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!

Five Pillars of Financial Freedom: Break Free by Blasting Bad Debt!

“The rich rules over the poor, and the borrower becomes the lender’s slave.” – Proverbs 22:7

One of the reasons I write this blog is to help you understand the potentially negative long-term effects of poor financial decisions so you live a better more peaceful life. The quote above affirms reality. Are you spending more than 40% of your life working just to realize at the end of each and every month you have nothing left to save? If so, you are not alone.  You are literally slaving away to pay the lender – typically, a bank and the shareholders. Keep reading if you want to move from slave to lender.

But before we jump into bad debt discussions, if you are just joining us, we are diving into a series entitled Five Pillars of Financial Freedom. If you missed it, check out the introduction to the series. Alright, let’s jump into a discussion on bad debt.

“… 50% of people are woefully unprepared for a financial emergency, new research finds. Nearly 1 in 5 (19%) Americans have nothing set aside to cover an unexpected emergency, while nearly 1 in 3 (31%) Americans don’t have at least $500 set aside to cover an unexpected emergency expense.”

 

The above statistics cited in a Marketwatch story show that a large portion of Americans work a significant portion of their lives and have nothing saved to cover an emergency expense. This is a serious problem. Why? Because unexpected expenses are exactly what cause people to take on bad debt.

You know that sinking feeling when you receive the emergency room bill, the quote to fix the car, or you need to pull together the first month and last month’s rent to move to a new home. If you don’t have $500 set aside for emergencies, then how in the world are you going to pay to fix your car? You absolutely need to do everything you can to save some portion of your paycheck each month. That is step one to avoiding bad debt. There is a reason personal finance talking heads so strongly advocate for an emergency fund of three to six months of your income. Your first step towards becoming extremely wealthy is extremely unsexy – save $500 and never for the rest of your life touch it unless you have an emergency and have no other money to pay for said emergency.

Why is this $500 thing so important? Because if you don’t have the cash, then you borrow and become a slave to the lender. If the lender happens to be a credit card company and you can only make the minimum payment on the $500 charge, let’s take a look at the consequences. Assuming the rate is 18% per year and the minimum payment is all interest plus 1% of the balance, then you would pay $198.71 in interest over the course of 47 months. 4 years!!!

If it isn’t bad enough that you are paying almost 40% more than your initial cost of $500, you are also forfeiting the investment returns you could have achieved by putting $15 per month for 47 months into an investment. By using the credit card, you paid $700 and were left with zero in the ol’ piggy bank. By not using the credit card, you paid $500 up front, but then you put $858 ($15/mo. for 47 months compounding at 10% per year) in Ms. Piggy’s purse. That is a huge difference at the end of 4 years – $0 or $858.

Credit cards are bad debt – if you don’t pay them off each month stick them all in your toaster.

So what is bad debt? Glad you asked. Bad debt is any debt that prevents you from growing your assets. For example, a mortgage is not bad debt because it permits you to grow your assets from the amount of your down payment to eventually the fair market value of your home once you own it outright. A credit card payment is bad debt because, as we saw above, it leaves you poorer after having paid it off.

A car payment can be bad debt, but it might not be. If you can get a car loan at 2.9% annual percentage rate, then that is a good financial choice. Why? Because you could trade $10,000 for the car, or you could borrow the money and invest the $10,000. If you invest the $10,000 and make 6% after taxes, then at the end of a 7 year period (which is the period over which you will pay the auto loan off), you would have $15,036. On the other hand, borrowing the money and paying off the car over 7 years, you would pay $11,061.35. By simply borrowing the money, after 7 years, you are about $4,000 wealthier than had you just paid cash up front. That’s huge!

In conclusion, stay the heck out of high interest debt situations. Anything that is greater than 10% you should avoid. Shoot, if you are going to borrow money at 10% or 15%, come see me first. But seriously, avoid high debt like the plague because there aren’t many things that will ruin your ability to become financially free like bad debt. When determining whether to borrow money, ask yourself, “when I’ve paid this debt off, will I have an asset that has the potential to increase in value?” If the answer is yes, then borrow away. If the answer is no, then strongly consider not borrowing unless it is for a necessity and you can get a rate lower than what you could earn in the stock market (see car example above).

Stay tuned because in the next part of our series I am going to explain why owning a home is a road to riches.

