spread loan basis. Loans for business proposes in these policies are tax-free and the interest can be tax deductible. Learning how to use these great financial vehicles can be very beneficial in your planning but beware, there will be other “professionals” out there who will consider these values as “easily pickings” – they will suggest you surrender or strip the values out of them so they can sell you an investment. If at any time someone recommends that you surrender a cash value policy, you may lose: 1) The immediate income tax free DB protection under current law. 2) Loss of the tax deferred features. 3) The death benefit, which can assist in meeting IRS demands on your estate and the needs of a surviving spouse, 4) the flexibility of a personal source for tax free loans at low or no cost. 5) A wealth accumulator; tax planning/reduction vehicle; a conduit for money; a source of flexibility, security and liquidity (LUC). 6) Future accumulation of your dollars because surrender charges could apply to the CV.
A Secret Weapon
These are very valuable tools:
• It permits tax-deferred accumulation of money under current law; the IRS will impose no tax if the policy is active – (even if you surrendered it there would be no tax unless the value exceeded the basis).
• If you have the disability waiver of premium rider, the company will pay the cost of the death benefit for the rest of your life should you become disabled before a certain age (say 60); and, if you take ‘waiver of specified payment’ the company pays the entire payment – including the savings and/or investment amounts you contribute to the cash value CV.
• In most states the cash in the policy is protected from creditors, absent fraudulent intent.
• Under current tax law, it can help you fund a tax-free retirement by allowing you to withdraw or borrow the CV without a taxable event, and to structure it in such a way that your income increases each year of your retirement (indexing to a hypothetical cost of living increase).
• A powerful benefit is that the cash value can be used as collateral/leverage in buying other assets.
• It can allow you to become your own bank – to pay cash (from the cash value) for something and then pay yourself the equivalent amount of a loan so you get to keep the interest instead of the bank.
• Allows you to structure an income for the family in the event you are not here to provide it.
A Secret Bank
These policies give you LUC. Whenever you can have access to your cash value without creating a taxable event – and if the policy has a zero spread loan – you can use the money and keep the interest plus not pay any taxes when you use the money – something other assets cannot do. All you need to do is keep the policy active. This is a pretty powerful concept once you understand how to use it!
Your Bank, Not theirs
As explained before, keeping control of your money, and having liquidity, is most important. When you control what would otherwise be equity in your home, and when you control all those monies in your CV, these are very valuable financial tools for you. They greatly help you eliminate or reduce transfers of your wealth in the future – you are using your bank, not theirs. When you use your own bank for something, you keep all the interest.
It Was Too Good to be True
In the 80s the government made an amazing change. In the tax reform acts of the 80s they made it very clear that life insurance was a formidable foe of government taxation. At that time private citizens, with no help from anyone, could buy contracts, create CV, and escape a lot of taxation. The government was appalled because the government had its own savings programs, such as IRAs and they didn’t want any competition from the insurance industry. Cash Value life insurance was offering many more benefits than what IRAs offered so the government sought to control and limit life insurance policies. The public suffered the wrath of government while the banks and investment companies applauded – they were the direct beneficiaries. For government it meant more ways to tax the public – and greater income for the government!
All Was Not Lost
What the government did was establish a limit to what you could put into a policy, but it did not reduce the benefits within the policy. The next time you consider writing a check for an IRA or other plan, consider if it has the following benefits that are available in a cash value life policy.
• TAX DEFERRED GROWTH – Mutual funds, CDs, stocks and other investment products do not offer tax-deferred growth of your money. It is said that qualified plans (QRPs) offer tax-deferred growth but what is not often mentioned is that your taxes are also compounding at the same rate as your account! So perhaps they should be called tax-deferred/tax compounding vehicles because they certainly are different than life insurance where there will be no taxes when you take it out, if done correctly. Remember qualified plans defer both the taxes/growth of the account but they also defer the tax rates you will have to pay.
