retirement

An Observation Regarding Money Worries

There are a few things that I noticed over the years that seem to contradict each other regarding money worries. There seems to be a link between being charitable, concerns over saving too much, and stress about money.

Charitable giving: some people make a lot of money and give little to nothing to charity, especially as a percentage of their income, and the opposite is sometimes true regarding those with modest incomes. Theoretically, the greater your income then the greater should be your charitable giving. Why does this make sense? I believe that it has to do with a scarcity mentality and a fear of letting go. If you are overly concerned with not having enough money, whether real or imagined, then why would you part with your money?

Overly concerned about saving: Let’s face it, it is daunting to think that we have to make sure to save enough for retirement, college, a house or a larger house, 6 months of expenses for an emergency fund, weddings, sweet 16 parties (they can be over the top nowadays), vehicles, business ventures, and everything else. It even makes me exhausted just writing that! However, some take it too far and save so much or are concerned so much about saving that they get really stressed out. Although I am an advocate for saving up for most of the above (I’m not a big fan of massive weddings and outlandish sweet 16 parties), you have to balance that with current needs or you will be miserable. Who wants to eat the cheap steak to save an extra $10 for their retirement?

Do any of these apply to you? Maybe just a little?

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5 Financial Truths

There is a lot of information out there about finances, and it’s hard to figure out what is exactly true or not true. Always seek the truth, especially from someone that is not trying to sell you something. Here are some examples:

College: We are led to believe that all of our children must go to college to be successful and make a lot of money. While I am a big believer in education and college, it is not the only route and it is not for everybody. With the high cost of college, the decision to attend college should not be automatic. There are alternatives, such as becoming a tradesman, learning a special skill that does not require college, starting a business, sales positions, military or government positions that do not require college, stay at home parent (yes, this is a vocation), etc.

Retirement savings: Saving for retirement is a good thing, however, it should be balanced with both short and mid-range needs. For example, if you allocate virtually all of your savings towards retirement accounts and ignore having a cash cushion, then your risk of financial catastrophe increases. If a financial crisis arises or a large purchase needs to be made, then you will have to withdraw from your retirement accounts, which is one of the worst financial decisions to make due to both income taxes and penalties on the withdrawals. Furthermore, if you do not have withholdings taken from your distributions, then you will probably end up with a tax problem once you file your return. The prudent action is to have a cash cushion of 3 to 6 months of expenses for emergencies and to save for mid-range goals, such as a house purchase.

Debts: Debt truly is a double-edged sword. There are some who advocate staying away from debts at all costs and others who encourage you to leverage yourself to make more money. The truth is that debt should be used wisely and sparingly, if necessary and as a last resort, and it should not cripple you. If you are able to avoid debt, then that is excellent, as debts increase your risk and they also encourage risky behavior and increased spending in many cases.  To prove this point, why do you think McDonald’s started to accept credit cards, why do auto loans have 7 year terms, and why can young adults take out massive loans for college?  It is to get you to spend more than you would have otherwise.  As you mature financially you should seek to decrease your debts.

Most people would not be able to afford a house without obtaining a mortgage, and if they waited to purchase a house and rented instead, then they would most likely be worse off financially over the long term. Also, some businesses may need to incur debts to purchase expensive equipment, inventory, or improvements that would not be possible if they did not incur debts. To emphasize, it should be used wisely and sparingly.

Expenses, income and savings: Most likely your expenses are way too high. If you are able to save 15- 20% of your income and have no debts then spend whatever you want. Otherwise, set aside money towards savings to steadily increase the percentage that you save each time you get paid. This way you will spend whatever is left over. If you are not able to do this then you need to take a serious look at decreasing your expenses and increasing your income. The truth is that it is really not that hard, but most people have a hard time doing this. As Yogi Berra said, “Baseball is ninety percent mental. The other half is physical.”

Home and health = wealth: In the quest for success, don’t ignore your most valued relationships or your health. Nothing can cripple your finances as quickly as health or family issues, such as divorce. With either of these issues your expenses increase exponentially while your income suffers at the same time. Make sure to prioritize.

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Don’t Make These Easily Avoided Financial Mistakes

We are all not perfect and everyone makes mistakes. However, the key is to avoid these financial mistakes as much as possible:

Penny wise and dollar dumb: The actual expression is penny wise and pound foolish, but I still remember a partner from my first job saying this to a client (maybe it’s the American version). I guess it doesn’t matter how you say it as long as you make your point. The message is to not be cheap so that you save a few dollars, but it ends up costing you a lot more down the road. This can happen with almost any financial transaction so always be aware of what you are trying to accomplish.

