A tale of two 401K funds

401K Fund #1

wealthA long time ago, I shifted the money that was going into my old 401K into an EIUL. This vehicle is geared to survive negative downturns and hence, only go up. In a sense, I think of my EIUL as my new 401K. Again, it doesn’t participate in market down swings, which has huge advanages. It also has better odds at beating the earning average of mutual funds.

401K Fund #2

house_cashBut that is not all. I travel with my family periodically to Florida, specifically to the Orlando area. My wife works for Disney, and we take their kids there 2-4 times every year. Spending money on hotels would have been outrageous. My wife heard from someone a few years ago cheap condos were. We finally bought one back in 2011 after I figured out that my bonus check that comes every six months could fund the entire thing, mortgage, utitilies, and all. Perhaps you’ve heard of the 401K condo?

On one hand, we have enjoyed every moment spent there. It’s great. Fully furnished. Appliances, bedrooms. I even have WiFi. The memories we have built are the best and only getting better. But that is not all. We bought it on short sale. Since then, the housing market has recovered and it’s estimated value has doubled. By paying it off slowly but surely, we are building equity. In the future, if need be, I can always refinance, invest the money into discounted notes, and pay off the loan. It’s another powerful real estate asset that offers more options.

“The investor with the most options wins.” –Jeff Brown

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Are you saving enough?

Financial speaking, the money that goes into both of these avenues is coming from my company salary. The total dollars is about 20% of my take home pay, which is not bad.

I’ve spoken before of this terrible investment exercise where people suggest you skip your daily $5 mocha and instead put that money into a mutual fund. According to those selling mutual funds, if you saved like that for 40 years, and 11% year after year, you would accumulate $1MM.

Except that in 30 years, $1MM won’t cut it. Assuming a 4% inflation, that dollar figure would be roughly equial to $208,000 in today’s dollars. Drawing 4% yield from that (as recommended by these same people) will grant you $8,320 Surrender 20% to Uncle Sam, and you’re left with $6700. We’re talking $560/month. What?!? So does skipping that daily mocha really turn into the cash generating machine you think it does? And do you really think you can earn 11% every year for 40 years, when Dalbar reports that people buying mutual funds can’t even average 4%?

That is pretty bad. If we are to turn things around, imagine that today we had $1MM.  How much would we need to start saving if we started 40 years ago? Doh! $5/day! So, set the wayback machine to 1975 and start chugging away. What is $5/day? About $1800/yaer. In 1975, median household income was about $11,800. This means that to save over $1800/year would translate to save almost 17% of gross income. Assume that 20% of that household income goes to the government and the savings rate against media take home pay would almost 20%.

So according to this, I’m on track to earning something the equivalent of $1MM in today’s dollars. My odds are much better because it isn’t based on earning 11% in mutual funds. And it isn’t based on having 40 years to save. Very few people start saving relentlessly when their 25. Instead, it happens in people’s late 30s/early 40s. They start to realize that their savings plan isn’t getting anywhere. So shift that 20-25 years of good solid savings.

Isn’t it time to switch to something that works with the odds rather than against them?

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Building wealth isn’t free

habit-saving-moneyAll too common, I see people obsessing about fees at the wrong phases of building wealth. There are countless websites and forums where people discuss low cost index funds. The problem is, they haven’t calculated the Big fee that will hit them at retirement: taxes.

Standard IRAs and 401(K)s are designed to get you to sock away money tax free today, only to turn around and pay income level taxes at retirement. And to top it off, Uncle Sam demonstrates his hunger for that tax revenue by forcing you to start cannibalizing your savings at the age of 70 1/2. If you save up a big pile of money in something that pays a handy dividend, you can’t keep it forever. You will be forced to start taking minimum withdrawals.

To illustrate, I tracked down an online early withdrawal calculator. I plugged in $1,000,000 balance, and it told me that the age of 70 1/2, the minimum withdrawal amount was just shy of $36,500. To frame this in lingo that financial consultants use, we are all told to withdraw no more than 4% per year in retirement. 4% of that balance would be $40,000.

A subtle but little discussed point in all this is the “no more than” piece of that advice. The idea is that our retirement fund is expected to grow by more than 4%. Hence, ONLY withdrawing 4% should let our principle grow. But if we only have a 3% growth, we should ONLY withdraw 3% and hence NOT tap into the principle.

If we have a losing year, we shouldn’t draw anything at all. The hope is that our retirement funds would throw off dividends to fund ourselves. Anything else, and we are cutting into the principle and forever reducing future earnings and available cash. But these minimum withdrawals don’t grant us the ability to scale back to 3% or even skip a year of withdrawals. Instead, we are forced to cut into that principle so the government can get their piece of revenue.