• COMPARABLE RATES OF RETURN – Everyone needs market rates of return. Other products also have market rates of return but they also have ordinary income taxes (interest based products) and normally don’t have much if any LUC of your money.
• GUARANTEES – All policies have certain guarantees.
• SAFETY – The insurance industry is larger than the banking industry.
• ACCESS – Can you borrow your money for anything you want or is it locked in place because of fees and/or penalties?
• CONTROL – Do you control your money, or does someone else?
• DISABILITY – Will other vendors deposit money into your account if you are disabled and are unable to fund it yourself?
• CREDITOR PROTECTION – Are your other assets protected from creditors?
• TAX-FREE WITHDRAWALS – Do you own anything else where you can take the money out tax free?
• PROBATE – Do your other investments avoid probate?
• INSURED – Do other products provide a tax-free death benefit in addition to the investment/savings?
• SELF COMPLETING – Are any of your other investments self-completing when you die – will they fund your goal if you die before you finish funding them yourself? Will the banks or the government programs do that for you?
All of these benefits plus very liberal funding escaped the legislation in the 80s.
MEC – Modified Endowment Contracts
Policies have very liberal contribution limits over and above the cost of the term insurance death benefit. You can literally contribute unlimited amounts to a policy as long as the size of the contract (death benefit) is big enough to accommodate more money. But if you try to contribute more than the Gov’t says you can pay, it will create a Modified Endowment Contract, called a MEC, and then those monies will be treated and taxed like an IRA, a TSP, or a 401(k) – at your highest marginal tax bracket. So the idea is to contribute up to the maximum in order to create a different kind of MEC, referred to as the Maximum Efficient Contract. The policy performs best and has optimum benefits when it is fully funded, if your goal is to accumulate the maximum amount of funds. But like a high performance car, it will need enough gas to perform to its optimum!
Need vs. Want
It comes down to this: Need vs. Want. While you are alive you want you and your family to have the best lifestyle you can have – home, car, education etc. But what about if you die prematurely – what kind of lifestyle do you want for them? What kind of love letter have you written for them? Will you still want them to have the same lifestyle they have now or will they only NEED enough to get by – a small home, a run down car, minimum care and no money for education? It boils down to the type of commitment you have made for your family if you are not here, or for your future if your goal is to create wealth. What do you really want to happen if you don’t wake up for breakfast tomorrow morning??
TRANSFER # 7 – Disability
One of the greatest fears of most people is becoming disabled. The possibility of becoming disabled is 2½ times higher than the odds of your premature death. If that happens just how are you going to pay your bills? Do you have disability coverage at work? A private policy? Adequate savings? Good health coverage? Does your life policy have waiver of payment so your company continues to fund your wealth accumulation (your cash values) unabated? Are other assets available that you could sell? Are you qualified for SS coverage and could you wait for it to begin? Do you have worker’s compensation?
If you are the primary wage earner, you are the goose that lays the golden eggs! Income is your most valuable asset and 49% of all foreclosures on homes, sans sub-prime loans, are due to disability. Without some kind of coverage, or some kind of protection against the loss of income from disability, the unnecessary transfer of wealth will be enormous.
TRANSFER # 8 Financing Automobiles
Keep in mind most of the things we buy are depreciating assets. This should be part of your thought process whenever we buy anything. The automobile is one of the most expensive transfers of wealth you will experience because the value of an auto goes down every year, plus most cars are financed (and the interest is non deductible), which compounds the problem.
To demonstrate say you are age 35 and buying your first car (if you bought your first car at 25, the problem is much bigger). Let’s say you buy a new car every 4 years until age 79. You believe you can earn 7% net after taxes on your investments; the car costs $30,000 (the first one), increasing each year by a 4% cost of living; and the auto loan you get has a 6% loan rate.
