Bitcoin 101: The Revolution is Now

Bitcoin 101: The Revolution is Now

I get asked all the time about Bitcoin. Just in the last two weeks I have discussed Bitcoin with a 45 year old woman at my church, a portfolio manager, and a room full of accountants, lawyers, and financial advisors. If you are interested in Bitcoin, welcome to the revolution. I say revolution simply because the technology that makes Bitcoin possible is truly revolutionary, but before we get too deep into why that is, watch this short video explaining Bitcoin.

The reason that Bitcoin (and more specifically the blockchain) is revolutionary is that we now have the ability to exchange value with anyone in the world almost instantaneously without a centralized authority being in the middle of the exchange such as a government, a corporation, or other middle man.

Why is eliminating the middle man so valuable? To reduce the risk of a government destroying the country’s currency. Zimbabwe and Venezuela are the most recent examples of hyperinflation destroying the value of a country’s currency. Don’t be fooled by the size of those two nations – hyperinflation can hit the largest of nations. Germany, Greece, and China have each in the last one hundred years experienced hyperinflation. See this recent Business Insider story on hyperinflation for more examples. The takeaway here is that there are billions of people that would rather wipe their… nose with the government currency because said dollar bill wouldn’t buy them a single roll of toiler paper. Enter Bitcoin – a decentralized (i.e. no government middle man) digital currency that literally only requires an internet connection once to acquire and then it can be traded via a laptop or even via a piece of paper.

As a quick aside, in Zimbabwe there is a Bitcoin exchange, BitcoinFundi. I just pulled up the website and Bitcoin trades at a 50% premium to the rest of the world. Why? Because Zimbabweans want to trade their garbage currency for Bitcoin. If you want to see the price for yourself, click here to see BitcoinFundi’s latest price quote. At the time of writing this post, a BTC on Coinbase (U.S. Exchange) is around $4000. On BitcoinFundi, almost $7000.

Bitcoin has a fixed supply of 21M coins. These can be subdivided so it is possible to have 0.00000001 Bitcoin (BTC). The limited supply of Bitcoin is significant because previously creating digital scarcity was very difficult. I mean think about Napster and other peer to peer protocols that allowed us to essentially copy any song, movie, or other digital asset. Bitcoin can’t be copied due to the decentralized security provided by the network of nodes and miners. Suffice it to say that the Bitcoin network itself is extremely secure.

In short, Bitcoin is the first real use case that demonstrates the power of a blockchain and a decentralized network. This model is revolutionary. Think of the internet in the 1990s. I’m talking HUUUGGEEE.

 

National Beverage Corp. Superstar La Croix Fueling Growth

La Croix Owner National Beverage Corp. Bringing Healthy Beverages to America

If you’ve been reading EGS you’ll know that I recently posted on why I sold my shares of Coca Cola (Symbol: KO). Recently, I have been drinking lots of La Croix. I’ve noticed at backyard barbeques and other events that La Croix cans litter the premises. As a result, I decided to research the La Croix brand, which turns out to be owned by National Beverage Corp. (Symbol: FIZZ). The most recognizable FIZZ brand is La Croix. However, FIZZ has a number of other sparkling water and healthy beverage brands. This post will hopefully pique your interest and cause you to do some research of your own on FIZZ.

Sales and Income Growth Accelerating at FIZZ

Sales for the fiscal year ended April 29, 2017 were $826M. This was an increase of 17.4% over the prior fiscal year. The cost of sales was $500M resulting in a gross profit of $326M. The gross profit number reflected an increase of approximately 35.3% year over year. Jumping to the bottom line, net income for fiscal year 2017 was $107M, an increase of approximately 75% over the prior fiscal year. Fiscal year 2017 represents a huge jump in net income for FIZZ.

Historically, FIZZ has had net income between $43M and $49M (Fiscal Years 2013-2015). In 2016, FIZZ started to experience noticeable growth and 2017 has seen an acceleration of that growth trend. The cause of growth is likely due to a well-timed marketing campaign in 2015 targeting millennials as well as the continued macro trend of declining sugary soda consumption. Bottom line – this is a business that is experiencing rapid growth that started in fiscal year 2016 and has continued through fiscal year 2017.

With rapid growth, the primary concern is whether the FIZZ team is ready to handle the increased demand. With beverages, distribution is crucial. It remains to be seen whether FIZZ has the distribution infrastructure to accommodate continued rapid growth. One option would be to strike a deal with Coke or Pepsi to assist with distribution, but I see this as a problem that management should be able to deal with.

Potential for Exponential Growth

La Croix reminds me a bit of the growth in the energy drink market. Ten years ago I had my first Monster energy drink and my heart about pounded out of my chest. Thankfully I survived, but needless to say I’ve avoided the energy drinks since that day. I digress. Monster Beverage Company (Symbol: MNST) has a market cap of $31.39B dollars. FIZZ has a market cap of $5.78B so there is definitely opportunity for FIZZ to continue its growth.