It’s okay to pay taxes

TaxesIf there is any kind of lesson, it’s that taxes must be paid. The only question is when. People obsess over paying taxes today. They would rather push them off and score all the tax deductions possible. But that might not be the most efficient strategy nor the most stable one for your retirement.

The truth is, it’s better to pay the taxes now. That way, in retirement, there is no need to ship off a chunk of your retirement wealth to the government at who knows what tax rate. And if you use Roth IRAs instead of standard ones, there are no required minimum withdrawals! If there is any hint of what the IRS prefers, just checkout the fact that people making over $191,000/year can NOT contribute to a Roth IRA.

There is an old adage: would you rather pay taxes on a bag of seed or on the harvested crop? In true mathematics, if the rate at both times is identical, then you would pay the same taxes on either side. But that is rarely the case. And who knows what the tax rates will be 30 years from now?

Don’t forget about management fees

panic_buttonI’ve talked about fees many times. One really surprising article was about a couple that held dozens of mutual funds and never consolidated. They actually had a big chunk of cash. The effect was disastrous!

The couple in that linked article were paying a financial advisor 2.5% annually. Sounds small, except that they had saved up $1.3 million. Annual fees exceeded $32,000! Imagine paying $32,000 each and every year of your retirement.

The actual plan they were pursuing was to consolidates into half a dozen funds, and reduce annual costs to 1%. That is terrible! Cutting down to $13,000 in annual fees is terrible. The irony is that if they looked at the top ten stocks in each fund, they might find a lot of well recognized companies: Coca-Cola, Walmart, Apple, General Mills, Pepsi, Dr. Pepper-Snapple Group.

If they simply sold everything and bought $130,000 of each of the top 10 stocks, their annual fees would drop to nothing. There would be a one time cost of selling the funds and buying the positions, but after that, no management fees. And then they could drop the financial advisor! To top things off, they would probably rack up better dividends, dividend growth (like getting a raise in retirement), and also see asset appreciation.

Stocks aren’t the only way

Mortgage_Loan_Approved1Other options would include discounted notes. I’m in the middle of migrating my Roth IRA into a Self Direction Roth IRA. The plan is to buy warrantied, discounted notes. The noted fund I have joined sells 1st position notes at a discount. That means mortgages that were perhaps written for 5% would yield me something much higher, like 9-12%. They are also warrantied meaning that if the payee stops paying, I have the option to either foreclose and sell the property, or I can collect on the warranty and get back what I put in. Show me a stock or mutual fund that offers that.

As an example of discounted 1st position notes, imagine a note where the payee owes $100,000. Imagine it was written with a 5% interest rate. Monthly payments would be $536. The person holding the notes decides to sell it for whatever reason. Maybe they needed a quick source of capital. To move the note quickly, they are willing to accept $65,000. For $65,000, I can get that monthly stream of $536. Punch that into your calculator, and you’ll see that we are getting 9.9% yield on that investment.

To top it off, whenever the payee decides to pay it all off, I collect an extra $35,000 (remember, original balance owed was $100,000). If that happened five years out, the annualized ROI would be about 9%. Pretty good return on the money. And then I can take all this cash and buy more notes, boosting my monthly yield.

Thanks to having this inside a Self Directed Roth, there are no taxes involved. I have to pay a service fee to my note payment collectors of about $15/month. And the Self Directed Roth custodian needs a minimal fee as well. But nothing close $13,000 year! That is horrendous.

EIULs are designed to reduce costs in the future

EIULeffectThe last leg in my talk about good vs. bad management fees are EIULs. I frequently hear life insurance products criticized as being ridiculously expensive. The truth is they ARE very expensive….for the first ten years. After that, the costs drop dramatically.

Insurance companies design these products so that they collect their profits up front. That way, if you fall through on future payments, they don’t care so much. It also makes the products better guaranteed to last properly. A key ingredient, though, is to overfund as much as possible. By overfunding a policy, the cash value grows much faster. And the faster the cash value grows, the less total insurance must be bought. It’s a vicious cycle. If you slow down the growth of cash value, more of your premiums is used to fund the difference, i.e. the corridor between face value and cash value.

But when you overfund the policy, the total amount of insurance purchases through the life of the policy is greatly reduced and in the end, the annualized costs drop to somewhere like 0.5-1.5%. That’s pretty handy for getting a big chunk of cash in retirement that is completely tax free according to IRS tax code.

It’s not simple or easy to build wealth all by yourself. But delegating ALL decisions to a financial planner can be very costly when you reach retirement. The key is understanding the fundamentals of building wealth so you can hire the right experts to set up things most efficiently.