During your lifetime you’ll buy 10 cars. But if you were able to invest all the interest you will pay on the loan instead of financing it, you would have accumulated $576,473 by the time you are age 79. After all those driving years all you end up with is a 4 year old car! What makes this so painful is that, unless this car is for business purposes, the interest is not deductible from your income!
The only realistic answer is to either use a home equity line of credit to pay for the car and deduct the interest or to take money from a liquid account, such as cash values from a life insurance policy that won’t be taxable, pay cash and then pay yourself the amount you would have to pay if you financed the car. In the end your asset has been replaced plus the interest!
Remember you create a large lost opportunity cost by having a non-deductible loan and/or by paying off a depreciating asset early. But you could estimate the residual value it will have after 4 years, pay only enough so when you sell the car you have paid off the loan, deducted the interest, and invested the difference between a car loan and equity line of credit!
TRANSFER #9 Credit Cards
Personal debt can and will ruin the economy of the US if not addressed. The GAO estimates taxes must double and entitlement programs must be cut drastically if we are to survive financially. Many people have huge balances on their credit cards. This is a serious transfer of wealth.
Here is an example. If you have a credit card at 18% and always have a $5,000 balance, you will pay $39,433.00 in interest over a 40-year period. If you had invested that interest and earned 8% on it over the 40 years you would have earned $255,383.00. If your credit card company is getting 18% on their investments, the interest you paid them over that 40 year period would net them $6,680,280.00! You must avoid this trap!
If you will only establish “your own” bank, you can use it over and over – but remember, this is not a slush fund, it must be a loan to yourself which you must pay off. Once you start this process it becomes a game to you, you use your imagination all the time in creating more opportunities to contribute to your bank.
TRANSFER #10 – Investments
The essence of transfers is this: Any dollars that you are able to recapture, that you are unknowingly and unnecessarily giving away, that can either be saved to one of your own “banks” or used to enhance your lifestyle. By eliminating or reducing these transfers, the amount of money you will be able to keep will increase.
We have seen that the expenditure of a dollar always has opportunity cost. The difference is whether it is unnecessary or an unknowing transfer, or it is a necessary transfer. In many things we must make the transfer, the difference is whether we do it knowingly or unknowingly and what the cost is of transferring money we didn’t have to.
Even investments have transfers and opportunity costs. For instance, if the money that is invested is after-tax dollars, the tax you had to pay has an opportunity cost. As it grows, you will have to pay taxes on the gain also. Those taxes have opportunity cost. So after we subtract the actual payment of taxes; the opportunity cost of the taxes on the original investment; the original investment; and the lost opportunity on the taxes paid; there often is little gain.
Alternatively, if you could invest after-tax dollars but the growth of the account as well as the end distribution (the spending down of the account) was tax-free, we would be much farther ahead. That is looking one layer deeper!
If an account is taxable and you are contributing to it every year, at some point in time the annual tax due on this account will be more than your contribution. About that time you may start wondering why you have that investment – you started out contributing X amount, say $10,000 a year, but at some point that investment will cost twice that amount – the $10,000 you contribute plus $10,000 in taxes. You won’t like that.
This demonstrates the need to consider what is happening with your retirement program. Once you have a large sum of money it in and you know the amount you need each year, calculate how much more you will have to take out to cover the taxes that will be due – the taxes which will have to be paid on every withdrawal.
TRANSFERS # 11 (one extra) – Renting
One of the more obvious transfers of wealth is renting a home because the reason is you never get any of the rent back – it’s gone, there is no cost recovery. This means the amount you paid compounds against you for life. For example say your rent was $1,000/mo and you rented from age 30 to 40 – a total payment of $120,000. But there would have been lost opportunity cost on the money too and at 7% it would have equaled more than $53,000. If at age 40 you then buy a home in order to stop FUTURE transfers, the amount from age 30-age 40 continues to compound. From age 40-65, the $173,000 would have grown to $938,945. If you live to age 85, just the rent money you spent from age 30-40, cost you $3,633,424 in wealth you will never see!
