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.

So you want to build wealth? Look for multiplicative ways, not additive ones

“Another day, another dollar” — common expression

This expression is commonly known by many. It represents a common, core feeling we get as members of the vast work force. We go to work, put in the hours, get paid our wages, and go home for the day. This is not the way to build retirement wealth.

When it comes to building wealth, getting paid on a day-to-day basis is additive. To accumulate enough wealth to last for years, we have to put away huge amounts of money. Typically 30% of our take home pay is a minimum amount.

Why do I say that? Because the tools we are being sold on for investments don’t work unless we compensate by over-saving. A good example is the classic skip-that-daily-latte and instead save the money, and it 20-30 years, you will be a millionaire. I had heard that a few times, and figured it sounded great. Until I read an objective analysis of that. Basically take $5/day and multiply it by 365 days. What do you get? $1825/year. Doesn’t sound too bad. Today. But let’s take this concept and back up to 40 years ago. What was the median income for people back then? According to one source, median household income in 1974 was $9780/year. That would imply that saving $5/day, the price of a cup of coffee, was like putting away over 18% of gross salary. If you can assume 28% in withheld taxes, the percentage saved against take home pay would be 25.7%.

Wow! If we are to read that correctly, it suggests that saving $5/day today may result in $1MM, but in 40 years (if you started this when you were 25), $1MM probably won’t be worth much at all. Instead, we should read that correctly as needing to save AT LEAST 26% immediately.

Many people, if they looked at that, would just throw their hands up in the air and give up. But if you’re here, you surely have guessed that I’m going to say something different.

We need to look for options that have a multiplicative effect. What is that? It’s when you make some making by direct action, but the more actions you take, the more they interact with other actions already in progress.

One thing that I realized as I wrapped up the last chapter of my 3rd book, is that doing something as small as writing books on the side can introduce multiplicative money making. Today I finally got some time to watch a TV series with Neil deGrasse Tyson. I’m quite fascinated by astrophysics and his series seems entertaining. In the opening credits, it notes that Dr. Tyson has written ten books. Something I can realize is that the more books you write, the more books you will sell. Not additively, but multiplicatively. Simply put, people that enjoy one of your books are VERY likely to go and buy your others. My first book has yet to earn enough to pay off the advance I received. The second accomplished that about two years ago. My dream is that my 3rd will accomplish that even sooner, possibly through more social media, more people that read my previous works, and that some will even go back and buy my previous writings.

It’s only natural. I read the first Jack Reacher book, got hooked, and have now read ten so far. I read “Schrödinger’s Kittens and the Search For Reality”, and have since ordered the predecessor. When you go out and invest yourself into more and more and more opportunities that can yield more and more wealth, the opportunities grow.

So I highly suggest that you take some time to sit down and think. Simply think. Look at what you are doing today. What you have done for the past week. And think about what else you could be doing that can generate secondary effects. What if you started a blog and wrote on a daily basis? It could be small stuff. But it might grow your public image. It might open doors you didn’t expect. Open your mind to looking for new opportunities such an endeavor could raise.

These are all important the rather narrow vision the corporate 401K plans have. The general idea of a 401K is to sock away money in a fund that doesn’t grow very fast. And when you hit retirement, you are required to cannibalize it. Why do I suggest this? Because the federal government has a schedule after which you are obligated to start taking withdrawals. If you’re retired and doing just fine, it doesn’t matter. The government set things up such that they can collect taxes on your withdrawals and they will NOT be blocked from you doing just that.

In case you didn’t know this, the rich NEVER cannibalize their assets. There is this mantra out there that rich people adhere to: NEVER TOUCH THE PRINCIPAL.

In essence you are on a mission to accumulate wealth producing assets that themselves generate wealth you can live off of. You can’t wait until you are retired to begin writing books, building a blogger reputation, or something else. Instead, that is what must embrace while you still can earn enough of a daily paycheck to keep afloat. This is your opportunity to start buying real estate, dividend yielding stocks, EIULs, and discounted notes. Simply putting away 50% of your take home pay and planning to live like a pauper doesn’t sell very well. Good luck!

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.

Know anyone that has actually done buy-term-invest-the-difference?

wealth“But term and invest the difference” is a catch phrase idea that has been bouncing around for 10-20 years.

To do this, you must get a quote for cash value life insurance, like whole life or universal life. Then you get one for term life for the same amount of coverage. Buy the term policy and then start stuffing the difference into some mutual fund.

I have yet to meet anyone that has done all this. Many glorify the concept and are quick to bad mouth cash value life insurance. But ask them to show you a real illustration for both, and it seems everyone is empty handed.

Some have mocked the concept by calling it “buy term and spend the rest”. Probably because most spare money that isn’t forced into savings ends up getting spent on “stuff”.