What is happening to the stock market?

graph_up2The stock market lately has gone CRAZY! So what’s happening? Well, I don’t have all the answers, but let’s look at some of what’s going on, and see what we can figure out.

At the beginning of this latest market crash, news reports came out about the price of oil dropping drastically. In case you didn’t know, oil is a key piece of the economy. Whose economy? Well, I know the most about the US economy, but oil is an international commodity, so it affects everybody. In essence, we all use oil to drive cars, fuel shipping trucks/planes/trains, and deliver most other goods of the economy. When oil prices fall, other parts of the economy rally. And when oil prices shoot up, other parts of the economy suffer.

So why is the whole market sliding down? One word: panic. Back in the 1970s, OPEC tried to control the oil market at an extreme level, and they actually contributed to a worldwide recession by pushing the oil market too hard. I’m not saying that is what’s happening, but when the price of oil moves a LOT, MANY investors panic.

All the oil stocks dropped off quite a bit. Strangely enough, stocks like VNR, which is 85% natural gas and has little to do with oil, has dropped 50% in the past 2-3 weeks. That is probably because many of the people that bought VNR are panicking that for some reason, VNR is next. In general ALL energy stocks will typically suffer a hit or a rally when stuff like this happens. A nice side effect for people like me that have a more long term aim at things is that I just reinvested a monthly dividend and picked up twice the usual shares.

But what about other things? VMW is a stock I pay attention to, because I still have a sliver of stock option. It has dropped to $77/share. It has nothing to do with the oil market. But many investors freak out and simply want to get their money out of the market when “shaky” situations like this occur.

This is known as systemic risk. Financial planners push mutual funds hard by selling the story of risk avoidance. They make it sound like during rough patches, mutual funds help you avoid such situations by spreading your risk across the whole market. The trick is, in these types of situations, emotions run high and people will pull their money out of everything. Hence, mutual funds will suffer losses just like other things. The trick is, when people cash out, they want their money. Mutual fund managers are forced to actually sell to dispense cash, and thus lock in losses. The time to get back to where you were takes too long and hence we all suffer.

The thing is, I have little money now invested in mutual funds. Instead, I have real estate, an EIUL, and other vehicles (one which I’ll post about soon!) My net worth has hardly dropped at all. And the yield on my investments is just as strong, meaning I’m not waiting for the market to recover nor am I waiting to “get back to where I started”. This saves me from having the proverbial “201K”.

I don’t have all the answers. I can’t tell you what the market is going to do next. But I can point out the risks that exist, and how mutual funds don’t provide the answers their salespeople claim. Everything comes with risk, and I have that nicely managed by having a super sized bank account filled with cash.

Happy investing!

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Is defeating the beast of debt the best way to reach retirement wealth?

wealthI’m back! I’m been on a hiatus for the past 4-5 months, nose to the grindstone writing Learning Spring Boot. But I turned in my last rewrite about two weeks ago, and after a bit of decompression, am more stoked than ever to write!

I was spurred to comment about cash and cash flow based on what I heard on the radio. I listened as someone talked about how to get out of debt and move forward with reducing costs. The person calling in was stuck with student loan debt. They had already tackled some other things like credit card and auto loan debt.

As I listened, I kept hearing the same things. Get rid of debt, get rid of debt, and more git rid of debt. On the face of it, it make sense. But I kept thinking, what happens when they get past all this debt? What then?

Consumer debt is a menace. Many people take on too much. They don’t budget well. Translation: we all make more than enough to get by. Because we don’t manage our money well, we end up spending too much on things we don’t need. Get it under control, and you can go far. But at that stage, people start stuffing their spare change into 401K plans and IRAs. They don’t realize how much they are shooting themselves in the foot.

401k funds have shown a 20-year history of performing at or below 4% annualized growth. How bad is that? Inflation is slated to be around 3%. This means that if you get the average (and don’t tell yourself you’ll beat the average), you are barely ahead of inflation. How good is that?

When you consult a financial advisor, they will talk to you about how this fund and that fund are performing. That may be true, but there are some innate biases built in that aren’t obvious. First of all, the funds that exist today aren’t the same funds that existed ten years ago. When funds perform poorly and people dump their holdings, brokerages houses end up closing things out. Those that are left, get transferred into another. And the next year, if you were to ask for the brokerage house’s average performance, the closed out fund isn’t part of that picture.

Another factor not mentioned is that funds don’t invest; people do! People buy funds. People buy stocks. People buy real estate. Hence, the question you should ask an investment advisor is how has his clients performed? What is his client’s average annualized growth rate? What is the average/minimum/maximum life he has held clients? A good investment advisor that is making his people wealthy should have long standing clients. Their annualized growth rates should be high. Measuring the performance via a prospectus is the wrong focus and won’t reflect how clients are doing. In other words, it won’t show how YOU will do.

