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.

Having a team makes all the difference

I have talked about hiring experts in the past. It’s your responsibility to manage your experts. But in the end, having the right team can make the difference between a moderately successful wealth building plan and a superior one.

Many people think about financial advisors, CPAs, and lawyers when they hear the term “expert”. It’s valuable to have the right people. For one thing, I don’t have a financial advisor. I hold that role. Regarding CPA, it has taken me awhile, but I have found one in California who knows what cost segregation studies are, how to handle K-1s, and even spotted a loss that was never credited to me from a previous statement. I haven’t needed a lawyer yet, but I have contacts should the need arise. Finally, I have a superb mortgage broker. Those are hard to come by, because most are used to handling primary residence financing, not your fifth rental property.

Raising rents

But that isn’t the only reason we need a team of experts. Recently I had opportunity to raise the rents on our units. My management company recommended we stay where we are. Of course they would! They want to ensure we maintain 100% occupancy without having to work too hard.

The first person I called was Jeff Brown. We talked for about a half-an-hour. The benefit of this is the fact that he has his fingers in all kinds of deals in that area. He can tell me about rent rates in all kinds of other developments. To top it off, we also have a leasing agent that works in the area, and I also contacted her for an opinion. This type of information is gold. If I didn’t have either of them, I would probably defer to the management company, and not enjoy a rent increase for some time, perhaps when everyone has raised theirs and its unavoidable.

I can tell you this: I don’t want to be the last one to the party on rents. The sooner they go up, the better. That is the beauty of financing with fixed debt. The payments stay the same, but the profits increase.

Naturally I offer a lower rate to tenants that want to renew. I like to reward them for staying on and not forcing them to move up to the full market rate. But costs of living rise regardless. I’m on the hook for paying rising insurance and property taxes.

Valuable quotes for investors

I recently read an article that pointed out supposed advantages of mutual funds and then tore those assumptions to shreds by pointing out that something like 85% of actively managed funds under perform their relevant indices. The article proceeds to point out the incredible evidence of how index funds outperform actively managed funds.

The author finally wraps things up with some notable quotes including a partial one from Warren Buffet’s 1996 shareholder letter:

…the best way to own common stocks is through an index fund…  –Warren Buffet, 1996 shareholder letter

If there’s one thing I don’t trust, it’s partial quotes. I decided to find that quote and read it’s entire context. As you see up above, I have linked in the letter so you can find it as well.

Do yourself a favor and read this entire section Waren Buffett wrote:

Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.

Though it’s seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders: Our look-through earnings have grown at a good clip over the years, and our stock price has risen correspondingly. Had those gains in earnings not materialized, there would have been little increase in Berkshire’s value.

I highlighted one section in particular, because I’ve read other versions of that in other places. Given all this, does this sound like someone that thinks the true path to wealth involves index funds? Or is he possibly saying IF you are going to buy funds, your best bet will be index funds?

Warren Buffett clearly points out that investment professionals aren’t the ticket to building wealth. He also eschews the complex statistics and fancy theories taught at business school. Instead, he leans on a business’s ability to produce and grow earnings. Balanced against price, he is obviously suggesting buying quality companies when they are on sale. When people panic and sell quality businesses, driving the price down, that is your real opportunity to buy. The price may flutter, but if the company is solid, it will recover and you will succeed.

One last thing. I noticed that further down in the comments a rather strange assumption from one person.  They suggest that if you know only 15% of the mutual funds will succeed, why not spend the extra to find them out and invest in THOSE funds. The problem with that advice is the assumption that it’s the SAME funds on top each year, an assumption that can have a dreadful effect on your overall performance as you chase yield.

In summary, I prefer finding quality stocks and real estate that have shown a strong history of earnings and holding onto them long term.

HOW and WHEN to invest in real estate

In many previous columns, I have discussed the benefits of real estate, but maybe you felt like something was missing. I have keenly mentioned the WHYs of real estate investing.

  • It has some of the best tax laws on the books (depreciation anyone?)
  • Prudent usage of leverage makes it top stocks
  • Adequate cash reserves can mitigate the risk involved
  • Everyone needs a place to sleep at night meaning there will always be renters
WHY we do something isn’t the only question we should ask when thinking about a plan. We should also investigate HOW and WHEN. These are very critical to a successful retirement plan.
WHY gives us the reason to pursue something. But once we decide it’s a good idea, we have to discover HOW to do it and sometimes more importantly WHEN to jump in.
These second two questions we ask ourselves can be the different between success and failure. Many people that decided to get into real estate learn lessons the hard way. Learning lessons in RE can be expensive. Can I give you an idea of how much? 
Do you know HOW, or should you find someone that does?