At the utter extreme of the size comparison is Coke with a market cap of $191B. While I don’t think FIZZ has the potential to get as big as Coke, it certainly gives an outer limit to what one could expect. A reasonable expectation for FIZZ would be to become the dominant brand in the seltzer/water space similar to what Monster has become in the energy drink space.

Up, Up, and Away Goes the FIZZ Share Price

FIZZ currently trades at about 49 times prior earnings. This is slightly higher than MNST which trades at around 42x earnings. I would expect a slightly lower price to earnings ratio for MNST simply because it is about six times larger than FIZZ.

Year to date, FIZZ has increased 142.85%. Over that same time the SP-500 ETF, SPY, has increased 12.39%, KO has increased 8.56%, and MNST has increased 24.61%. FIZZ has outperformed all of the aforementioned by over 100 percentage points. Again, it is a relatively small company so one would expect slightly higher returns for the added risk, but this growth is huge!

A definite concern with FIZZ is the fact that it is heavily dependent on growth of the La Croix brand. Although the company does not break out sales of La Croix specifically, by most estimates La Croix accounts for 25%-40% of FIZZ sales. Regardless, if La Croix continues to grow by increasing sales in the U.S., and Canada, and is able to move into international markets, I think there’s more room for this stock to run.

Invest on!

I do not own any positions in FIZZ.

Time for Me to Sell Coca Cola (KO)

I sold Coca Cola (Symbol: KO) today for a few reasons.

  1. Consumption of Coke is declining.
  2. The stock has trailed the SP500 over the following periods: Prior month, Prior 3 months, 2017 year to date, and going back as far as June 2015. The underperformance will continue as the healthy food and beverage trend continues.
  3. Although Coke has and will continue to invest in healthier alternatives to Coke, it’s core business and brand is based on the sugary beverage we all know.
  4. There are more intriguing investment alternatives that will perform better over the next year, three years, and five years.

Invest on!

Are You a Financial Dreamer? Financial Goal Setting 101

It’s a dream until you write it down, then it’s a goal.

  • Emmitt Smith

Last night I was watching A Football Life. The show was profiling Emmitt Smith – the NFL’s all-time leading rusher. When he said the above words it hit me that I know tons of people who are financially dreaming. They think about what they’d do if they won the lottery. They imagine being debt free or paying for their child’s college tuition. They imagine having the money to quit their job tomorrow. Lots of people have ideas, lots of people have dreams, but not very many people pursue the three steps necessary to achieve their dreams and aspirations. So here you go – three steps to achieving your financial goals.

Step One – Dream Big!

I am not into all the touchy feely ethereal self-help nonsense, but I am a big believer in having big dreams. I mean your options are have no dreams, have dreams you believe are safe or achievable, or have dreams that, in your mind, are borderline insane. Now, if you have no dreams, boom you have accomplished your goal already… and you have gotten nowhere. If you have safe dreams, you might realize your dream and you will have grown some. If you dream huge, you are going to experience many awesome benefits. A dream is “huge” if it requires you to undergo significant transformation to achieve the dream. What type of transformation? You will become more focused, more disciplined, rooted in a mission, be operating with purpose, and the list goes on.

By having big dreams, you are going on a journey that will change you for the better. Why cut the journey short with safe or easy goals?

Step Two – Write It Down!

As Emmitt Smith said, write it down! Distill your dream to a definable goal, then stick it on a 3 X 5 card and put it on your bathroom mirror, hang it from your rearview mirror in your car, and stick it on the back of your laptop.

According to a study of Harvard graduate students, only 3 percent had written goals and plans to accomplish them, 13 percent had goals in their minds but hadn’t written them down, and 84 percent had no goals at all.

10 years later, the same group of Harvard graduate students were interviewed again and asked about their income. Here were the results:

  1. The 84% group with no goals at all earned half as much money as the 13% group with goals.
  2. The 3% group with written goals and plans on how to accomplish them earned ten times as much as the other 97% combined.

Let’s put some numbers behind these statistics. Assuming the group having no goals (84%) earned $75,000 per year, the group with goals in mind (the 13%) would have earned $150,000 per year, and the group that had written their goals and plans to accomplish them (the 3%) would have earned $825,000!!!

Step Three – Take Action!

Dream big – check. Write down your financial goals – check. Now, underneath each goal, I want you to write down at least three things you can do to move you one step closer to accomplishing that goal. Once you’ve done that, I want you go take action and complete one step. When you have completed a step, cross it off. After you’ve completed all your action steps, add more, and keep repeating until you’ve accomplished your goal.

My Goals

Since I’m walking this journey with you, I am going share a few of my goals.

Have a Net Worth (Assets – Liabilities) of a Million Dollars Before I am 40.

  1. Save 40% of my household gross income each year.
  2. Give 12% of my household gross income each year to my church and other ministries sharing the Gospel of Jesus with people and meeting their physical/temporal needs.
  3. Highlight at least one company’s stock every two weeks to keep me looking for great investments. If you are interested in investing, feel free to check out my portfolio.

