Financial Literacy

Last month, people were meeting with their certified public accountant to file their income taxes. At this time of year, I hear all sorts of stories about advice being dispensed by CPAs to their clients. When his or her advice is outside of immediate tax consequences, their advice can be problematic. This is because of the goals and structure of a CPA’s focus. They usually have a goal of reducing this year’s income tax liability instead of the entirety of their client’s financial life. Instead of looking at a lifetime or more, the CPA is looking only at this year or next. Instead of looking at investment portfolio returns over decades, the CPA is looking at the immediate tax consequences of an investment. Instead of looking at a family’s actual financial behavior, they only look at tax tactics. The result of these mis-matching viewpoints can result in poor financial advice from some CPAs. Below are a couple I heard this year:

“You should make a maximum contribution to a new IRA to get a nice tax deduction.” If you review income tax rates over time, they are very low today and these rates are set to expire in 2026. Unless the Republican Party has the majority congress, senate, and presidency, it is unlikely these low tax rates will be renewed in 2026 and so they will go up. Now is the time to do the opposite and get long-term money OUT of tax-deferred accounts, not put money into them. Withdraw money (if you can avoid penalties when under age 59 ½) with today’s low tax rates and place that money into a Roth IRA or some other location that can be withdrawn later and tax-free when rates are higher.

“Whatever you do, do not pay down that mortgage!” Just because there may be some favorable tax treatment does not mean it is a smart financial move. Where would that money go if not to paying down the mortgage? In this particular case, I knew where it would go – to extra “bonus” shopping. Instead of building equity for more financial stability and options, the money would be spent at a shopping mall: not a good financial move. In another case that received similar advice from a CPA, paying off the mortgage would also be the smart move because it is how they manage their rental portfolio equity. Building equity faster would allow the couple to re-finance and purchase more units, ramping up their portfolio faster.

A CPA is knowledgeable and skilled with the tax code, but it does not mean they are all equally skilled with business, real estate, investing, financial planning, or wealth management. A CPA should be a part of your financial team but not your sole consultant for financial decision-making.

State-run investment accounts promote their 529 accounts as a tax-free vehicle for saving money for your child’s college tuition. These accounts are so problematic that I have never heard of a single success story. Two people I know claimed it was beneficial for them, until I went through the math to reveal that they were 18% worse off than if they had simply saved cash under their mattress. Last week, a relative with a 16-year-old in high school was bemoaning that he didn’t follow my advice and their 529 account keeps losing money.

Briefly, a 529 account is a college education savings program run by each state so no two plans are exactly alike. Although the investment gains can be free from federal and state income taxes, there are many rules on how and where the money can be spent (without penalties), and very limited selection of investment options. There are two types of 529 accounts, a savings program or a pre-paid program. In my opinion, neither of these programs are any good. Let’s go through some of the issues on why you should avoid 529 accounts in general:

1. It is a timing mis-match. If there is a stock market fall then it can take 10-20 years for stock prices to recover to their prior level. So unless you started contributing to the account 20 years before their birth and exit all funds with stocks the day that the child is born – you are in a structurally incorrect product. If there is a big stock market correction when the child is 8-14 years old, it is likely there won’t be enough time for the market to make up for these losses.

2. 529 investment fund options are a prison of poor-performing mutual funds. Mutual funds incur far higher fees than ETFs (exchange traded funds). 529 funds then add an EXTRA layer of fees onto these expensive mutual funds, so they always perform worse than what you could do on your own. Even the “stable fund” that only pays interest offers far less than what you can get on your own because of high expenses. Although 529 account costs have been moving down, they are still the highest-fee location for money.

3. 529 plans are a maze of rules that have been known to change each year. So unlike other financial products, such as life insurance or an annuity, you do not actually know what you are buying until it plays out over time. The whims of the state administrators (politicians and bureaucrats) have dramatically altered plan details over the last 20 years. When it comes to kids, education, careers, training, and timing – you and your family need the most flexibility; but a 529 account is the opposite of flexibility.