As we have seen earlier, while a home does not give us liquidity, owning a home has many advantages, including being able to take $250,000 profit from it tax free – $500,000 if you are married filing jointly.
THE CREATORS OF THE TRANSFERS
The Government – Your partner in life and death
Government is a system of compromise – all laws passed are compromises. There are two political parties that are bent on destroying each other and will go to any lengths to use the public as a pawn in order to fight for ultimate control and power. Their goal is to fulfill their agenda, not the publics. Every time the government passes a law to doing something, it costs all the people who work, money. No mater how righteous or practical or how generous government programs sound, they are very expensive. Thousands of government give-away programs are funded every year which workers must pay for. The harder and the smarter you work to help yourself and your family, and the more you earn, the more you are taxed.
The largest financial transfer of wealth is in the form of taxes – there are literally hundreds of kinds of taxes and fees, many you haven’t even heard of or don’t even see. And whenever you buy a product or service, you pay for every single tax leveled at every stage involved with growing, developing, producing, packaging, shipping, storing and marketing the product or service. Most people could not conceive how many taxes and how many times a wooden pencil or a can of soup are taxed, for instance.
The country is heavily in debt. The future of taxes and tax rates are a big concern for those who are aware of the problem. There is a lot of uncertainly over taxes as we look forward to our aging population retiring. Some of the uncertainty includes: over spending by the government; the growing debt; increased costs of health care; and the long war on terror. In the future all of this will affect the amount of money you will be able to keep from your hard work. Since the Government has an interest in all your savings – you should too!
Contrary to what you may have concluded from above, Banks play an important part in our lives – how about an equity line of credit for example? But do you know that your savings in the bank is insured by an agency of the government that is 6 trillion in debt itself? Someone once said, “Banks will lend you money if you can prove to them you don’t need it. Humorously, a banker is defined as a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain!”
One must understand how a bank works. By you putting your money into a bank, you are lending money to that bank, so they can lend it to someone else at a higher rate. The Federal Reserve allows banks to loan out 8 additional dollars for every dollar of deposits. They earn interest and fees not only on the money you lend them but also on the 8 dollars of paper money. In turn you earn a very low rate of return on your money plus many accounts require you to pay fees to keep them open or to give you copies of your checks etc.!
The author of Unintended Consequences identified over 100 separate fees banks impose on their customers and over the past few years the amount of the fees rose twice the rate of inflation. He claims charges and fees account for more than 40% of banks revenues.
It’s difficult for government to step in and reduce the cost to the customers of the bank because government needs the banks. The Federal Reserve, which represents banks, prints the money and then lends the money to the Federal government. The government pays interest on these loans and the debt and the interest is passed on to us in the form of taxation. Now who in this process is the happiest? If you guessed the banks, you can go to the head of the class! It costs very little to print the money to give to government yet the banks get the interest! And since the public debt is always increasing, do you think your total taxes will ever go down? Does it seem logical that the government would aggressively address bank charges/ practices?
This is not intended to knock Banks but have you ever tried to close out your account? Aside from all the forms you must sign, you will get grilled by bank employees asking what you intend to do with the money and why you are closing the account (of course they never asked you why you opened it or suggested reasons for not opening it). In reality it is none of their business but they aim to hold on to your money as long as possible. Without any financial planning advice (generally) they will also steer you to their products, not necessarily those that are best for you after getting independent advice. Credit Unions are less intrusive.
The Federal Reserve (The Fed) – bridging the gap to plunder.
The central core of banking under the guise of the Fed is very simple: An ability to print money at very little cost, which has no real value – no backing by gold or silver – and loan it out to purchase things that does have value, which in turn creates value for the “unbacked” money. Holding property liens on things you purchase gives the banks the right to book these as assets, minus the balance of the debt. All the money that has been credited by the banks is created out of nothing (because it is no longer backed by gold).