Feel free to contact me on Twitter @jordanurness.

 

Five Pillars of Financial Freedom: Intro

Five Pillars of Financial Freedom

“Someone is sitting in the shade today because someone planted a tree a long time ago.” – Warren Buffett

I have two daughters. In fact, as I type this they are both not in their beds where I left them around 8:45 p.m. They are quite cute. One is wearing doughnut pattern pajamas. The other is wearing her blue t-shirt she received from participating in Bloomsday – a local 7+ mile run (she cheated and rode in a stroller the entire way!). In any event, I mention this because my kids are huge part of why I want to be financially free. I submit that it is an absolute necessity for you to clearly and concretely answer this question, “why do I want to be financially free?” If you fail to do this, you will regularly sacrifice your future freedom for the pleasure of the present.

Take some time and answer “why.” Is it so that you experience a less stressful life? Is it so you have more time to spend with your family? Maybe you want to devote time to solving some of the biggest problems our world faces: poverty, malnutrition, or child trafficking. The point is that each of us must have a clear vision of why we want to be financially free before we can realistically expect to achieve financial freedom.

Once you’ve determined why you want to go after financial freedom, we need to define what “financial freedom” constitutes. Obviously, there is a diversity of definitions for financial freedom. Most of us think the lack of financial freedom is represented by having to go to work each day to pay our expenses. If you do not have to go to work and you can pay your annual expenses, then that constitutes financial freedom in my mind. As a result, I define financial freedom as having annual income, excluding wages, greater than annual expenses.

Ok, so you’ve determined your “why” and your definition of financial freedom. Now, how do you achieve financial freedom? Great question – which I am going to answer over the course of a five-part series. In part one I will cover why avoiding bad debt is extremely important. In part two I will explain why home ownership is crucial to building wealth. Part three will address employer provided retirement plans such as a 401k or 403b. In part four, I will cover both the Roth individual retirement account and the Traditional IRA. In part five, I will explain why a health savings account might be the single greatest retirement tool you are not currently using.

In short, if you stay out of debt, own your home, contribute to your 401k, IRA, and HSA, then you are a saving superhero, and you probably don’t need to read this guide. For the rest of the mere mortals in the room, this guide will explain to you with concrete numbers how you too can achieve financial freedom.

If You Give a Mouse a Cookie: Teachings on Money

As a kid, I was introduced to the book, “If You Give a Mouse a Cookie.” I love the book because of its application to personal finance and money. If your memory is a bit foggy or you have never heard of the book, the main character is a mouse who asks for a cookie from a boy. Of course, the boy gives the mouse the cookie. What does every cookie monster need? A glass of milk. So the mouse asks for a glass of milk. However, he is just a mouse, so how is he going to drink a big glass of milk if he has no straw. You get the point. A simple request for a cookie leads to the mouse hanging a drawing on the refrigerator which makes him thirsty and… he asks for another glass of milk. Repeat cycle. If you have never read the book, or would like to read it to your kids before bed, click the link above to purchase a copy from Amazon.

So what does the book illustrate and how does it relate to finance? Simple. The book illustrates how obtaining one thing inevitably leads to wanting or needing something related. Think in  your own life how often this occurs. You purchase a cellphone. What do you immediately want to do – protect your purchase. So you buy phone insurance, a case, and a glass screen protector. Once you have protected your investment you want to maximize your phone’s features so you buy a 128GB micro sd card to store all your photos, 4k videos, apps, movies, books, and music. Once you have high quality photos, what do you want to do? You want to make photo albums to give to the grandparents, and on the cycle goes.

When I am considering buying something, I always try to think to myself how many add-on products or services this one purchase will require before I am able to enjoy the original purchase. This thought exercise helps me realize the true cost of the product, which is always more than the number on the price tag.

To illustrate this cookie concept, I recently bought a new LG 55″ OLED TV. I bought it on eBay. I’ll admit that even I was a bit surprised when it showed up in its original packaging as opposed to having been poorly repackaged by some shlub in New Jersey who sold it to me on eBay. That isn’t the point though. Once I unboxed the beautiful, 4k Ultra High Definition (UHD), High Dynamic Range (HDR) TV and turned it on, I immediately realized I was missing something – an UHD HDR Blu Ray player was needed to display the beautiful picture to my now somewhat skeptical wife. So I went down to Best Buy and looked for the least expensive HDR Blu Ray player.  To my surprise, most of them were around $200. When I asked the Best Buy employee what I should get he said, an Xbox One S because it plays HDR Blu Rays and on top of that you can play video games. Two is better than one, am I right?

