All 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
If 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
I’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
Other 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
The 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.