The fed was designed as a legal private monopoly of the money supply under the guise of protecting and promoting the public welfare. All of this was done in a secret meeting on Jekyll Island in November 1910 off the coast of Georgia. The government itself cannot print money of no value as it would be against the Constitution but there is no such restraint on the Federal Reserve (The Fed). For more information on the secret meeting, read the book “The Creature From Jekyll Island” by G. Edward Griffin. Understanding how the government, the banks, and the Fed relate to each other will open your eyes to the transfers of your wealth that they create, control, and profit from. If you don’t already know, you may be amazed.
Fuzzy Wuzzy Thinking
When you see or listen to so-called financial experts on talk shows, when was the last time they proved mathematically that any of their opinions work? Many make broad statements about things, for or against other financial products, but when do they ever prove their statements? They often blow off any comments to the contrary by making statements that insinuate any other alternative is stupid. Just keep in mind that most of what is said is only their opinions and is often only surface thinking. Not only do they fail to do the math, present no facts, present no research or independent studies, they present no discussion as to the person’s income, age, assets and liabilities, family status, tax bracket, insurance in force, the love for the family or the security of his/her job. Nothing is presented to justify their conclusion. Wouldn’t that seem to be an important prerequisite?
The failure to think a layer deeper about any and all financial concepts is causing the transfer of thousands of dollars of your wealth. It is like looking at a beautifully frosted cake – you have no idea what kind of cake is under it, or if there really is a cake, or what it tastes like by just looking at it. Or, looking out at the ocean one never knows what may be under the surface. We must go a layer deeper – to get under the surface – to fully appreciate what is there. This applies to just about everything we buy.
All the magazines, financial TV shows, brokers and consultants are there to promote their products and concepts. With all this information, why are so many people doing so poorly – what the majority are doing must not work because the majority do not retire financially independent. Why is it that the successful people, who are a minority, seem to do things differently than the majority? Perhaps the majority needs to take this subject more seriously; perhaps they need to get below the surface to understand why (maybe they should read “BEYOND MAJORITY THINKING.” Change is difficult for many but perhaps we need to learn to change. As in golf, changing your driver may not be nearly as effective in improving your game as changing your swing, notwithstanding what the golf club manufacturers tell us. But the majority focuses on the clubs and not the swing. In a recent British Open, Tiger Woods used his driver twice during the Open. What does that say for clubs? So does it stand to reason that just changing products is probably not the best thing to do? But improving the swing and looking a layer deeper may help much more.
TAX CUTS AND THE RICH
We frequently hear that tax cuts are for the rich. These comments amount to nothing more than “get me” or “get my politicians” elected talk. It is obvious that the wealthy make up a very small portion of the tax payers (5% pay 55% of the taxes). The politicians view them as a small group of voters. And since there are more poor and a large middle class voter base the wealthy are a good target to pick on because all the other groups will be happy that someone else has to pay more taxes. It’s an old tactic – divide and conquer, blame someone else for the problems so people will vote for you or your candidate. Ever wonder why they will spend hundreds of thousands of dollars, even millions, for a job that pays a fraction of what they spend to get it?
In addition, the average person does not know where money comes from; where taxes come from; or where jobs come from. No one stops to consider that it is nearly impossible for poor people to create jobs or that a poor person pays no taxes. They do not know where the money comes from to develop our economy. Since it is the wealthy who take these risks, how could our community be better off if the government confiscated more of their capital through taxation? Furthermore, the wealthy are already wealthy. They really don’t have to work if they find taxes are too high; if taxes are too high they will just keep their money, they will not invest more of their assets to develop the economy and create more jobs.
Here is a great story that helps almost everyone understand the phenomenon. Compare our tax system to 10 people going out to dinner. The common belief is that a tax cut gives more money back to the rich than the ordinary taxpayer – sometimes called Joe six-pack. The reality is that the rich pay much more in taxes, and they pay higher rates too, so naturally they save more dollars from a tax cut, but it is their money that is invested to expand the economy and to create more jobs.