Well that Xbox One S set me back about $250. Once I had the Xbox One S, then I of course had to have a second controller “just in case” someone might want to play some video games with me. That set me back another $45. Once you have a white box that can play video games, you need games so I bought Tom Clancy’s  Rainbow Six Siege, which set me back another $45. Oh, and did I mention that to play this game online with your friends you need a couple more things: (1) a headset – $20; and (2) an Xbox Live Gold blah blah blah subscription to play the game over the internet – $40/year.  I finally get out of Best Buy about $450 poorer than when I entered, but I’m excited to get home and unwrap everything.

I now have an Xbox One S to play movies and games – check. I have a TV to display beautiful, 4k, HDR content – check. Then it hits me, I have no HDR movies! Ugh, so I head back to Best Buy. Luckily, I find a few movies on sale and only spent $50.

Are you catching the point? My initial purchase of a TV led me to somewhat logically spend another $500 beyond what I had anticipated or planned on spending. The big idea is before you buy something think of the additional products and services you will want or need to buy to use and enjoy the initial product you purchased. Then ask yourself if there is something else you would rather spend that money. Great examples of these so-called money pits are boats, pools, and cars.

Alright, so before your next seemingly small purchase, count the true cost, and then enjoy that cookie knowing it will lead to a glass of milk.

 

Social Insecurity – Maximizing Your Benefit

My parents are great. My mom is a young 64 years old and is in great shape. My dad is 59, and has worked his entire adult life (and most of his childhood too – the 60s were different times I’m told).  In any event, growing up my mom stayed home with me and my two siblings while my dad worked. I help them from time to time with their money questions. The most recent discussion we have been having is around when they should claim their Social Security benefits.

The issue of when to claim Social Security benefits is a complex issue with literally thousands of different possible outcomes. However, the following factors are the keys to selecting the optimal strategy for claiming Social Security benefits. I am not addressing unmarried individuals, but know that there are Social Security benefits that exist for individuals, widows, children, ex-spouses, dependent adult children, and the list goes on. Please consult your financial advisor. The following information is general information only and is based on my parents’ situation. Ok – in no particular order, here are the factors.

Factor #1 – Relative Expected Benefit at Full Retirement Age for Husband and Wife

The first factor I considered with my parents’ situation is their relative expected benefit. My mom does not have a lengthy earnings record, her expected benefit at full retirement age is about $870. On the other hand, my dad has a lengthy earnings record, and he continues to earn because he is currently employed. His expected benefit at full retirement age is $3750. Unless you were alive to see the fall of the Third Reich, then your full retirement age is likely age 66 (unless you were born in 1955 or later, in which case your FRA will be between 66 and 67). Go here to determine your FRA – Social Security FRA Chart.

The key mathematical relationship is the difference between the benefits to be received. For my parents, that difference is $2880 per month.

Factor #2 – Relative Age and Life Expectancy of Husband and Wife

The second factor I considered in my parents’ situation is their difference in age and life expectancy. My mom at age 64 is about 5 years older than my dad who is 59. In addition, my mom’s mother just turned 90, and is in relatively decent health. On the other hand, both my dad’s parents passed away before turning age 75. As a result, my dad is convinced that my mom is going to outlive him and probably live into her 90s. Although nobody knows the future, I think he is probably right that my mom will live well into her 80s or 90s.

Factor #3 – Can You Wait?

For each year you wait to claim your Social Security benefit, you will receive a delayed retirement credit. A delayed retirement credit simply means your benefit gets increased by a set percentage in recognition of the fact that you have waited to receive your benefit beyond your full retirement age. For most that increase is 8% per year after FRA until age 70. Click here for more information on delayed retirement credits. My recommendation to my dad was to wait to claim his benefit until turning age 70 thereby allowing his benefit to grow by 8% per year for 4 years. By waiting, his benefit will be 126.67%  of his FRA benefit ($3570). You are probably asking yourself, why is his benefit not 132% (i.e. 8% * 4 years). It is because his FRA is actually 66 and 8 months. Thus, his 8% delayed retirement credit applies for 40 months resulting in an increase to 126.67% (8% * 3.5). Here is a Social Security calculator to determine how much your benefit will increase by waiting or how much your benefit will decrease by claiming early.