Be a Father My Children Know, Love, and Respect.

  1. Take my oldest daughter to breakfast once a month.
  2. Take my younger daughter to ice cream once a month.
  3. Write my daughters love notes at least once a week.

Start Earning Income from a Business I Start.

  1. Take 15 minutes to write down every business idea I can think of.
  2. Take 15 minutes to order the list of ideas from best to worst.
  3. Take the top 5 ideas and sketch a simple cash flow/business model to make clear how the business will generate income.
  4. Depending on the business ideas, get one paying job, project, gig, or make one sale.

Go!

Five Pillars of Financial Freedom: What does IRA stand for?

 

Hey Freedomites! So I have to say, I am a fantasy football addict. I am just in that mood, hence the picture above. Thank you for indulging me – now let’s get to it.

Be honest did you think IRA was short for individual retirement account? If so you aren’t alone – it actually stands for individual retirement arrangement. Before we jump into IRAs, make sure to check out my prior posts in this series starting with the Intro. We have covered how avoiding bad debt, owning a home, and investing in your retirement plan at work are key to your pursuit of Financial Freedom. Alright, let’s do some IRA lifting and get pumped!

There are two types of IRAs – a Traditional IRA and a Roth IRA. But before we dive into the details, if you do not have an IRA and you want to open an IRA, it is simple. I have always used TD Ameritrade so I am biased. I am certain there are other wonderful online brokers, but I have had a great experience with TD Ameritrade. I will say that the commissions are around $5, which isn’t the cheapest option. However, I think it is worth it to be able to have access to TD Ameritrade’s trading platform, ThinkorSwim, as well as the educational materials on the site. Last, TD Ameritrade has always been much better for me around tax time than some discount brokers I have used. Oh, and that is not an affiliate link – I don’t get paid if you click on it.

So you are ready to open your IRA, now what? Glad you asked – you need to decide whether to open a Traditional or Roth IRA, or both. The Traditional IRA allows you to contribute money and receive a deduction (this is what is referred to as pre-tax money). In a previous post, I talked about the value of a deduction and commented that if you do not itemize your deductions, then the mortgage interest deduction is not actually reducing the taxes you pay. This IRA thing is a totally different animal. The deduction you receive for your contribution to the Traditional IRA is what is known as an “above the line” deduction. That means that the deduction reduces your total income. This means that regardless of whether you itemize your deductions or take the standard deduction you still get the benefit of the deduction for a contribution to your IRA because it reduces your total income.

Here is an quick and dirty tax lesson. Your income tax is calculated as follows:

Add all income to determine your TOTAL INCOME.

Take your total income and subtract off “above the line deductions” to determine your ADJUSTED GROSS INCOME.

Take your AGI and reduce by “below the line deductions” (i.e. standard deduction or itemized deductions – think mortgage interest) to reach your TAXABLE INCOME.

Taxable Income is then used to calculate the actual tax you should pay for the year.

As you can see, we love, love, love above the line deductions because they reduce your adjusted gross income dollar for dollar, which in turn can push you into a lower tax bracket and means you play less income tax.

Alright, so the Traditional IRA results in you receiving an above the line deduction in an amount equal to your contribution.  How much can you contribute you ask? In 2017, you can contribute a maximum of $5,500 to all of your IRAs. This can be split up between a Traditional and a Roth, but you cannot contribute more than $5,500 in total, unless of course you are a young spring chicken with at least 50 years in this League of Life. If that is you, go ahead and put $6,500 in your IRA. Please note that if you are covered by a retirement plan at work and earn more than $62,000 (single) or $99,000 (married), then your contribution may or may not be fully deductible. Check with your tax professional. If you are unsure, you can always contribute to the Roth IRA to be safe.

A Roth IRA does not generate a deduction for you, but when you withdraw the money from your Roth IRA at retirement age (at least 59.5), you do not pay any income tax on the money! Also, because you are not getting a deduction up-front, there is no issue with losing your deduction because your income is too high. However, keep in mind that if your income exceeds $186,000 (married) or $118,000 (single), then you may not be able to contribute the full $5,500 to your Roth IRA. Here is a handy chart to help understand the fundamental difference between the Roth and the Traditional.

Contribution Deductible? Withdrawals Taxed?
Traditional IRA Yes No
Roth IRA No Yes

So why are these accounts so important for building financial wealth? Because the money that you invest in stocks inside these accounts grows completely tax-free (Roth) or tax-deferred (Traditional).

Assume you bought 1 share of Apple stock today for $150.00. News comes out that the iPhone 8 is shattering sales records and tomorrow your 1 share is worth $300.00. That is a pretty amazing investment so you sell it and lock in your $150.00 profit. Unfortunately, since you did not own this stock in your IRA, you will have a short-term capital gain of $150.00. A short-term capital gain is a gain realized on the sale of a capital asset that you held for less than a year. A short-term capital gain is treated just like ordinary income you earn at work. Assuming you have no capital losses and you are in the 25% tax bracket, you would pay $37.50 to Uncle Sam ($150.00 gain * 25%) and be left with $262.50 to invest in the next hot tech company.