Let’s say you buy an investment duplex and manage to sign up some tenants. A year from now, one of them loses their job and decided to stop paying rent. Do you know HOW to handle that? 
If you decided to save a little money and manage it yourself, you have to decide on whether or not to evict the person, or let them live in your duplex rent free. The mortgage payments aren’t going to stop, so you are effectively paying them to live in your unit. Let’s say you decide to evict them. Do you know the state laws regarding due process? County laws? If you don’t follow the right process, your tenant may get extensions and be able to stay much longer than your expected, all of it potentially at your expense.
I don’t think I would make a good landlord and I also have a full time career and family that I focus on. That is why I have a property management company to handle all this. They do the background checks, handle the leases, collect the rent, and if needed, evict the tenants. That is HOW I hire a good expert to serve my needs.
HOW do you even find good property to invest in? There are lots of units for sale. I almost bought one not far from where I live. We visited the unit, walked through it, and got a feel for the place. I thought it looked alright. Then when I talked to Jeff Brown on the phone, he asked me why the place had been on the market for SIX MONTHS. If this place was a good deal in a good location, why had no other investor in the area scooped it up?
I knew then and there that this place WASN’T good, so I let it by. Later on, I got the properties in Texas I have written about before. And they have done great. We have 75% occupancy and are still widely cash flow positive. I’m just hoping in the next month or two, we can find a tenant for the fourth unit. In fact, Jeff Brown hired someone specifically for that task; to find tenants for the units in that subdivision not already rented.
That is why I have experts like Jeff Brown and my property management agency. They are hand picked to help me complete the HOW of real estate investing.
WHEN should you invest in real estate?
This question is very important as well. I would generally say, the sooner the better. Many people suffer because they wait until everyone around them is doing something before they feel it’s safe to “get into the water”. That is usually the worst time. No one buys a mutual fund BEFORE it has sprung into value. Sadly, that is the time it needs to be bought. Once people discover its value, its price will start to rise. Those that wait until everyone else is onboard have probably missed the major upswing. And then when its bubble pops, they may be the last ones to sell, losing much.
To get into real estate I could have waited until my 401K money had recovered more, but who knows how long it would have taken to actually get back to my original value. Instead, it was better to eat whatever losses I had, and get moving on things. So my first decision was to call up that financial institution and start the withdrawal process.
But the next step, WHEN to buy a rental duplex, is trickier. Again, that’s why I have people like Jeff Brown that have been doing this for over forty years. He knows the market, and I’m counting on him to help tell me WHEN to sell, WHEN to move, and WHEN to use other arrows in my quiver of real estate investing.
That is they key reason to finding the right expert. They know the HOWs and the WHENs of what you are trying to do. The right expert may have higher fees, but its usually because they will generate more profits for you! If you do this the other way around, and look for the cheapest option, you will undoubtably have far less success.
Sorry if you were looking for a column that told you in no uncertain terms HOW and WHEN to invest in real estate, but the truth is, there is no single rule for that. Instead, its based on how much capital you have, where you can get in, what your needs are, how much extra you can save every month, and whole host of other factors. That is why we need top notch experts that understand all this to help form a plan, instead of just throwing money into some deferred savings plan and hoping it will work.

Can your CPA protect you from the IRS?

In a previous post, I mentioned that we must guard ourselves from experts. Reading an article on Fidelity.com, this is shown yet again. It appears that the government is getting hungry for more funding.


Tell me something I don’t already know.

It appears the IRS is getting more stringent on cracking down on things like excess contributions to IRAs. This appears to be another case of where all the complex rules for accessing my own money bugs me. I like the idea of collecting dividends on dividend aristocrats tax free, but if I exceed the limits for making Roth IRA contributions, I will have to shift to other means.

Back to the article I just mentioned. In the middle, it shows a case of a husband and wife who for seven years made contributions to their IRA where they weren’t qualified due to their level of income. This wasn’t discovered until they changed accountants. The prior CPA was totally unaware he was making this mistake. This is another case where you can have someone with the right pedigree and the proper licensing where they must properly protect, but they flat out can’t handle it.

Do you think the IRS extends much leniency in these situations? Not. At. All. In fact, the whole atmosphere of this linked article is the fact that the IRS has let TOO MUCH slide by. They are apparently looking high and low for violations of the IRA regulations, demanding their “fair share” and even exerting penalties.

This is a key reason why picking your experts based on fees is the wrong approach. It is important to find a CPA sharp enough to protect you from these errors. It is equally important to find one that can help you have the most tax efficient wealth building possible. It may take some time to find such a person. Work hard to find this person and the cost will be worth it.

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.

Guarding yourself from experts

Ever heard the joke about what you call someone who graduates last from medical school? The answer is “doctor”. It means that no matter how good or bad someone was in medical school, they are still a fully fledged doctor.

It’s an interesting fact that groups tend to click together, and groups of experts are no exception. They also tend to eschew anyone giving anything remotely close to advice in their area of expertise. Of course there is a reason that these people are experts: they went to certain classes, studied key material, and passed some sort of test to earn their certification, degree, or designation.

Do you think this is enough qualification to totally hand over all your decision making to one of these people? It’s not. Amidst certified financial planners, lawyers, real estate advisors, and others are good, honest people as well as snake oil salesmen. Sadly, it is up to us to sift through all these people and find the best person for our needs.

