Missed Fortune – A Critique Part 2/5

[Editor’s Note: This is Part 2/5 of a critique of Missed Fortune 101, a book by Douglas Andrew.  If you’re not coming here from part 1, better go back and read that first.]

Don’t Contribute To A 401K?

Mr. Andrew isn’t completely unreasonable.  He does acknowledge that you should contribute to a 401K enough to get the match (well, most of the time) and that Roth IRAs are pretty cool.  But aside from the fact that he doesn’t understand effective tax rates on 401K withdrawals, he also glosses over several other issues when he recommends against retirement accounts.  First, he gets onto this idea that “tax rates are going up!”  Everyone seems to believe this (just ask around), but it isn’t always true.  Everyone believed it in the 1990s, then what happened in the 2000s –  the Bush Tax Cuts, which were just made permanent this year for the 99.4%.  Tax rates DON’T always go up.  But even if they did, thanks to the fact that effective rates are not marginal rates, it still isn’t a reason to avoid tax-deferred retirement accounts during your peak earning years.

Second, he places undue emphasis on the “Age 59 1/2 Rule.”  Sure, there’s a 10% penalty for taking money out of retirement accounts before Age 59 1/2.  But how many of us retire before that age anyway?  If you have a good reason to have that money, like medical issues, disability, college education, a house downpayment, or early retirement (using the SEPP rule), you can get it without that pesky 10% penalty.


Third, he makes the mistake of assuming paying less tax is the goal.  Less tax isn’t the goal.  The goal is to end up with the biggest stash of after-tax money.  If you pay the same rate upon withdrawal as you would save upon contribution, you’ll end up with the same after-tax amount whether you pay the (small amount of) tax up front or whether you pay the (large amount of) tax upon withdrawal.  It makes no difference whether you pay the tax on “the seed” or on “the harvest.”  It’s just as easy to pay $200K on $1M as $2K on $10K.  The only question you have to answer is whether your marginal rate upon contribution is likely to be lower than your effective rate upon withdrawal.

Fourth, he doesn’t seem to realize that Roth IRAs or 401Ks could be used for his “equity management” plan (more on that later) far better than any life insurance policy.  Roth accounts allow for all the upsides of “mortgaging your retirement” with none of the downsides of using life insurance.  To be fair, Roth 401Ks were not widely available when he wrote this book and Roth IRA contribution limits were quite a bit lower.  But based on what I’m hearing on the radio, he’s still advocating for the life insurance approach.

Fifth, he places too much emphasis on required minimum distributions as being some awful thing.  We’re talking about RETIREMENT money here.  You’re supposed to spend the money on retirement.  The RMD is 3.6% at age 70, 5.3% at age 80, and 8.8% at age 90.  That’s hardly some huge burden.  I guess maybe you shouldn’t put money into a 401K that you don’t want to spend in retirement.  Did you need me to tell you that?

Pull Your Money Out Of Your IRA?

The author spends a chapter or two explaining how to get out of the 401K/IRA “trap” or “dilemma”, i.e. that you’ll pay more tax by leaving your money in than by taking it out, paying the 10% penalty, and paying all the tax due over a year (or perhaps several.)  He likes to call this “the enlightened way” or an “IRA roll-out.”  This isn’t some new concept.  People do this all the time, especially in early retirement years prior to taking Social Security or in years when income is low.  But they don’t pay the 10% penalty, and they don’t put the money into life insurance.  They put it into something better- a Roth IRA.  If you’re going to pre-pay taxes on an IRA, I sure as heck wouldn’t do it to buy cash-value life insurance when I could avoid the penalty and put it into a Roth IRA instead.  In my opinion, this advice qualifies as financial malpractice.

Real Estate Always Goes Up?

Several chapters in the book were dedicated to developing an “equity management plan.”  Basically, stripping equity out (or better yet never putting it in) of your home(s) so you can invest it into universal life policies.  All the illustrations in the book are awfully favorable- home values only go up, and they do so at 5% a year (in fact at one point he brags about how his go up 7-8% a year.  I’ll cut him a little slack, since he wrote the book in the early 2000s prior to the real estate meltdown.  He is also very good to note that you should never strip equity (or avoid putting it in) to consume it, only to “conserve” it.  But when you run assumptions that don’t account for home values falling up to 75% as they did in Las Vegas during the meltdown, or for the more likely long-term appreciation rate (usually inflation or inflation + 1%), you arrive at the wrong conclusions.  For example, if you avoided putting $50K down on a $250K house so you could put it into a universal life policy, and then the house value went down 20% and you had to sell it a couple of years later to move to a new job, there’s no way you’re getting $50K back out of that policy to pay off the mortgage enabling you to sell.  The interest-only mortgages (and even negative amortization mortgages) that Mr. Andrew advocates for were one of the main reasons home owners got into trouble with the real estate bubble.  Leverage absolutely does work, but it works in both directions.  Mr. Andrew’s idea of a “401K Cabin” illustrates this idea perfectly.  He figured it was going to appreciate at 7.2% a year and in 30 years his $100K cabin would be worth $800K.  How’s that working out for you buddy?

Home Equity Has A 0% Return?

This one really irks me.  Equity doesn’t have a zero percent return.  That’s silly to think so.  The return might not be high, and you might be better off investing money instead of paying down your mortgage with it, but the expected return certainly isn’t 0%.  There are two easy ways to think about it that easily demonstrate this.  First, when you pay extra principal toward your mortgage, what is the return on it?  It’s exactly the same as the interest rate on your mortgage.  8% mortgage = 8% return.  If that mortgage interest is 100% deductible for you (more on this below), then you adjust the mortgage rate by your marginal tax rate to calculate your return.  If your mortgage is 8% and your marginal tax rate is 25%, then your return for paying it down is 6%.  That seems awfully different from 0% to me.  The other way to look at home equity is to consider your home as an investment.  If a $400,000 home rents for $2000 a month ($24,000 a year) and costs you $3000 in taxes, $1000 in insurance, and $2000 in maintenance and repairs, then the $400K investment yields a dividend of $18,000 a year, or 4.5%.  Again, a lot different than 0%.  Bad assumptions lead to wrong conclusions.

More bad assumptions to come tomorrow.  Save your comments for Friday.  You can find part 3 here.

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