4. Only the state and school come out ahead with Pre-Paid 529 plans. The plan’s marketing claims that you are locking-in a tuition price now to save money from tuition price inflation; they are taking on the tuition price risk. However, I have NEVER seen this happen. Instead, either tuition will increase at a lower rate than expected (so you come out financially behind), or tuition will increase at a higher rate and they change the plan rules (so you also come out behind). Basically, the plan administrators will always change the rules so that they do not lose money – which means it is 100% certain that you will come out behind.

If these plans are not so good, what, in my opinion, may be better? Rather than go through the math modeling to prove it, if I had a child born today and wanted to begin saving for their college, this is what I would do:

1. Estimate the total cost of a 4-year degree from a potential candidate school, 18 years from today.

2. Divide that number by 19 years (mid-college age) to get an annual savings goal.

3. Then divide that number by 12 to get a monthly savings goal.

The result is the amount of money that I would put into a simple savings account with FDIC insurance. This way, the account would only ratchet upward with interest income. I would search for a high rate, usually from one of the online bank accounts, and re-check this once a year to make sure the account is earning a competitive rate (today, I’m earning 2.37% at MySavingsDirect). When it comes to saving or investing, the amount that you contribute is far more important than getting an unrealistic and spectacular return that is more likely to backfire. Another college savings candidate may be U.S. Treasury iBonds (these pay interest that is income-tax free and are paying 2.83% today).

It is my view that 529 plans are swamps with many dangers and drains for your money. The lure of saving a few bucks on income taxes is never worth the changing rules, poor investment choices, timing mis-match, and restrictive policies on your money.

When you begin living on your own and working your way into a higher income, one mis-step many make is to sign a lease on a great apartment that takes all your income. I know, you finally want to be in a hot downtown area with the great workout room, dog park, pool, valet trash, with a fabulous view. You got the nicest apartment you could find and at the limit of your budget. Too many renters discover too late that it was really too much money and later regret it.

This is the detrimental path after you’ve reached too soon for the high-end apartment in the hot area:

• The apartment consumes all of your income so your lifestyle spending goes on your credit card.
• Rent sharply increases year after year.
• You wake up in 5-10 years to discover that you are broke and cannot afford to renew your lease.
• You realize you’ve been sinking in rental quicksand with few affordable living options.

In growing cities, this quicksand was bound to happen from the start. Living in the hotspot is not cheap and if your income isn’t rising as fast as your rent is rising, then you are falling behind into serious financial struggle. When rent is consuming all of your income, you will have nothing for savings, nothing for investments, and nothing for retirement – with highly predictable financial troubles ahead.

You must save money every month while you have a chance while renting. If you had a home there are some large potential expenses: new carpeting, new roof or driveway, appliance replacement, etc. While you are renting, you have an opportunity to save the money that you would be using on these expenditures. In addition, anytime you are renting, you should set money aside as if you were an owner building up equity. You could start by saving 10% of your rent into a separate account and work toward raising the savings rate to 20%-30% of your rent. This way, you are creating and controlling your “housing equity” and building up a fund that can be applied toward a down payment when you are in a position to purchase your own place. Purchasing your own home/apt/condo fixes your housing expense while renters keep getting rent increases over the next decade or two. You do not want to be a continual renter and realize in your 50s that you have no savings, no home equity, and are struggling with rent increases. This financial situation can be equated to leasing a brand new car vs. buying a 3-5-year old car with low miles. Leasing is the most expensive way to pay for a vehicle while buying a used car with lows miles is the cheapest way to buy a vehicle. Renting your expensive apartment and leasing a new car is going to eat away your financial stability in large chunks each month. This can be fine in the short-term but financially destructive as a medium or long-term lifestyle choice.

There are two financial flywheels that you can add to your routine cycle of earning and spending money. One of them you want to avoid and the other you want to employ.