So if you realize that 401K funds aren’t the answer, the next question is: what DOES work? What are you willing to do to get there? I invest in real estate, stocks, and EIULs. And being cash flow positive with no consumer debt, I am willing to take on debt. The caller on this radio show sounded unready for anything like that. I fear they will clear out all this debt and then be unready to entertain borrowing money to invest in real estate. Instead, they are going to go with the host’s plan of buying up mutual funds. Things will really sizzle, because they won’t be hampered by car payments, student loan payments, and credit card payments. And they will make it to retirement, perhaps saving up $1MM.

And that is when they will discover that it’s not enough. Their financial advisor will tell him or her that they can start withdrawing NO MORE THAN 4%, i.e. $40,000. Then Uncle Sam will ask that they submit $4000 in taxes. (I’m being gracious and assuming that landing in a lower tax bracket results in an effective tax rate of 10%). At the end of the day, this person that tackled small bits of debt thirty years earlier, is now raking in $36,000/year. That maps to $3000/month.

Can you comprehend living on that tiny amount of money? Do you see cruise trips or spending a month in France on that kind of cash? Was slaughtering the beast of debt and not considering future loans to buy cash flowing real estate worth it? Not for me. I plan to reach retirement with MUCH more than $1MM, because it takes much more than that.

Stay tuned for more discussions about building retirement wealth.

Can you really live your retirement tax free?

TaxesI have heard a lot of radio ads for various shows and products where they like to brag how you can live on the “tax free side of life”. Perhaps you’ve heard them too. If this really possible? Or are they selling a bunch of malarkey?

Let’s dig in and find out. If you’ve read some of my past entries from here, you’ll surely have noticed me talking about things like EIULs, real estate, and MLP stocks and their tax advantages. In this article, I want to look at how EIULs operate compared to a 401K in the arena of taxes.

Now before we go any further, I want to make one thing clear.

There ain’t no such thing as a free lunch, especially in taxes.

When you dig in and see how various investments operate, it’s more about picking the best, most efficient tax strategy that will serve your needs. Since this blog is about building retirement wealth, I generally talk about the best tax strategy for your retirement.

401K taxes vs. EIUL taxes

That sounds pretty vague, ehh? Let’s use a concrete example: 401K taxes vs. EIUL taxes.

If you use your company’s 401K plan, you get the nice benefit of writing off your contributions. You don’t have have to pay a nickel in taxes for every dollar you stuff into your plan…today. The trade off? (There’s always a trade off). When you start making withdrawals, you will be subject to full income tax rates on every dollar you take out.

Many people are drawn to the allure of avoiding taxes today. It sounds great to take home more pay. I certainly liked the sound of that when I got started at my first job. The problem was, there was no one there to coach on the options and benefits of other vehicles by which I could pay taxes today and pay considerably less in retirement. As the saying goes, you don’t know what you don’t know.

If you buy an EIUL instead, you fund it with after tax dollars. Every dollar that goes in has a certain amount skimmed off for Uncle Sam based on your income. Then when you decide to withdraw money later on in retirement, you do so tax free. The trade off is that by paying taxes up front, you can skip paying taxes in retirement.

Which is better? Well from a tax perspective alone, I prefer the EIUL for two reasons.

  1. The total amount of taxes I pay will smaller, because the total money in action is smaller. In general, as I get older, I make more money, and pay more taxes. So the sooner I can move that money off the tax rolls, the better.
  2. Tax rates and policies are always moving around and the subject of elections. What will this country’s entire tax structure be like in twenty or thirty years? Who knows. I’m still waiting for my crystal ball to get out of the shop. Until that time, I’ve decided that I don’t want to gamble my retirement on such a huge unknown.

If you’ve read this blog, then you know I also advocate EIULs due to better and more consistent historical performance, but I’m leaving that aspect out of this article. For tax purposes alone, it’s generally better to pay up front than later on in life. (But this never precludes doing a complete analysis!)

The tax man cometh

I’ve run into people that don’t understand why EIULs let you “get away with dodging taxes.” Some of these people I’ve chatted with tend to believe any chunk of cash you receive should be subject to income taxes.

For starters, any time you start making withdrawals from your EIUL, the first batch of money is considered return of capital. Essentially, whatever money was put into your cash value holdings is simply being handed back to you. And as pointed out earlier, you already paid taxes on it. Is it really fair to tax you twice on money that effectively didn’t go anywhere?