On the other hand, had you done the exact same thing in your IRA, you would pay zero, that’s right zero taxes on the $150.00 gain you realized when you sold that share of Apple stock. This leaves you with your full $300.00 to reinvest. Over time, this makes a huge difference.  To illustrate, if you invest $10,000, earn 12% per year, with a 20% turnover rate (ignore this if it confuses you), and are in the 28% tax bracket both on the day you invest the money as well as 35 years later, you will only have $218,130 if you invest in a taxable account. If you invested in a Roth or Traditional IRA (or other tax-deferred growth account like a 401k), you would have a whopping $527,800 – more than double!!! Go here for an academic article illustrating the math behind the above numbers … if you are an insomniac it will do wonders for you.

Big Picture

Each year you should do everything you can to put $5,500 into an IRA. The tax-free/deferred growth is infinitely better than a taxable account, all things being equal. If you need help opening an IRA or with any other financial matter, leave a comment with your email address and I will try to point you in the right direction.

Five Pillars of Financial Freedom: Free Money & Retirement Plans

 

Why, hello. Welcome. If you are just joining into the community here at EGS, please check out the first few posts in this series entitled, Five Pillars of Financial Freedom. Pillar One was focused on avoiding bad debt. Pillar Two was broken down into a three-part mini-series and focused on the value of owning your own home. We are on Pillar Three today. Pillar Three is all about motivating you to put money into your 401(k) style retirement plan at work.

When I wrote the title for this blog, I was envisioning a beer guy at Fenway Park walking up and down the stadium stairs on a sunny afternoon in August yelling, in that thick Boston accent, “Freeeee money here, get your free moneeyyyy here!” Wouldn’t that be nice. I mean a cold beer for $10.00 on a hot day is great, but if I have the option, I’ll take the $20 and you can keep the overpriced beverage Mr. Beer Guy. But seriously – what if there is a way to get free money? Would you take it? It turns out there is a way to get free money, and odds are, you wouldn’t take it! Read on and find out how to reach into that beer guy’s cooler and pull out a half a million dollars of free money.

There are a variety of employer sponsored retirement plans. There are far too many plans to cover each one in detail in this post, so I am going up 30,000 feet and looking down from drone-level…. ehhh drones – sore subject. Anyways, most retirement plans are either defined benefit plans or defined contribution plans. A defined benefit plan is what your parents might have referred to as a pension. Defined benefit plans are becoming less and less popular, especially in the private sector. For that reason, I am going to focus on defined contribution plans, which would include the 401(k) and 403(b).

Defined contribution plans permit an employee to defer money into an investment account without paying income tax on the money. With a typical 401(k), an employer is required to contribute money into the plan for the benefit of the employee.  To qualify for certain tax benefits,  the employer must contribute at least 3% of the employee’s pay into the 401(k) for the benefit of the employee. Many employers have what is commonly referred to as a matching plan. A matching plan requires the employer to match the employee’s contribution. Usually, the match is 100% of the first 3% of the employee’s pay. Some generous employer’s will match up to 6% of an employee’s contribution.

For example, if you earn $50,000 and participate in a matching style 401(k) where the employer matches 100% of your first 3% and 50% of the next 3% (a max employer contribution of 4.5% of your pay), then you’d be in for some nice benefits. If you deferred $0 into the plan, you would receive $0 from your employer. If you deferred $1,200 per year (i.e. $100 per month), you would be deferring 2.4% of your pay into the plan so your employer would match 100% of that ($1,200) because it is less than 3% of your pay. Not bad, right? That is a 2.4% increase in your annual pay just for filling out some forms.

However, if you want to reach into the beer guy’s cooler and pull out $2,250 of free money, here’s how. Defer 6% of your pay into the plan. 6% is $3,000 per year or $250 per month. Now don’t think of this as lost money – it is deferred. You are deferring income from the current you to the future you. Because you deferred 6%, your employer is going contribute 3% ($1,500) plus an additional 1.5% (remember 100% of the first 3% plus 50% of the next 3%). This additional 1.5% is equal to $750, which leaves you $2,250 wealthier. This is free money because you didn’t have to do any additional work to receive it.

Why am I writing about this? Because most people want more money. People look for jobs that pay more, search how to start a side hustle, and how to work from home and make six figures. Apparently, no one told them that their employer might just be giving money away for free on Tuesday in the lunch room.

In a recent article, Bloomberg cited a study which found that 79% of Americans work at a place that sponsors a 401(k) style plan. However, only 41% of the 79% are making contributions to the plan. This means that only 32% of Americans are making contributions. That is crazy! If you have a 401(k) style plan available to you, especially a matching style plan, you can’t afford not to get that employer match. I’m talking about getting you a 3% to 4.5% raise just by filling out a few forms and foregoing 3% to 6% of your pay. You have to be in the lunch room on Tuesday people!