The Hamster-Wheel Cycle

This is the so-called rat race which consists of earning money and then quickly spending all of it. Since all of your earnings are spent, so there is no extra money for maintenance, saving, or investing. If you remain in this earn-spend cycle for your entire career, you will likely experience financial struggle and it may be very difficult to ever retire.

2. The Debt Flywheel

This is borrowing money in order to spend more than you are earning. The more money that you borrow, the more interest expense will be devouring your disposable income, leaving you less to spend. This is a negative flywheel, one that damages your financial life as long as it exists. As this flywheel grows in size, you are pre-spending more of your income and the more you’ll experience financial struggle. Simply having this flywheel makes your earn-spend cycle more difficult.

3. The Investment Flywheel

This is earning income from investments that regularly pay you income (interest, dividends, rent, etc.). By routinely feeding this wheel with new additions of money, and re-investing all of the investment income into more investments, your investment income will become an ever-growing flywheel. This is a positive flywheel, enhancing your financial life as long as it exists. As this flywheel grows in size, its investment income provides more financial options, more financial stability, and the possibility of an early retirement. Starting this flywheel is the most certain structure to break the earn-spend cycle. 

If you are having trouble saving any money to start or grow investment flywheels, then I offer the two easiest potential sources of funds:

• Cut your taxes. There are several types that you can actively minimize, such as income tax, sales tax, property tax, etc. and then save that money or use it to pay down debts.
• Cash back credit cards. Instead of using a credit card that provides airline miles or other non-cash benefits, search for a credit card that pays you at least 2% back in the form of cash.

Years ago, I assisted someone in setting up her investment flywheel in a tax-free retirement account (basically a fixed-income portfolio with auto re-investment). She just told me that her investment income is now increasing by $46 per month. She had not added any new money recently, her investment flywheel is compounding upward on its own, every month. So she receives a pay raise of $46 each month, and this raise becomes a little larger each month. It is my best advice to start and build your own investment flywheels. Even if you can only add just $20 a month to an income-producing investment, over time you will be improving your financial stability.

When taxpayers receive their annual Social Security Retirement Income statement (SSI), they look at the benefits page to see the monthly amount that they will receive. There will be a number for declaring your maximum SSI benefits at age 70, your full retirement amount around age 67, and early retirement at age 62. As exciting or disappointing as these dollar amounts are, the embedded assumption is that you will continue working until the day you file for SSI benefits, and that you’ll be earning an increasing amount of income each year.

This means that if you stop working any time before you file at those ages, then your actual SSI payment will be lower than that estimate. You can calculate what your real SSI payment will be by using the online calculators on the SSI webpage. Look up “Social Security Detailed Calculator” or it is on this page today: https://www.ssa.gov/oact/anypia/anypia.html

Your SSI payment is based upon the highest 35 years of your actual annual income. For example, if you stop working at age 60 and file at age 62, then you have two salary zeros for age 60 and 61. Those zeros will likely reduce the amount of SSI money you’ll be receiving compared to the estimates that you had been reviewing from your Social Security statements each year. One financial advisor wrote that a client approached him after she had retired at age 61 and filed at age 67. To her horror, she discovered that her SSI payment was $1,206 lower than the estimate on her SSI Statement. So, her retirement plan is short by $14,472 in income per year, plus the annual inflation adjustment. The grand total of missed income, if she lives to age 85, is $300,000 in cash payments during her retirement from her calculation misunderstanding.

When you are formulating your retirement plan and making critical decisions, do not:

• Wing it on your own (which most people do)
• Ask your company’s Human Resources department (which a lot of people erroneously do)
• Ask your brother-in-law, who is a stock broker or insurance agent (which never ends well)
• Definitely do not take any advice from Social Security Administration staff (they do not know your whole retirement situation, financial goals, or let alone all the SSI rules and nuances)

Only act on advice from a full-time professional that only does retirement planning. Get referrals first, interview many advisors to narrow them down, go over references, and then do all the homework you can up front yourself so you can ask intelligent questions and understand their financial language. Or you, too, may unexpectedly find tens of thousands or hundreds of thousands missing from your retirement.