After you get your premiums back, then you begin taking out loans against the cash value left. Loans are non-taxable events. For my friends that believe this is trickery, I wonder if they are ready to pay income taxes every time they finance a car. If you borrow $200,000 to buy a house, do you think you should suddenly be hit up with a $48,000 tax bill that year? And what about using your credit card? Every time you use it, you are borrowing money to buy something. Should that also be taxed?

I’m sure you don’t want to pay taxes on any of that debt, but what’s the underlying reason you shouldn’t? Because you will ultimately pay off your debt using taxable dollars. The government WILL get their cut of money based on this debt. They just get it in smaller chunks. Bought a $20,000 car? You will end up paying it off with $20,000 of hard earned money subject to good ole’ income tax laws. In fact, thanks to financing, you might actually be shelling out a little bit more, all paid with taxable dollars.

But wait! EIUL loans aren’t paid off!!! How can you justify THAT?!?

An EIUL is a life insurance contract. The amount of money you pass on to your heirs is tax free. It is an enticement by the government to leave something to support your family, friends, or whomever you wish. When you take out loans, the loans+interest are paid off by the death benefit. And don’t forget: it was funded with after tax dollars.

So as I wrote early on, there is no free lunch. You aren’t “getting away” with anything. You funded a plan with taxable money and structured things so that you could pay the taxes now instead of in retirement.

Mutual funds are just fine…if you’re rich

rodin_thinkeI listened to a famous financial radio host talking on another radio show this morning. The question was asked, “do you still believe in the 401k?”

His answer? “I invest in some mutual funds in a 401k along with rental property I pay cash for.”

I listened to this and could immediately see the fallacies in such a statement. Let’s dig in and examine them.

First of all, the key to building a retirement portfolio is putting money there. Duh! The reason many of us read a report or a prospectus is because we don’t have gobs of money to fund a portfolio. Instead we have much less so we must lean on the power of ROI and compound interest.

What do I mean? Imagine you made $1,000,000 each and every year. What if you could live off just half of that? I promise you: saving $500,000 every year for twenty years will set you up real nice.

With no growth at all, that adds up to $10 million. And if you bought something that yielded a paltry 1%, you would be raking in $100,000 forever without dipping into the principle.

Instead of plowing half a million into some 1% CD, what if you peeled away half of that and bought a new rental every year all cash? I think accumulating twenty rentals would be very nice.

$5 million in rental equity could easily yield $20,000/month in rent. Apply Murphy’s rule and assume you only get half due to repairs, maintenance costs, vacancies, etc. $10,000 is still pretty good.

Combine that with an adjusted $4000/month in CD interest, and you will do just fine.

As a side effect, people would probably stand up and take notice. The synergistic effect would let you write books that would sell like hot cakes because everyone would want to know how you did it.

So how did you do it? The secret is the original business you built that generated all that capital in the first place!

If none of us become entrepreneurs, we have to think up other ways to scrape up some capital. If your rich, you can afford to pay all cash. Not rich? Then your stunting your returns by going too debt-is-evil. There are good ways to take in debt and mitigate the risk.

Make no mistake. We can still accumulate $5-10 million in rental property. We just have to be ready to take on strategic debt, hire the right experts and do things smarter. We have to keep our eye on the ball.

We can become very successful. Sadly no one will want to read a book about how we did it. Oh well. You win some you lose some

But it irritates me when certain rich people go out of their way to tell us that mutual funds are great for everybody. They’re not. They suck. It just doesn’t matter how badly they suck when your pile of gold is really big.

To generalize that this approach to building retirement wealth works for eveyone is ridiculous. History doesn’t support it. And this is where I must part ways with this radio host when he begins to talk about investing.

How to build retirement wealth

If you are a new reader here, perhaps it’s time for an introduction. I like sharing my opinions on how I am building retirement wealth. I also like to document how my own investments are doing. Some of these ideas might sound outrageous or in contradiction to what you’ve heard from your financial planner, financial adviser, or some popular radio hosts.

But the concepts I lay out in my articles are backed up by historical evidence. In fact, I look at history to try and determine the best ways to build wealth. Do you know how you always hear “past returns are no guarantee of future returns”? While true that there is no guarantee, trying to shirk the past and it’s strong evidence is reckless and frankly won’t lead to a good retirement.

So what are the investment vehicles I employ?

  • No mutual funds.
  • No 401K or IRA wrappers.
  • Direct ownership of stocks (not mutual funds).
  • Leveraged real estate
  • Over funded cash value life insurance (also known as permanent life insurance)
  • Build wealth using various forms of arbitrage

These may the types of vehicles I use, but it also includes the concept of actively managed wealth building. Some of these vehicles may be considered passive forms of income, but it takes an active approach to do it right. The concept of simply dumping money into a mutual fund inside your 401K and assuming it will grow to serve you in retirement just doesn’t work.