Frankly I think the fallacy of this idea is how people don’t realize how much money is being suggested to be set aside. I admit I haven’t done this exercise myself. But that’s partly because I don’t believe it’s the right approach. I have a term life policy AND and over funded EIUL. My EIUL’s face value is about 1/3 the face value of my term policy so I deduce if I triple my EIUL premium, that would be my target amount.

And it would equal about 30% of my take home pay. Who wouldn’t do well setting aside 30%? The truth is, I can’t afford that much! And I doubt many out there can. Or at least, I doubt most would be willing to live such a lifestyle.

You might criticize me about not committing myself to the cause at hand or being unwilling to eat rice-and-beans. But the truth is, I don’t know to set aside such a huge amount of money to build a tasty amount of retirement wealth.

My father always told me, “work smarter, not harder.” –Scrooge McDuck

My real estate investments are doing well and they are realized by my willingness to set aside 15-18% in my earlier years. Part of the credit for that goes to my brother, who told me over the phone the week before I started, to max out my 401K.

VNR and my other stocks are doing well and paying me cash dividends. They are made possible by my willingness to take advantage of a HELOC.

Combine that with me slowly paying off a vacation home and stocking cash in my EIUL and I have no need to save 30%. And I also have mitigated away the downside risk of mutual funds.

Don’t get depressed over lack of wealth mobility

Something that seems to be sweeping the newspapers and blogs is how bad the economy is. The articles seem to point out how pay has been flat for several few years and that there is little income mobility.

What may not be clear is that there are two different results. One set of results is found when you average large groups of people and then compare different time periods like now vs twenty years ago. An entirely different set of results is found when you pick individual flesh-and-blood people, track their wealth mobility over twenty years and then average THAT. The results are much more pleasing.
Why is that? Well, the people in a given group today aren’t the same people that were in that same group twenty years ago. Which makes the first result set inherently flawed. But the fate of your retirement wealth shouldn’t be tied to such metrics.

Instead, you should focus on how you can become an owner, not just an employee. The wealthy members of society don’t settle for being simple employees. Instead they go out and own things including real estate, cash yielding stocks, cash value life insurance, and business equity. When you become an owner, the weight of income mobility, whether a valid concern or not, eventually fades in importance.

It may seem beyond your reach to build a million dollar business. But setting aside $100-500 every month and buying blocks of VNR, KO, WMT, GD, or any other blue chip stock that has paid increasing dividends for 25+ years is very realizable. 
These stocks become cash generators. By becoming business owners you can partake a piece of the profits. $500/month over 30 years would turn into $180,000 of pure investment capital, growing at 9% a year, would turn into $817,000.  Collecting 4% dividends would be tantamount to receiving over $32,000 a year just for being alive.
This is just one strategy but should illustrate that instead of worrying whether or not your salary is going up or not, people like Dividend Mantra are showing that your future is very much in your control. You’re the boss. Don’t let politicians and newspapers deter you from building your retirement wealth. 

Saving money is a key component to building wealth

Your savings plan and my savings plan might be different. But it’s important to have one. Let’s dig into mine first.

I make a monthly contribution to my EIUL. This a vehicle is designed to only go up in principle value and never go down. I won’t go into how it does that here. But know this: while an EIUL’s returns might not rival the stock market, when you remove the losses, it has historically kicked the heck out of mutual funds. Throw in its tax free perks and you’re gold. I can borrow from it down the road at virtually no cost. That is my first savings account. 
I also own a Florida vacation home that I bought on short sale. My family travels there all the time so my wife can maintain her status as a Disney employee, and we love taking the kids to Disney World. Not only does it meet our needs, it has let us create wonderful memories. But that is not all. It is financed at 4.5% with fixed debt. When I acquired it, I guessed the price was about half what it cost to build. Over time I will accumulate it. In the future I will certainly be able to harvest some wealth building equity. That is my second savings account.

Both of these are different than routing money into an IRA or a traditional savings account. But the money poured into both of these add up to an effective 10% savings rate. How many times have you heard people like Dave Ramsey tell you to work towards putting aside 15% of your earnings?
On many web sites I have read people citing that savings as a key factor in building wealth. I heartily agree. I’m acquiring hard assets as well as building cash value life insurance that both offer lots of options down the road. More options is the key to success. Borrowing cash off my real estate or life insurance can make it possible to build more wealth or deal with unforeseen issues when life intervenes. 
Nonetheless, when people ask me how much extra money I can apply towards either my rental loans or buying more stocks, I usually say “none.” That’s because I’m already setting aside 10%. To top it off, I’m also plowing the extra rental cash and monthly dividends I get towards those loans. The rent and dividends add up to the equivalent of 13% of my annual salary. So you could say in pouring 23% into my wealth building plan.

Hence the reason I don’t sweat NOT writing a check from my bank account towards savings after I get my paycheck. I’m already socking away plenty of money into rock solid investments.

Now your story may be completely different. Have you taken the time to figure how much your saving? And through what means? Feel free to share it here in the comments.