You may be tempted to say you can’t afford to lose $250 per month. I will leave open the possibility that there are people who despite their best efforts to cut costs are unable to put any portion of their pay into their retirement plan. Having said that, in his book, Rich Dad Poor Dad: What the Rich Teach Their Kids About Money That the Poor and Middle Class Do Not!, the great Robert Kiyosaki says you should always pay yourself first. Also, keep in mind that retirement benefits are often protected from creditors depending upon the particular type of plan/account and applicable state law. With that principle in mind of paying yourself first, let’s look at the effect of paying yourself first.

If you deferred the minimum 3% of your pay to get the employer match each year and increased that amount by 2% per year (due to pay raises) you would start out receiving $1,500 of free money in Year 1 (see above for math on that). If your pay increased 2% each year, you’d be making $51,000 now instead of $50,000. If you then deferred 3% of that $51,000, your employer would contribute $1,530 in Year 2, which is effectively a 2% increase on the $1,500 you received for free in Year 1. The following chart illustrates how much free money you would have at age 65 assuming 10% annual growth, 2% increase in pay annually, with the variables being your starting age and the employer contribution (3% or 4.5%).

Starting Age Free Money at 65 on 3% Employer Contribution Free Money at 65 on 4.5% Employer Contribution
25  $                    847,571.00  $           1,271,356.00
30  $                    513,894.00  $               770,841.00
35  $                    307,874.00  $               461,811.00
40  $                    181,009.00  $               271,513.00
45  $                    103,193.00  $               154,790.00
50  $                      55,743.00  $                 83,614.00

As I write this, I am literally in shock. I keep checking the numbers. The question is, “how can you afford not to take this free money?” Seriously. We are talking the difference between $0 at retirement (68% of Americans) and over a million dollars of FREE MONEYYYY!!!! This is not the money you contributed. This is solely the money your employer contributed.

This chart illustrates the power of starting early, but it also illustrates that it’s never too late to start. Even at age 50, if you defer 3% each year of your pay, increase your deferrals by 2% per year, and earn 10% compounded over 15 years, then you are literally leaving over $50,000 in the beer cooler by not putting money into your retirement plan.  Take notice of the huge difference between the employee who only defers 3% and the employee who defers 6%. The difference is tens of thousand if not hundreds of thousands of dollars just for going that extra mile. Just do it! Victory!

People, the beer guy is literally walking around with a money tub shouting, “Freeeee money here, get your free moneeyyyy here!” Go ahead, reach in, and grab that free money! You won’t regret it.

If your employer does not currently offer an employer sponsored plan, you should consider asking them about setting one up. Alternatively, tune into the next post in this series because Pillar Four is focused on individual retirement accounts (IRAs). I got my start saving for retirement using an IRA.

Save on!

Five Pillars of Financial Freedom: Home Ownership – Part Tres

Today, will be our last installment in the mini-series on why home ownership is a pillar upon which you should build your financial future. If you missed Part One or Part Deux, those are required reading so hit the browser brakes and reverse on back to those other two posts.

  1. Borrow via Home Equity Line of Credit (HELOC)

Alright, so borrowing by opening a home equity line of credit is something I don’t typically advocate, but it can be beneficial in the right circumstances. So here are the basics on HELOCs. Typically, you have to own at least 20% of your home (i.e. have 20% home equity). A HELOC is secured by your home. You don’t pay, you lose home. The interest rates on a HELOC are much lower than a credit card. However, they are typically variable rate which means that if interest rates increase, then the interest you owe on the balance will increase, and thus, your monthly payment will increase. I did a quick search and saw HELOC rates around 5.5%. Again, these are variable so they can increase.

The ability to access your home equity via a HELOC is extremely helpful for a variety of financial samurai ninja moves. One, you can remodel your home by using your home equity. The interest you pay is deductible, and it is usually much lower than a credit card interest rate. Depending on your remodel, you may be able to create additional equity in your home by paying $15,000 to increase the value of the property by $20,000.

A second ninja move is to pay off high interest rate debt with the HELOC. This is relatively straight forward, move credit card balances to the HELOC so you pay 5.5% interest (deductible) instead of 15.5% (non-deductible). Granted, you may not want to do this if you plan not to pay the debt off, in which case you’d be putting your house at risk when you could just file bankruptcy and get the credit card debt discharged. That is called converting unsecured debt to secured debt. That is no bueno if you can’t or don’t intend to pay back the debt. That’ll have to get tackled in another post.

Third, again, not advocating this, but you could borrow to invest in assets that will appreciate more quickly than the HELOC interest rate. If you could take $50,000 and earn 10%, that’d be $5,000. You’d then pay capital gains tax of 20% so $1,000 to the tax man. In the meantime, the interest on the HELOC for the year might be 5.5% multiplied by $50,000, so $2,750. However, as we learned above, we would save taxes of $2,750 * 25% (tax rate) = $687.50. After all is said and done, we will have earned $5,000 and paid $3,062.50 leaving us $1,937.50 dollars richer! That’s not bad, but keep in mind it does come with investment/market risk (i.e. what if you don’t earn anything or worse you lose some of that $50k in the market). In short, I close with this, I am not advocating his, but it is an option.