Ignoring tax notices: Don’t be surprised to find out that your bank account has been levied or there are liens against your assets if you don’t address tax notices. Surprisingly, the notice may actually be wrong, but the IRS or states do not know this. If you do not resolve the notice timely, then penalties, interest, and collection costs may be added to your balance or you may not receive your refund.

Not filing your returns: Sometimes taxpayers hesitate to file their tax returns when they know that they owe money, but do not have the ability to pay their balance. Fortunately, there are usually payment arrangements that can be made in these cases. Also, every now and then I come across a situation where there is actually a refund due to a client, but they took too long to file their returns so they are not longer eligible to receive it. Now that’s painful!

Not saving anything: Just about everyone can save at least 1% of their income to make this a habit, and then can increase their savings rate over time. The earlier you start, the better and don’t convince yourself otherwise.

Too much long-term savings/illiquid assets: Sometimes the opposite is true when people tie up all of their money in their retirement plans or real estate, but do not accumulate short-term savings. What tends to happen is that retirement savings are tapped if there is a financial emergency or long-term financial set-back, which in turns ends up creating a tax issue.

Traditional IRA vs. Roth IRA

Traditional IRA:

An individual retirement account that allows individuals to contribute pretax money to investments. The investments grow tax-deferred until the amounts are withdrawn at retirement, generally age 59 1/2. The maximum amount you can contribute for 2015 is the lesser of your taxable compensation or $5,500 ($6,500 if you are 50 or older). There are phase-outs for tax deductible contributions if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels.

Roth IRA:

An individual retirement account that allows individuals to contribute after-tax money to investments. The investments grow tax free and there are no taxes when withdrawn at retirement, generally age 59 ½. The maximum amount you can contribute for 2015 is the lesser of your taxable compensation or $5,500 ($6,500 if you are 50 or older). The eligibility to contribute starts to phase-out once your modified adjusted gross income reaches $183,000 if your filing status is married filing jointly and $116,000 if single or head of household.

What is a Self-Directed IRA?

Individual retirement arrangement or IRA’s are very common and well-known. Normally when someone owns an IRA they invest in stocks, bonds, and mutual funds, but did you know that there is alternative arrangement, called a self-directed IRA?

A self-directed IRA allows an individual to invest in a wide array of assets, including real estate, private equity, and to make private loans. There are prohibited transactions though, such as living in a property owned by the self-directed IRA, so you must be careful to comply with the rules.

Why Use a Self-Directed IRA? Because of the ability to invest in non-traditional assets, you have the ability to earn a higher rate of return and to diversify your investments from traditional stock and bond portfolios.

Traps to Be Aware of: The easiest mistake to make is to not be aware of the tax traps of investing in private equity or real estate. For example, if you invest in a restaurant that is formed as an LLC, then the income from the LLC will be “passed-through” to the IRA. Although this is allowed, the income is considered “unrelated business taxable income” and would trigger tax on the income. A way of getting around this is to invest in a company organized as a c-corporation and receive dividend income.

Other Traps: These traps are called prohibited transactions and if you engage in them then the IRS will tax all of your IRA assets as a distribution as ordinary income plus penalties, when applicable. A sample of prohibited transactions includes borrowing money from your IRA, selling property to it, using it as security for a loan, and many other self-dealing transactions.

Despite the traps that need to be avoided, a self-directed IRA may be appropriate for your portfolio. As with any investments you need to perform your due diligence to choose the right investments, IRA custodian, and advisors.

Don’t Make These Mistakes

With all of the financial and tax laws, changes to the laws, and life changes it is almost impossible to stay on top of everything. We have to constantly assess our situation all of the time. Here are a few things to consider:

Wills, Beneficiaries and Estate Matters: Did you recently get married, have children, or get divorced? If so, then you need to make sure that your will is up to date, along with your beneficiaries of life insurance, retirement, and other financial accounts.

Required Minimum Distributions: Once you turn age 70 ½, you need to start taking distributions from your IRA’s the following year; the first one by April 1st and the next by December 31st. If you don’t do this then you may be subject to a 50% excise tax on the amount that should have been withdrawn.

Retirement Accounts: Are you contributing to your retirement accounts at work or through your business? If not, then what are you waiting for? You may be losing out on employer matches and also tax savings. The simplest way to start is to contribute a small amount, such as 1% of your income and then increase the percentage over time. If you are already contributing to a retirement account, then try to increase your contributions.

Social Security: The biggest mistake with social security is the temptation to start receiving your benefits at age 62. Unless you have known health issues, the biggest risk is actually living too long and receiving a small benefit for the rest of your life. Let us know if you need us to talk you out of this!

No Action: This applies to absolutely everything and not just financial matters. By far, the largest mistake is not taking any action to help your financial situation. Don’t let this happen to you!