No mutual funds

The Dalbar report has been monitoring mutual funds and tax deferred savings plans for 20 years. According to the 2013 report, mutual fund investors have significantly underperformed the S&P 500 over the past 3, 5, 10 and 20 years. In 2012, they reported the average performance of investors in equity funds was 4.25%. They further indicate that this is mostly tied to investor behavior rather than fund performance.

The performance numbers are clear: people investing in mutual funds average poorly. Dalbar goes on to make a judgment that it’s the consumer’s fault. This might or might not be a valid judgment. But is that relevant? If people don’t do well, and haven’t been for 20 years, do I really want to plan my retirement under the assumption that I can beat the average? I’m sure it’s what most others think. Dave Ramsey is happy to quote the FDIC in saying that 97.3% of people don’t follow through on their promise to pay off a 30-year mortgage in just 15 years with extra payments.

So why would we expect people to follow through on their attempt to not buy when things rise and sell when a market correction hits? I prefer to build my wealth building plans using the averages.

No 401K or IRA wrappers

401K and other government wrappers come with an incredible entanglement of regulations, restrictions, and other tricks to basically keep your hands off the money. The concept is to get you to put away money and keep your hands off of it until you reach retirement age. But many investment houses take advantage of this situation in the sense that mutual funds and other vehicles available tend to have the highest expense ratios.

People will eagerly point out things like IRAs as giving you more control, but the government has strong limits on how much you can put into an IRA. Suffice it to say, the limits on IRAs aren’t enough to build a retirement plan.

And do you really think the government designed the 401K to help you set aside money and save on taxes? The government wants you to put away money today without paying any taxes, so that you will grow the money into something bigger, and then start paying full blown income taxes when you reach retirement. Yikes!

It’s true that I have a Roth IRA and a 401K, but that is money I put in before I realized it wasn’t working. As you’ll see below, most of that money has been re-applied and is already making way more than what it used to. The only money I have left is trapped in my current company’s 401K and I can’t get to it. The Roth IRA I have is small as well and would serve little benefit if I extracted it.

Direct ownership of stocks

This one really stuns some people that I meet. I don’t like the dismal performance of mutual funds combined with their fees. Instead, I prefer owning stocks directly. If you look at all the studies done over the years, there is one stock market strategy that has proved fruitful: buying and holding dividend-paying stocks.

If you look at people like Warren Buffett, they have created billions by acquiring strong companies when they were on sale. Warren Buffett has also bought cash flowing stocks and companies, and reinvested their proceeds in other strong companies. This has created a compounding affect that has let him beat the S&P500 for years by great margins. The book value of Berkshire Hathaway has averaged it’s growth by 28% during the boom years, and by as much as 18% during bad recessionary times.

It’s not hard to find solid companies. In fact, there are many blog sites dedicated to this, such as Dividend Mantra and Dividend Growth Investor. The companies they invest in are not fly-by-night shady outfits. Instead, they mention thinks like Coca-Cola (KO), Walmart (WMT), and other names you’ll recognize. Companies like Coca-Cola have created millionaires for decades. You can find a list of companies that have paid consistent dividends, increasing them year after year, for over 25 years. It’s not that hard. It turns out, these are some of the best investments regarding inflation. A company that has managed to increase payouts to its shareholders through thick and thin is pretty solid.

Leveraged real estate

After the 2008 housing melt down, many people won’t entertain investing in real estate. The problem is that newspapers were reporting the worst scenarios regarding foreclosures. The truth is, 99% of mortgages are current and paid for. The number of people that suffered rate hikes on risky loans while having insufficient money to keep up were a fraction of a percent.

Real estate has shown a more consistent growth rate than mutual funds. And real estate is one of the easiest investments for middle class people to get into. Using prudent leverage, an average 4-5% growth can turn into 20-25% growth in your investment capital. That certainly beats the 4.25% average growth of mutual funds. Again, this is what happens if you use the averages. You can make more and take on riskier, higher paying options, but why take a risk? You’re already ahead of what mutual funds in 401K wrappers have to offer.

Since real estate was a no brainer, I cashed out my 13-year-old 401K from my old company, paid 37% in taxes and penalties that year, and used it to buy two duplexes with 20% and 25% down. I couldn’t be happier.

The rentals I own are paying me a nice monthly profit as the tenants pay off the mortgages for me. I keep a fair amount of cash in reserve to handle vacancies. And seeing my property yield monthly cash helps me to focus on that instead of pure growth in value.