Last, it is available for emergencies when you might need cash unexpectedly. You know, the Russian mobster calls your cell phone and says, “if you don’t pay $50,000 or boost 100 exotic cars in 24 hours your brother is dead.” I mean you just never know what might happen.

  1. Your Home is Protected from Creditors

This is something that you hopefully don’t know. Your home is protected from creditors. What that means is if you owe someone money, they typically can’t take your house to get paid. Now there are some exceptions to this. As we discussed early, if the someone you owe secured the loan with a deed to your house, then they can foreclose. But credit card companies, medical systems/hospitals, that jogger your dog bit causing him rabies and ultimately death, none of them can force a sale of your home to get paid. This is awesome because it means you will continue to have a place to rest easy after another of those panic attack inducing phone calls from a creditor.

Ok, so for the limitations on this protection. The protection is typically not unlimited. In Washington, your home equity is protected up to $125,000. This means if you have equity in your home in excess of say $125,000 and you owe someone $20,000, then they might try and force a sale of your home in order to get paid. If you only have $120,000 of equity, then that possibility is essentially non-existent. However, there are some states that protect 100% of your home equity, such as Arkansas, Florida, Iowa, Kansas, and Oklahoma. Even these states typically limit the size of your property that can be exempt (i.e. unlimited value but only up to ¼ acre in size). If you have a specific question on this, talk to your lawyer.

The key takeaway is that your hard earned equity is protected from future creditors. If you have existing creditors, talk to a lawyer.

Conclusion

In short, owning a home is a way to force yourself to save. Historically, a home beats inflation so that is a win. Moreover, you can borrow a significant portion of the money you need to buy the home. However, limit yourself to buying what you absolutely need and investing the difference in stock because the rates of return are much higher. In the meantime, know that your home is providing you social benefits, home equity you can access if you need to, and protection from creditors. At the end of 30 years, most renters have paid a lot of money to landlords and have no assets to show for it. For that reason alone, make it a primary goal to buy a house. If you need help with this, let me know because I will try to help in any way possible including connecting you with people who can help you more than myself.

Freedom!

 

Five Pillars of Financial Freedom: Home Ownership – Part Deux

If you missed Part One in the home ownership mini-series, stop. Go back. Read it. If you have completed the required reading, then we are going to soldier on to tax benefits of owning a home.

#3          Tax Benefits

Homeowners enjoy a number of tax benefits, including the mortgage interest deduction, the real property tax deduction, and the exemption from tax for capital gains realized on the sale of a qualified principal residence. There are a couple others I won’t discuss: mortgage insurance premiums can be deductible, as well as points purchased in connection with your home loan.

The mortgage interest deduction applies to interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan. You can deduct home mortgage interest if: (1) you itemize deductions; and the mortgage is a secured debt on a qualified home in which you have an ownership interest. Secured debt means if you don’t pay you lose your house. Thus, a mortgage is almost invariably secured debt because if you don’t make your payment the lender can take back possession of your home.

The real property tax deduction is exactly what it sounds like. You can deduct real property taxes you paid during the year to state and local governments. Real property tax is usually between 1% and 1.5% of the assessed value of your home. For reference, my property tax rate is 1.36%. You can check yours by simply dividing the real property tax paid during the year by the assessed value of your home for the same year, then multiply by 100 for the percentage.

Last, when you sell a capital asset, typically, you pay capital gains tax of between 0% and 20%. Not so fast Batman! A house is treated differently. When you sell a qualified principal residence, $250,000 of capital gains is exempt from capital gains tax. If you are married, double that to $500,000. This is huge because stock or other assets you are almost invariably going to pay capital gains tax upon realizing a capital gain.

At any time there are a number of tax breaks for homeowners. Talk with your real estate professional or lawyer if you have specific questions concerning your home or your taxes.

Quick Aside: Calculating Capital Gains

Capital gain is calculated by taking the amount you realized on the sale of your home (i.e. sale price) and subtracting your basis (i.e. the amount of money you paid for the home plus amounts paid for improvements). For example, if you buy your home for $250,000, do $50,000 of remodeling, and then sell it for $600,000, you would have a capital gain of $300,000. If you lived in the home for two out of the last five years, then the residence is considered your “principal” residence. If you are married, you owe no tax because you have a $500,000 exemption available. If you are single, then you would pay capital gains tax on $50,000 (i.e. the amount in excess of your exemption) resulting in actual tax owed of $10,000 (20% capital gains rate * $50,000 capital gain).

I Have a Few Deductions from Owning a Home, So What?