This increase in benefit is valuable to the extent you will live longer than expected. For example, in isolation, if my dad waited to age 70 but then died at 71, he would have been better off claiming as soon as possible. However, in his case, the reason waiting is so important is because of the spousal and survivor benefit.

Factor #4 – Spousal Benefit

The spousal benefit can be claimed by the spouse of the non-worker. So when my dad files at age 70, my mom will also file for an increased benefit called the spousal benefit. She is entitled to receive the greater of her own benefit or 50% of my dad’s FRA benefit. Importantly, she does not receive 50% of his benefit including the 8% annual increases. She receives 50% of his FRA benefit. In my mom’s case, this is still significantly more than her own benefit of $870.

In short, my mom is going to claim on or before reaching FRA to get income started. Once my dad hits age 70, then she will receive the spousal benefit and jump from $870 per month to $1585 per month. At that time, my dad will receive his increased benefit of $4522 for total benefits of $6107 per month while both are living.

Factor #5 – Survivor Benefit

As mentioned above, my dad is most worried that my mom will outlive him and not have enough money to support herself. If he happens to outlive her, I am not that worried because he is as frugal as they come – not in a bad way, but that’s just who he is. He could live on very little if he had to. Now if his assumption proves correct and he dies prior to my mom, then my mom will begin receiving the Social Security survivor benefit. The surviving spouse is entitled to receive the deceased spouse’s benefit, in an amount equal to what the deceased spouse was receiving. This means that if the deceased spouse received delayed retirement credits, then the surviving spouse will receive the benefit of those credits. Similarly, if the deceased spouse claimed early and received a reduced benefit, then the surviving spouse is stuck with that reduced benefit (or his or her own benefit if that is greater than the survivor benefit).

The confluence of my mom having a relatively low monthly benefit, a long life expectancy, and my dad having a high benefit all led me to conclude that everything should be done to ensure he waits to age 70 to receive his benefit. This will result in my mom having the absolute highest benefit possible after he has passed, which gives him peace of mind.

Conclusion – Optimizing the Outcome

Full retirement age, delayed retirement credits, spousal benefits, and survivor benefits. If this all sounds complex, it is. To determine the optimal claiming strategy for my parents, I used Bedrock Capital’s social security optimizer called SSAnalyze!.  Please consider consulting a financial professional because claiming social security represents a lifetime of working hard to contribute money into the system, and you want to ensure you have all the information before making your decision on when to claim. This is simply the analysis I went through to help my parents out.

On a semi-related note, keep in mind that you still need to sign up for Medicare by age or within 7 months of turning age 65. If you have begun receiving Social Security at that time, then you are automatically enrolled.

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The Opposite of Saving Money – Losing It Quickly!

So here is a video I took right after I crashed my new DJI Mavic Pro drone into the Atlantic Ocean. The crash resulted from an unexpected drastic increase in headwinds which caused the battery on the drone to drain rapidly. Here is the actual crash footage.

Brutal! I should have considered many more factors before undertaking a huge flight such as a 4 mile flight out to sea and back. In some ways, there is a financial metaphor here. If you risk all you have with no margin of safety or “outs” as a poker player would say – then you may experience a total loss. I could have structured my flight to have a number of “outs” such as flying along the shoreline, flying when there was zero wind, fly against the wind on the way out and with the wind on the way back, or simply flown inland. Although straight out to sea seemed to give me the best chance of maintaining radio signal (no interruption from buildings etc.), ultimately, I took a huge risk by going that route. In hindsight, I would have much rather risked losing the radio signal at 2 or 3 miles and still had the drone be able to return home or land somewhere short of home on terra firma.

Like many things in life, lesson learned. Albeit a $990 lesson, which hurts. Nevertheless, my takeaways are plan, anticipate potential risks to your plan, and then decide which risks can be mitigated and which you are willing to assume. This will leave you in a position of having better outcomes, and in the event you have a bad outcome, at least you know it was a risk you willingly assumed knowing the potential consequences.

In our financial lives, it is important to take risk in order to generate investment returns. However, think long and hard before investing in something that may sink to the bottom of the ocean before you can get out of the investment.