The 10 people decided to use the same rules as the tax code to pay the bill, every time the 10 people would go out to dinner this is how it would look: Say the bill is $100. Since over 40% of the people pay no NET income tax, the first 4 people pay none of the bill; person #5 would pay $1; person #6 would pay $3; person #7 would pay$7, person #8 would pay $12, #9 would pay $18 and person #10 (the wealthiest) would pay $59. They do this week after week. Everything seems to go well.
But then the restaurant owner decides to reward this loyal group that always comes to his restaurant with a 20% discount. Now the dinner is only $80. How should they divide up the savings?
Since the first 4 paid nothing, the savings would be divided among the rest. But if you divided the $20 savings by the remaining 6, then #5 and #6 would be paid to eat their meal (they only paid $1 and $3). This didn’t seem fair so the equitable answer is to reduce each person’s bill by about the same percentage. This would be the result: #1 through #5 would pay nothing; #6 would pay $2; #7 would pay $5; #8 would pay $9; #9 would pay $12; and #10 would pay $52 instead of $59.
Everyone started comparing and then complaining. Person #6 complains he only got $1 back but #10 got back $7. “Why should he benefit by $7 when I only got $2, shouts #7”. “Why should the wealthy get all the breaks”? Persons #1-4 yelled, “We didn’t get anything back – this system exploits the poor! “ Then the 9 people surrounded the 10th and beat him up. That seemed to satisfy them. But the next week when they went out to dinner, #10 did not show up so they sat down and ate without him. When they were finished, the bill came and they discovered they were $52 short! They then realized that the only way they could benefit was to have a wealthy person become the engine that pulls the train. That is our system of equality.
People who pay the most taxes will benefit most from a tax cut. It is the only way to encourage them to spend more of their money in our economy. It’s common sense math. If you tax them too much and then attack them for being wealthy, they may decide not to show up at the table anymore. For everyone involved this would create an unintended consequence. Every one would have to pay more.
DON’T LIMIT 401(k) DEDUCTIONS TO THE AMOUNT MATCHED
The following you have read in papers/magazine, saw/heard articles in other media, or perused the promotional materials of vendors: “Even though the company matches only part of the 401(k) contribution, it is to your benefit to put as much as possible in your 401(k) plan since they are an excellent way to save for retirement; that many people only contribute up to the match but not the maximum, and this is a mistake.” Then they finalize this train of thought by stating that with a 401(k) plan, an investor receives a double tax benefit – not only are you not taxed on your contributions into the 401(k), but all the income continues to grow on a tax-deferred basis.
Half the Story
Practically everyone has heard that presentation. It is “surface thinking” at its simplest. One keeps looking for the rest of the story – where the whole story and the whole truth are told. It is as if there were no other material facts to share and the public doesn’t need to know “the rest of the story.” They simply decide that it is not important to discuss the taxation issues and other restrictions associated with these strategies with the public. What should be said?
It would be nice if the articles would point out that accumulating money for retirement should be everyone’s goal, but that there are many other considerations. A qualified plan defers the tax you would have paid on the money this year because you have not actually receive that money yet. But the reality is the money in the account is not all yours, you have a partner – the IRS. And not only does the IRS control your access, by putting a penalty on pre-mature withdrawals and making sure you can not use the account as collateral, but before you can touch your share, you must pay your partner the taxes on your contribution as well as all the accumulations. And, as long as the money is in the account the taxes you must pay are compounding just as fast as your account grows. Maybe it would be good to suggest that: it not only defers the tax, but it also defers the tax rate you are going to have to pay on every dollar deposited, plus all the earnings on the account. Most people start out in a low income tax bracket when they are young and by the time they retire they are in their highest tax bracket. Are you in a higher tax bracket now than you were 10-20 years ago? Wouldn’t it be unreasonable to suggest that someone will never get a promotion the rest of their working life? Wouldn’t it be safe to assume most people will get promotions before they retire or that they might be offered a better job elsewhere where they will be in a higher income tax bracket; or that their business just does much better and they earn a lot more? If they do, they would be deferring a dollar of tax when they are in a low tax bracket only to take it out when they are in a high tax bracket. Does that make economic sense?