Let’s translate your deductions into real dollars saved. A key to this discussion is determining whether you itemize your deductions or take the standard deduction. The standard deduction is free to any taxpayer. You don’t even have to prove it. The IRS just gives it to you. In 2016, the standard deduction for single persons was $6,300. What about for married couples filing jointly? Daily double it for $12,600. So if you don’t have deductions that exceed $12,600, then the mortgage interest deduction is useless to you. So question #1, did you itemize your deductions last year?

Here is a list of deductions that I have each year (numbers are falsified go make you think I’m more charitable than I really am):

  1. Charitable gifts – $500
  2. Health Savings Account Contribution – $600
  3. Contribution to Traditional IRA – $1000
  4. Medical/Dental Expenses – $1000
  5. Real Property Taxes – $700
  6. State and Local Income/Sales Tax – $500
  7. Unreimbursed Job Expenses – $0

If these amounts total more than your standard deduction, then you should itemize your deductions. If they don’t, then the all of the individual deductions are not actually reducing your tax or increasing your refund.

If you itemize your deductions, beautiful! So what does a deduction translate into for you as far as tax savings? Easy – take the amount of the deduction and multiply by your highest tax rate. If you are in the 15% tax bracket, then a $5,000 deduction will result in you saving $750 of income tax. The formula is easy: Amount of Deduction * Your Highest Tax Rate = Cash Back in Your Vacation Fund.

Key takeaway on the deduction front: if you don’t itemize, then the deductions are not helping you one penny (doesn’t mean you shouldn’t pay, just keep in mind that the deduction isn’t why you are paying mortgage interest, saving in an HSA, paying dental bills, or paying your real estate taxes).

Nice work! You are 2/3rds of the way through the home ownership mini-series. Come back tomorrow for another filling of financial freedom from the fountain of finance!

Five Pillars of Financial Freedom: Home Ownership – Part One

“Owning a home is a keystone of wealth – both financial affluence and emotional security.” – Suze Orman

This is the third installment in our series entitled “Five Pillars for Financial Freedom.” If you missed Part One, check it out here, and if you missed Part Two on bad debt, make sure to check it out.  Next, I am going to explain, in this three-part mini-series, why home ownership is a pillar in the foundation of your financially free future. If you own a home, buckle up because you are about to learn why buying a home was a wise decision. If you do not own a home, this article will demonstrate why that should be at or near the top of your financial goals. The big idea is simple – a home is great investment because of its utility, social benefits, and financial benefits. If you analyze it solely from a financial perspective, there are much higher rates of return to be had than those found in real estate.

#1 – Leverage

Leverage is using borrowed money to buy an asset. It is an asset because you expect the profits from it to be greater than the interest you pay on the borrowed money. A simple example is the home mortgage. You borrow money and pay interest on that borrowed money. Currently, on a 30 year fixed loan you might pay 4% per year on the loan.

Why would you ever want to borrow money to buy a home if you have to pay 4% interest per year? Putting aside the social benefits and looking purely from a financial perspective, you would only borrow the money and pay the interest if you expect to be wealthier at the end.

Imagine you buy a $200,000 home. Assume you pay $20,000 when you buy the home, as a down payment. Your balance sheet would show an asset of $200,000. However, you would also have a liability of $309,365.11 ($180,000 (principal) + $129,365.11 (interest over 30 years)). On paper, you are actually $109,365.11 poorer after buying the house! So why do so many advocate buying a home? Because you can buy an asset that is likely to be worth more than $309,365.11 at the end of 30 years plus you will have received a multitude of other benefits.

According to the Case-Shiller Home Price Index, from 1928 to 2013, the rate of return on a home was 3.7%. We should then expect that at the end of 30 years, your $200,000 home will be worth just about $595,000 (1.037^30 * $200,000). Not a bad deal, plus your $400,000 capital gain will be tax-free if you are married (we’ll discuss this later). By making a $20,000 investment, you have forced yourself to save and received the benefit of some appreciation and are left with a $600,000 piece of real estate you could sell.

#2 Utility & Social Benefits

It almost goes without saying but you can put $20,000 into a purchase and you get the value of living in a $200,000 home. You get a roof over your head, and a place to sleep, shower, and study. The use of the home is the primary benefit in my opinion. You can own a dog or plant a garden. There are any number of benefits of owning a home that are primarily based upon your desired use of the home. The skeptic might argue that those benefits can be realized by renting too. This is only partially true because many landlords prohibit renters from certain activities such as owning a dog or cat.

In addition to the utility provided by owning a home, there are significant social benefits. Here is a list of statistics that demonstrate the positive social effects of owning a home versus renting:

  1. The decision to stay in school by teenage students is higher for those raised by home-owning parents compared to those in renter households.
  2. Daughters of homeowners have a much lower incidence of teenage pregnancy.
  3. Changing schools, which renters do more frequently than owners, negatively impacts children’s educational outcomes particularly for minorities and low income families.
  4. Parental homeownership in low-income neighborhoods has a positive impact on high school graduation.
  5. The average child of homeowners is significantly more likely to achieve a higher level of education and, thereby, a higher level of earnings.
  6. The children of homeowners with down payments are generally less likely to drop out of school than those of renters. However, those parents who buy homes without making a down payment have children who behave like children of renters, and thus those children are more likely to drop out than homeowners with down payments.

