The 2 Worst Financial Mistakes Everyone Makes

Finance is often considered a taboo topic in our culture; we don’t like to talk about it. Some people hire professional advice, and some people prefer to go the Do-It-Yourself route. The commonality between all of us, is we have all heard advice from a friend, a family member, a radio personality, or a tv personality. Here is a list of the top four worst pieces of advice almost ALL of my clients have heard or taken from these outside sources.

  1. Pay off your mortgage as fast as you can

The idea here is that you can finance your house on a 15 year mortgage, or you can make additional principal payments on longer term mortgage and save on interest. Sounds innocent enough, doesn’t it? I worked with a new client recently that told me their investment portfolio was earning an impressive 8% a year. In the same breath they proudly told me they had no debt because they paid cash for their house. I was dumbfounded they just admitted that they pulled a sizeable chunk of money out of a portfolio earning 8%, to pay cash for a house that they could have financed for 3.25-4.25% easily. They gave up use and control of that whole chunk of money and their house will appreciate OR depreciate regardless of how much they have paid off. What if they financed the house for 30 years, kept their money in their investment portfolio, and let the interest earned make their house payment for them with money to spare?

I don’t have the space in this article to explain the math, but it wouldn’t surprise me if they got 15 years down the road and could pay off the remaining balance of the mortgage if it made sense at the time. With interest rates on the rise, I believe it would be far more valuable to lock in the low interest rate mortgage for the longest period of time possible and keep their money working for them.

  1. Stuff as much money as you can into your 401k

We have all heard this one. You will be in a lower tax bracket in retirement! Save in your 401k, you get a tax deduction! Sounds great doesn’t it? The highest federal tax bracket estimated for 2017 is 39.6%. The federal income tax started in 1913 and the the average highest federal tax bracket since is 58.24%. Historically there have been spikes in income tax rates to help pay off debt accumulated during World War I, World War II, the Korean War, the Vietnam War, and the Gulf War. We have been paying for a war and the United States deficit is growing at an insane rate. With some of the lowest tax rates in history right now, do you think tax rates are going up, or down? My guess is they are going up. A 401k and other tax-deferred qualified plans are indeed a tax deduction right now, but what they do is POSTPONE the tax as well as the tax calculation. Whenever you take money from your 401k in retirement you will then owe income tax on the full amount taken.

If I were to write you a check for a loan you would ask me two questions: “what is the interest rate, and when do I have to pay it back?” What if I responded “you know what, I am doing quite well right now so let’s figure out the details later. One day I will have a need for my money. At that time I will figure out how much interest I need to charge you meet how much money I need”. Would you cash that check? I don’t think anyone would, but that is exactly the deal we make when we save on a tax-deferred basis. Now saving in a 401k isn’t bad for everyone, but for the average American it makes more sense to pay the tax now and save on a tax-free basis for the future!

These mistakes can cost you in retirement. Unfortunately though, I can only write based on my experience and not based on your individual situation. My best recommendation for 2017 is to hire a trustworthy Registered Investment Adviser who is required by law to act in a client’s best interest. Get an unbiased analysis on these two topics and check out the math to see if there is a more efficient way to handle your finances.

All About That Opportunity Cost

What is opportunity cost? I get asked this all the time. Just kidding, nobody asks me this. But here is why you need to know what it is: opportunity cost directly impacts every aspect of YOUR finances. In your personal economy, lost opportunity cost is everywhere.

Opportunity cost is defined as “the loss of potential gain from other alternatives when one alternative is chosen”. I break it down like this: opportunity cost is the potential future value of a spent dollar. If you buy a $25,000 car, that car didn’t just cost you $25,000. The lost opportunity cost is what that $25,000 could have earned if you had kept it and put it to work for you over a specified period.

It is very important to consider opportunity cost with big items. Many people look at the monthly payment of financing that car and don’t consider what else they are giving up having that car. Let’s say I bought that $25,000 car today and my hypothetical investment portfolio is earning just 5%. I reasonably have 40 years until retirement. The lost opportunity cost on that purchase would be the $25,000, plus the cost to finance it (let’s say $1,953 total of interest for a 5 year loan at 3%), plus the interest I could have earned, compounded each year for 40 years. That purchase would set me back $171,378 by the time I reach retirement.