The assumption that you will automatically be in a lower tax bracket when you retire is flawed. When one studies the demographics of the country today (more older people), and the history of the federal marginal tax brackets, it could lead you to the conclusion that it is very possible that you may retire to a higher tax bracket if you have accumulated the assets that would allow you to maintain your standard of living (remember you have to gross up for taxes and this may also put you in a higher tax bracket). Today we are in a historically low tax environment but in the last 5-6 years the President has done everything he could to raise tax rates. We only need to ask ourselves if we think taxes will be higher within the next 10-20-30-40 years than they are now. Will taxes be lower or higher in your view? If it turns out that taxes will be higher, then using a qualified plan may be a loosing strategy. Why? Because we are all at the mercy of the government. Can anyone tell you when the government ever allowed you a double tax benefit without the ability to recover these taxes, and maybe more, at a later date? We cannot forget our taxes compound as our account compounds.
When you read articles where they fail to mention the effects of taxation on 401(k) money, could that be considered an omission of facts? Unintended Consequences could result. Qualified plans are not bad, in fact there are a lot of people who would not save anything without them, but it may suggest that those who can go one layer deeper need to think twice about it. Once again, whose future are you financing, yours or the governments?
FEE-ONLY ADVISORS AND CONFLICTS OF INTERESTS
Probably more than once you may have seen an article regarding the need to meet with a professional advisor in order to go through the many aspects of planning. Many promote the idea that you should use a fee-only advisor as opposed to a commissioned sales person since they will not have a “conflict of interest”.
There is a cost when dealing with garbage, there is a fee for picking it up.
Fee-only planners charge you a fee, based on the total assets in your account (under management), in order for you to have the ability to talk to them. The assumption that fee-only planners are the only planners who are professional and who truly care about their clients, would be a stretch of the imagination wouldn’t it? It smells. Make no mistake; a fee is no different than a commission. The sanctimonious press leads people to believe that fee-based planners are not motivated by money. Now isn’t that just a little illogical? A “benevolent” profession doesn’t exist; they need to pay the rent/employees and to make a profit to sustain their standard of living just like everyone else, including the media. Their initial and continuous education requirements are enormous. Simply put there are both good and bad fee-only planners as well as commissioned planners.
Almost all professionals charge fees – it is a percentage of a certain number. Have you ever built a house? If you have, you probably have noticed that the architects and engineers charge you a fee. But wait, since it is a percentage, can’t that also be called a commission? How is it different? When you sell your house a real estate agent typically charges you 6% to sell it. Is that a fee or a commission? A percentage of anything can be called either a fee or a commission. Furthermore, as far as investing is concerned, which is going to cost more, (for instance) a 4½% one time charge on the capital amount invested or a smaller fee (say 1-2%) charge on your account balance each and every year as it grows larger and larger? Does it make much difference to you? In everything you do with money, someone is going to get paid besides yourself. Isn’t the bottom line how much you make rather than how much anyone else makes?
We buy “stuff” every day to satisfy our living standard. A retailer who buys something for $1 will then mark it up to cover all his costs. That often varies from 100-300%. Is that a fee or a commission? At a restaurant you may leave a tip of 15% for someone to put food in front of you. Is that a fee or a commission? How much education is required for that job? Now compare that to the miniscule fee from commissioned or fee-only planners.
Hopefully this material has been helpful for you. For the full details of each subject, pick up one or all of the books mentioned in the disclaimer on the first page. One last reminder, this information is not intended to be recommendations to do anything specific or to purchase anything; to be professional tax advice; or to be legal advice. You must consult your own advisors for information about your own situation.