Yun, Lawrence, & Evangelou, Nadia. (2016). “Social Benefits of Home Ownership and Stable Housing.”

Now don’t freak out if you are a renter. One of the key questions with any statistic should be whether the independent variable (home ownership or renting) is causing the dependent variable (less teenage pregnancy) or the two are simply related. Another example might hypothetically be that Democrats have higher incomes than Republicans. The independent variable (D or R) is probably not causing higher income, the two are simply related for some other reason. So don’t go become a Democrat just to make more money, and don’t go buy a house to prevent your child from dropping out of school.

What I think is going on with these statistics is that home owners tend to move less frequently than renters. Thus, that lack of movement we could call stability. That stability in turn leads to deeper relationships, greater accountability and oversight, as well as other social benefits that may not surface until many years later (think about the guy who gets a job from a high school buddy or gains a new client because he was friends with the client in high school, that is much less likely for the military kid who never stayed in one place for more than three years).

Come back manana for part dos in this mini-series on the benefits of home ownership!

Compound Interest: a Modern Day Miracle

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.

– Albert Einstein

I am assuming you already know this, but compound interest is so fundamental, so crucial, so important, I have to cover it. Financial freedom is simply a product of: amount of money invested, rate of return, time, and inflation.

#1 – Invest Money

It goes without saying that you must invest money to become financially free. It isn’t saving money that makes you wealthy, it is investing money that will result in you being financially free. I recently heard a story of a guy who invested for 30 years and has millions. He now lives, essentially tax-free, by borrowing money (debt) and using his investment account as collateral for the borrowed money. Borrowed money is not included in your gross income for tax purposes. His other option would be selling shares of stock, paying capital gains, and keeping the difference. This is genius, and is the product of investing money for a long period of time. His only real expense is the interest expense of 2%-3% which is much lower than the capital gains rate of 20% and results in a deduction for his investment interest expense (against his net investment income, if any).

#2 – Rate of Return

Since 1945, the S&P 500 has returned about 11% per year. If you adjust for inflation, the after-inflation rate of return was about 7.1%. Obviously, the higher the better.

#3 – Time

The longer your investments can compound and grow, the more dollars you will have. Let’s run some numbers. Let’s assume you are going to invest $1,200 per year, and you will increase that each year by 4%. You will start at age 18. You will earn 11% per year and inflation will run at 2.5%.

How much will you have at age 65? $2.08 Million dollars!!! The total amount you would have invested of your own money would have been only $159,534. The other almost $2M was all investment gains. Now, there’s a pretty good chance you’ll lose some of that to taxes, but with good planning you can significantly reduce the impact of the taxes (see above re: borrowing against your portfolio).

Ok, let’s do the same exercise but assume you start at age 25 – just 7 years later. How much do you have at 65? $975,597 – a little disappointing to know that had you started 7 years sooner you’d be more than twice as rich.

The point is that time is essential to growing your wealth. The later you start the more you must save, and as we saw above, you must save a lot more if you start later. So get going!

#4 – Inflation & Taxes

Ok, so inflation is best illustrated by McDonald’s hamburgers. When I was a kid, on Wednesdays you could buy a hamburger for $0.29. Now, I am pretty sure a hamburger is more than $1.00. The point is that the cost of goods such as food, fuel, plane tickets, tuition, and sweaters tends to increase over time.

A measure of inflation is the consumer price index. Typically, financial advisors will factor inflation at 3%. However, since the great recession of late 2007 through early 2009, inflation has remained low. In fact, the inflation rate according to the Consumer Price Index over the last 12 months is only 1.6%.

High inflation reduces the number of Playstation games I can buy for $100. Negative inflation actually increases the number of Playstation games I can buy for $100.

With respect to taxes, suffice it to say that we want to minimize or eliminate taxes. Tax-free growth can be achieved through the use of IRAs, retirement plans, and health savings accounts. Minimizing taxes is essential to growing wealth. Stay tuned because I am going to cover IRAs, retirement plans, and health savings accounts in my series on the Five Pillars of Financial Freedom. If you haven’t been following that series, check out the intro and part one on avoiding bad debt.

Conclusion

I want you to start thinking when you go to buy things about the lost opportunity of not investing your money in something that will grow or create value. You might think, “it’s only $10.” However, $10 compounded at 11% per year for the next 30 years is really $228.00. Make it a $100 expense and we are talking about a few thousand dollars. Make it a little $2,000 vacation and we are talking almost $50,000!!! If you want to become wealthy, think about every dollar in light of what that dollar could turn into over a given period of time invested at a certain rate of return. Something I do to help me prioritize the future over the present is to mentally picture my daughters before I buy something. That helps me to say no to things I really don’t need in favor of saying yes to my daughters and their future financial needs (college, weddings, etc.)

Invest early and often!