The law doesn’t protect you from incompetent advisors

I often read discussion forums and usually at some point, someone makes an appeal of authority that a financial advisor with a series 6x or series 7 license will put you first because it’s the law. Sorry, but you see, you don’t know what you don’t know, and that expert you’re consulting doesn’t know what he or she doesn’t know. A double blind spot! It is a tough situation to deal with, because after all, that is the reason you are seeking an expert! This person may be constrained by his education (or lack thereof) and whatever training materials he has. He may also not analyze every vehicle or have certain prejudices towards or against particular products for various reasons. He or she may be putting you first, but that doesn’t guarantee your advisor knows what they are doing.

One thing I’m aware of is that academics, you know, the people with the PhD’s, don’t like something that carries the weight of academic research coming from someone who doesn’t have a PhD. My dad told me this, and he was a college professor who retired as the department head of Biosciences Engineering at a well respected university. This is why when people write popular books that are filled with a lot of valid information, littered with evidentiary footnotes, like “Killing Lincoln”, they will be looked down upon because the author wasn’t an academic. Why is that? Is it because the book was faulty? Or is it because too many people that are non-PhDs might make the academic community to appear to be not as expert as they claim to be? Again, this is where just because someone has a PhD it doesn’t mean they are the expert you need. In fact, the most valuable advisor you can find needs to be able to say, “I don’t know” in certain areas. You will find that really good advisors tend to network with people OUTSIDE their zone of knowledge. These are people that have a much better sense of what they DON’T know.

One expert who lived on evidence

For another historical example, look at the famous Albert Einstein. We’ve all heard of him. So what was his story? He was an evidence based physicist. For 400 years, people had made assumptions about the laws of motion. This went back to Newton, who was well established in academic circles as the father of the laws of motion as well as gravity. One of the biggest theories that had existed for centuries was referred to as the Galilean transformations. It was used to convert coordinates of motion between two frames of reference, such as a girl bouncing a ball on a train, as observed by a man on the platform while the train passed. Buried in the middle of it was the assumption that time passed at the same rate for both the girl bouncing the ball and the man standing on the platform.

Einstein essentially said that he couldn’t accept such an assumption without any evidentiary way to prove it. Seeing none, he threw the Galilean transformations out, and started to form his own theory. This allowed him to derive the Special Theory of Relativity, which demonstrated that time in fact moved at different rates relative to the motion between two bodies. While he had a PhD, he wasn’t able to get a teaching post and instead worked in the Swiss patent office until after he had published these ground breaking papers. In fact, in one year he published four papers (1905), including the one on Special Relativity.

Even then, he wasn’t immediately accepted by the academic community. After all, the core of his conclusions said that Newton was wrong! His papers on photoelectric effect had managed to earn him a position as a lecturer at a university in 1908. In 1911, he became a full professor and also predicted a very different outcome than Newton’s laws when observing stars near the sun during a solar eclipse. But his career hung on a thread. Only when that could be observed, would the academic community finally believe his papers on Relativity. It wasn’t until 1919 that such an observation was made, and it catapulted Einstein to amazing fame.

Einstein worked from an evidence based approach. He didn’t accept assumptions. His willingness to be a gadfly and put centuries old traditional theories on the shelf and formulate whole new ways to look at problems led to amazing breakthroughs that still impact us today. (Did you know GPS devices must account for relativity to get the accuracy they achieve?)

Guarding yourself from experts

There is a way to guard yourself when seeking the right expert. Ask for the evidence and evaluate it before making a decision. Learn how to read the research so you can cross check what they are saying. When a financial advisor recommends a mutual fund to you, don’t ask “how has this fund performed over the past 10 years?” Instead, ask them, “how have investors done over the past 20 years in mutual funds?” After all, isn’t that what you are trying to do? Your advisor may stumble at that request, or hem and haw. The truth is, that answer has been published year after for some time now. The Dalbar Report indicates that investors, on average over the past 20 years, get less than 4% average annual returns when they invest in mutual funds.

Does the person giving you advice have some actual performance history proving their own investment advice has worked, and longer than a 10 year period? Have they accumulated wealth, and did they do it by buying what they are telling you to buy? For example, look at what happened in 2008 when the market went negative. Most of the mutual fund management companies increased their fees. You see, they tell you to stay in, but they don’t share the risk with you. Instead, when people pull out of mutual funds, they take their own share out of the pot!

Are the people making big money on investment books making their money on the advice in the book, or the fact that they can sell millions of copies? Did you know one of the best ways to get a book published is to already have published one? That is because fans of existing works are much more likely to buy other books from the same author. That is why you hear about famous authors writing many books, and the publishers know this!

What about those that have TV and radio shows? There is nothing wrong with having a show. But think about it: would you make more money using their advice or managing to get your own TV show? (HINT2: Research shows that one of the best money makers is running your own business. Maybe you CAN start a radio show and make a killing! But there are other places to build your business.) So try and figure out exactly what your expert is selling, and figure out if his advice is golden. If it is, then it probably doesn’t matter what fees he is charging. He is probably worth his weight in gold!

Cross posted from http://blog.greglturnquist.com/2012/05/guarding-yourself-from-experts.html.

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.