Thursday, May 27, 2010

Tax Advantaged Accounts

Another financial myth out there is tax advantaged accounts. There are countless tax strategies to go with the countless tax laws. I say countless because by the time you finish counting them the number has changed. Some of the most common tax strategies involve some sort of tax deferred investment account, the most common being 401k.
            The benefit of a 401k account is that you can invest pre-tax dollars and allow them to grow tax deferred until you withdrawal them. This is nice, but only helpful if you will be paying less taxes when you withdrawal money than you would have to pay now. If the amount of taxes doesn’t change then it does not matter if you invest pre or post tax money. This is demonstrated by the chart below. In this example we have a 35% tax rate. We start with $10,000 pre-tax and $6,500 post-tax and invest it at 7% for 10 years. At the end of 10 years the post-tax money has only grown to $12,786, while the pre-tax money has grown to $19,672, but we still have to pay 35% of that to taxes. After we do that we end up with the same $12,786.


After 10 Years
Tax Rate
 $ 19,672
 $   6,885
 $ 10,000
 $ 12,786
 $   6,500
 $ 12,786

            If your employer does not offer a 401k, you are probably eligible for an IRA (Individual Retirement Account). As far as pre- and post-tax income, an IRA works the same way as a 401k. If you are eligible for an IRA you are most likely eligible for a Roth IRA which allows you to invest post-tax income.
            So the question that each individual has to ask themselves is when will they be paying a higher tax rate; now or in the future? There are two variables when it comes to the amount of taxes you pay; the first is tax bracket, the second is tax law. Your tax bracket changes as your income changes. The more income you make the higher tax bracket you will be in. Higher tax brackets generally pay a higher tax rate.
            Many people believe that when they retire they will be in a lower tax bracket than what they are in now. That isn’t necessarily true. Just think about what retirement is. Retirement is like turning everyday into a Saturday. What do we do on Saturdays? Spend money. During retirement your free time will be plentiful, and you will search for things to do during this time. As you fill your time with multiple entertainment activities it is likely that your expenses will go up as well as your retirement income needs. If your income needs go up, to fill those needs you will withdrawal more income and may unwillingly move into a higher tax bracket. Granted, all of this is relative and dependent on your income just before you retire.
            Some may argue that you won’t have expenses like house payments, and car payments because you’ve paid those off. The flaw in that logic is that cars wear out and have to be maintained or replaced. Houses start to require more and more maintenance; paint, siding, roofing, pluming, etc. Not only that but you will still have to pay car insurance, home owners insurance, and property taxes. So the only thing you can do is estimate your retirement income needs to the best of your ability. Giving the benefit of a doubt, and saying that the debts you pay off do somehow compensate for the increase in entertainment spending, you can estimate your needed retirement income the same way that needs based planning does it; adjust your current income needs for inflation. As we have already discussed, this is not an accurate or reliable method, but it is about all we have right now. Still, I would not depend on it.
            When it comes down to it, the decision must be an individual decision considering your current income, outlook for future employment and income, your own personal habits, and what you think or want your retirement to be like. Luckily for many young professionals while they are in college and starting their careers they will most likely be in one of the lowest tax brackets. This is virtually the only time anyone can accurately know they will likely be in a higher or similar tax bracket when they retire. I would recommend that anyone in the lowest tax bracket use as much post-tax money as possible for their investments. Coincidently, because of the law of compounding, this is also the most important time for an individual to save for retirement.
            Something else that should be considered is tax law. Will taxes go up or down. I will write more on this subject in the future, but until then a nice little blog about past and future taxes go to

Friday, May 21, 2010

"Keep it secret. Keep it safe!"

Ok, maybe not secret, but definitely safe. Your money is not just money. It's all your hopes and dreams for the future. It's how you want to live and what you want to do. You should protect your money the same way you would protect your hopes and dreams.

The other day I got an email in response to a posting for an apartment I have for rent. It was from a man named Derek Rice who had been hired by a local company called Layton Construction to do some engineering work on a project here in Salt Lake. He would be moving here for a year from the UK and needed a place for him and his wife to stay. He sent me some references and gave me a phone number in the UK.

I have met people that are working in this country for a company for a year or two. It often is an engineer. I thought, "Wow, the company basically would guarantee my rent payment!"

I don't have long distance so I started with the company he said he was working for. It was a legitimate construction company here in Salt Lake. Then I went to the reference he gave me. They worked for the company but were unavailable. I was a little excited because it seemed to check out. I also knew he would have steady income and be able to pay rent.

I replied to the email and asked some questions about him. He quickly responded answering most of my questions and asking for specific measurements of the apartment so that he could order furniture.

Something wasn't right though. In the email he said that he would be making $80,000/yr. and he wanted to rent my dinky two bedroom for $650. No pool, no gym, nothing. It just struck me as odd. If I was him I'd be staying in a big complex I could find online with all the amenities. It just seemed to good to be true.

So, I decided to do  some more research. I googled "Layton Construction Scam." Sure enough Layton Construction had an advisory on their page about the exact situation that this man was describing. It said that it was a scam which would soon ask for personal information from me.

The point is that if it sounds too good to be true it is.  However, people often get distracted by greed. When someone sees an opportunity that could pay off big they have a hard time saying no. If it sounds too good to be true it is. Don't believe you've found an exception. There is none. Anything that pays off big has equally large risk.

Friday, May 7, 2010

Risk Promotion

Previously I have discussed "Needs Based Planning." This post is a continuation of that discussion.

Whenever someone is setting a goal for retirement it will be estimation. Estimations are inherently inaccurate. The fact there are so many estimations involved in needs based planning is not a problem by itself. What makes it a problem is when people mistake the estimations for fact. As long as you remember that needs based planning is estimation you can use it as a tool to help you create a plan and a goal for retirement. However, one estimation used in needs based planning encourages risk, and can cause recklessness or complete failure. The reason this is because theoretically the higher Rate of Return someone chooses as their goal, the less they need to save. For example, if I give you the following three options in order to reach retirement which would you choose.

Option 1: Earn 8% ROR and save $400/month
Option 2: Earn 10% ROR and save $225/month
Option 3: Earn 12% ROR and save $120/month

When given the option of needing to save $400 or $120 per month, most people would choose to only have to save $120, because they think about all the other things they could do with that extra $280. They would rather have the gratification of spending their money now, and Option 3 says that they can. We already know that their ROR (rate of return) is likely not going to be a consistent 12%, but someone looking at this doesn’t know that, and the financial advisor giving them these options probably hasn’t thought enough about it. However, the planner does know that this is not a promise. A 12% annualized return is a goal. And only if they reach that goal will saving $120 per month get their client to their targeted retirement amount.
The only way that they attempt an annualized 12% return is by choosing riskier investments. In some cases you can get a greater return with less risk, but in this case higher returns imply greater risk and greater variation from the targeted return. There are plenty of scenarios that are far less risky and still fail. If shooting for 12% increases risk and variation, what do you think the success rate is? If I want to gamble, I go to Las Vegas, but when it comes to the financial future of me and my family, I don’t mess around. This would be unacceptable.