Over funded cash value life insurance

This is one that stirs a lot of discussion. People have been preached to that cash value life insurance is a rip off and to never, ever, ever buy it! Phrases like “buy term and invest the difference” as well as “don’t mix insurance with investments” flies all over the place.

The thing is, many of the people that preach this opinion have an incomplete knowledge of how it works and how it was designed to function.

To be clear, I’m talking about EIULs, or equity indexed universal life insurance. And the critical component is over funding the policy to the limit set by the IRS. Essentially, buy a policy where you get the minimum amount of death benefit for a given amount of money. That causes your cash value to build faster. If you get the maximum amount of death benefit, then your cash value grows very slowly and it becomes an ineffective tool in storing wealth.

EIULs that are over funded give you the option down the road to borrow from the cash value. Essentially, you borrow money (without paying it back) and when you die, the loan is paid off with the death benefit. Whatever is left over is passed on to your beneficiaries.

EIULs have the benefit on not investing in the stock market, but instead in European options on the market. This is how they institute caps such that your principle is guaranteed to growth somewhere between 0% and 15% of the index it is linked to. If the index goes negative, your cash value stays the same. But if the market goes positive, so does your cash value.

You may not be aware, but that facet is incredibly powerful when it comes to wealth preservation. So many people have seen huge booms in their mutual fund holdings, but the overall performance is knocked back to that Dalbar average of 4.25% due to losses. If your account shrinks by 30% in one year, and then grows by 30% the following year, are back to where you started? Nope. $10,000 would drop to $7,000 and then grow back to $9,100. But if you had an EIUL, that $10,000 would stay put, and then grow to $11,500 (0% loss followed by a 15% gain based on the caps).

EIULs are very expensive for the first ten years; a fact many people like to point out such as Suze Orman and Dave Ramsey. But after ten years, the fees drop to almost nothing. After twenty years, the fees will probably average between 0.5-1.5%/year. Sure beats the 2-4% average cost of mutual funds. And then you get to start taking out tax free loans (compared to mutual fund payments at income tax rates), there is even less to fret about in retirement.

Once I understood the entire picture of what EIULs could and couldn’t do, it was a simple decision to stop investing money in my company 401K and reroute that money into an EIUL.

Build wealth using various forms of arbitrage

Something people are unaware of is how banks make money. Banks borrow money from the Federal Reserve at rates like 3.25% and then turn around and lend it out at 4.25%, pocketing the 1% difference. You can use the same concept.

I took out a HELOC against my home for (PRIME-0.25%) with a floor of 4%, so right now, it costs me 4% to get this money. Then I bought a position in Vanguard Natural Resources, an MLP that has been paying 9% distributions on a monthly basis. As I pay off the HELOC, I am essentially pocketing the 5% difference.

This is also referred to as equity harvesting. All that equity in my house was earning 0%. I am getting the cheapest form of money available, a mortgage, and using it to collect cash flowing assets. After I pay off the HELOC, I can redirect the money towards paying off investment mortgages, buying other dividend aristocrat stocks for even more passive income cash flows, or increase my position in Vanguard Natural Resources. And at that point, I can also renew the HELOC to get more investment capital.

When people ask “would you take out a $50,000 loan on your house and invest it?” my answer is a resounding “yes!”

Stay tuned

I hope you enjoyed this introduction to the concepts of build wealth at the Wealth Building Society. Wealth building isn’t hard, but when you boil things down to sound bites used by radio entertainers, some of the worst advice gets out there. Are the people that are telling you to only take out 15 year mortgages and pay them off as fast possible retiring on mutual funds? Are these people maxing out 401K and IRAs, or are they building wealth through writing books, running TV and radio shows, and piping their business equity pay offs into rental property?

Taxes are settled; net worth increases!

The last numbers for the month of July are finally in, and I have updated my monthly net worth spreadsheet. The results are spectacular!

I finally got my taxes completed, meaning I have paid off the IRS for my early 401K withdrawal. The giant liability I’ve been carrying for nine months is now zeroed out. Instead of my early 401K withdrawal costing me 50%, it ended up only costing me about 37%. Cue the happy feet.

My networth has growth by 10% from just last month. Total growth since last August when I began tracking is at 80%. Some of this is tied to estimated values of my rental properties, so it should be taken with a grain of salt. It will probably take a few years before those values settle down to something closer to reality. And you don’t REALLY know until you sell, right? But it’s good enough for now.

All my real estate holdings are settled now that I’m done moving into our new home and selling off the old one. I’m not buying any more real estate for probably five years at least. Next year’s tax bill will be MUCH smaller and also easier to produce. Now that I’m established with my new CPA things should be smooth sailing.