What about multiple purchases? What if you bought a $4 fancy large iced green tea latte with no sweetener, extra matcha, two scoops of protein powder, light ice, shaken-not-stirred, every work day? That would be $20 a week, $85 a month, and $1,020 a year. That doesn’t seem harmful considering you are receiving value from enjoying the beverages. What does it look like over 40 years though? You will have spent $40,800 on delectable beverages and the lost opportunity cost on that chunk of change would be $88,577 for a total cost of $129,377! I personally don’t enjoy fancy drinks THAT much.

Keep in mind that my two examples above only assume a 5% rate of return. The higher the return you can earn, the larger the lost opportunity cost becomes. It isn’t realistic, nor would I ever recommend, that you stop enjoying your own transportation or fancy beverages. It is possible to have healthy finances and a secure retirement while still enjoying the journey to get there. I simply want you to recognize that your personal economy isn’t just effected by the cost to purchase, you have to consider the lost opportunity cost in addition!

The 3 Ways to Spend Your Tax Refund

Good morning, afternoon, or evening as the case may be! This months topic is tax related. What do you do with your tax refund?

First let’s talk about what a refund is just to set some perspective. Everyone I talk to gets so excited that they have a huge refund coming their way. Huge is relative by the way. Maybe the refund is $500, maybe it is $5,000, or maybe it is $10,000. The average refund is about $3,000. Many people receive this check in the mail and view it as free money fallen from heaven delivered from the mail gods. Let me just remind you that tax refunds are money the IRS is returning to you that you pre-paid, in excess, throughout the year. In other words, the federal government got to use your money throughout the year above and beyond what was due to them, and now they are giving it back to you. That is the mentality to look at your tax return with.

Now that we got that out of the way, what do we do with it? Here are some ideas:
1. Vacation – This is a very common option and I put it first because, let’s be real, this is the most fun. Tax refunds do go far towards a well-deserved vacation. Check out discount sites like Groupon and their air-inclusive travel deals. There are REAL discounts on flight/all-inclusive hotel packages. I personally want to book that trip to Paris and Spain for $799 in November.
2. Donate it – If you are anticipating higher income in 2017 vs. what you earned in 2016, consider donating it to a nonprofit organization for a tax write off when you file taxes in 2018. Plus it feels good to support worthy causes you care about. (insert shameless plug for Sierra Passport Rotary here)
3. Pay off high interest debt – Did you read the article in January? Please don’t pay down your mortgage with your tax refund… Do consider paying down high interest debt like maybe a credit card or a car loan. Start with the highest interest rate debt, not necessarily the smallest balance owed.

In closing, let’s talk about how to maximize your deduction next year. And by maximize, I of course mean minimize! Rather than setting yourself up to have a massive refund each year, consider working through (or hiring a tax professional) to calculate your right offs and adjust your withholdings on your W2 so that you have more cash flow all year long! My goal is to always have the smallest refund possible. I don’t know about you, but I like my money, and I like it working for me all year long rather than lending it to the federal government for free all year.

Ideal Account Characteristics

When you are thinking on and planning out your finances, it is really important to understand characteristics you favor before you fund financial vehicles. Many people take into account risk, rate of return, or time period.

When I look places to park money, these are the top account characteristics I look for, and can help you find:

Ideal Account Characteristics

 

Tax deferred growth means you aren’t paying tax while the money is just sitting there.

Tax free distributions means you don’t have to pay tax when you are withdrawing the money.

A competitive return is important to outpace inflation.

High contribution limits are an absolute must. Sometimes it isn’t enough to max fund a 401(k) that has a cap on it.

Deductible contributions could be advantageous.

Collateral opportunities are very important. This puts you in a position where you don’t need to withdraw money and interrupt compounding interest, but can still leverage your money.

A safe harbor with no loss provisions and guarantees are very important for people with low to moderate risk tolerances.

A guarantee loan option can be very important when capital is needed quickly. Think about trying to take a loan against the equity in your home and the long process that requires certain qualification. Having immediate guaranteed access can be a life saver.

In case the loan option is utilized, an unstructured loan eases cash flow pressure. Payments when you can make payments, paying any amount you like, not having the loan reported to crediting agencies. This is especially valuable to small business owners.

Liquidity, use, and control of the money. This is another absolute must. The ability to access, use, and maintain control of the money at any given time.

Any additional benefits you look for when you are comparing financial vehicles?