The bills to Uncle Sam have been paid and the outcome is fantastic. Instead of fretting over whether or not my 401K will grow or shrink each month or worrying about the high costs of those funds, I am looking at an annual incoming cash flow of about 25% of my investment capital. Remember, I only had to put 20-25% down on the rental properties. So based on those rents combined with the monthly distributions from VNR, I have a pretty solid, consistent cash flow coming in. Divide that by the total money I invested, and that’s where you get 25%.

It’s true that probably 70% of that cash flow is used to service debt. But that’s okay. First of all, the debt is fixed and finite; rents and distributions are not. Based on history, the odds are pretty good they will both rise at some point. The cost for getting my money free from the clutches of that 401K have been paid. With this type of cash flow, I should probably recover the losses in just a few years.

The key here is that with a stable cash flow positive income, I can now wait for the market to speak. When property values rise high sometime in the future, I can sell bits of property and re-leverage things. I also have a huge boon of unused depreciation starting to accumulate that will help me reduce if not eliminate the tax bill down the road. That should allow me to reinvest a maximum amount of cash and continue to build wealth much better and more reliably than mutual funds wrapped in a 401K ever could.

You can check out the chart below to get a rough estimate if the time frame it will take me to recover the losses and leave the old 401K plan in the dust.

Is your wealth building plan out of alignment?

The other night I was putting together my desk. We recently move to a new house, and I had to take apart this giant desk. Putting it together was tricky, because I had to remember where all the pieces fit together. When I had finally lined everything up, I noticed that the center section of desktop was off by at least an inch.

I have one of those big, U-shaped desks. I had connected the lower part of the U shape, bridging the two sides together. This vertical piece was the main support for the desk component that would sit on top. As I placed the desk component on top, it seemed alright on the near side, but was off by more than an inch on the far side. That wouldn’t do!

So I took the top off and looked everywhere. I noticed that I had gotten the furthest bolt lined up, but had completely missed the second bolt. It was outside the support piece. This had to the reason! No wonder the cam lock never caught on to the bolt.

It seemed strange that being off by what was less than 1/4″ could have cause the opposite end to be off by such a big amount. But I went back and fix it so both bolts were properly locked on in that support piece. Then when I dropped in the desktop, it lined up perfectly. That’s when I remembered how small variations at one end become magnified the further away you get.

The same can be said about wealth building plans. Something that may seem like a small impact today can have a huge effect on your total growth in a twenty five year span. Studies have already shown that the exorbitant fees of 401K can end causing you to lose an average of 30% (or more) of your total growth.

Something small like 4% vs 1% fees in your 401K can have a detrimental effect long term. In one study, they showed that $155,000 on average was lost to high fees, which could equal an entire house in today’s dollars. With that much money, I could easily see buying another half-of-a-duplex and getting an additional $1300/month in cash flow. Think you could use that?

But who pays attention to 401K fees? Not many, I’m afraid. Most people don’t watch small stuff like that. Instead, they check if their value is growing or shrinking. When values plummet, people suddenly get interested and start moving their holdings into more conservative funds. This locks in losses, but the same fees are found in the other funds as well. This insidious issue continues unabated until its too late, when you are thinking about retiring. You want to, but discover there isn’t enough money, or at least not enough to retire completely. Instead, you need to find some other supplemental income.

That is what happens when your plan is out of alignment and not handling things like high fees, inflation, and complex rules surrounding 401K.

New 401K regulations will expose more fees

I have talked about this before. New regulations over the disclosure of 401k fees began coming out last year, with the last ones coming just last November. A Reuters article even bragged that there would be an “a-ha” moment when these statements came out. Have you heard it? Has anyone else started griping about their fees? I personally haven’t heard anything from my own co-workers.

Whoever is celebrating this reform in 401K regulations may be investing too much hope in the results. What is I fear is that these new regulations will only encourage those that pay attention to focus even more on fees and not actual net growth. (Those that don’t pay attention to their 401K probably won’t notice much.)

As I stated before, investing based on fees is the wrong approach. When people start looking for the cheapest option, they often throw away very viable investment options. When it comes to picking mutual funds, you may be splitting hairs when seeking the cheapest fund. That is because mutual funds have a terrible history at building wealth. So it doesn’t matter whether you spend a little or a lot in fees; you won’t build solid retirement wealth.

If you look at something like real estate, you will definitely see more fees. Closing costs, taxes, insurance, and brokerage fees are just some of the items you have to deal with. But because investing in top quality real estate can build a much sturdier portfolio that can support you in retirement, the fees are worth it. Buying an index fund may cut fees to the minimum, but their upside potential is also pretty bad.