Monday, August 10, 2009

You’ve Got to Be KIDDING!

You've Got to Be KIDDING!
That statement is in reference to this recently published New York Times article about a retirement boot camp run by two investment advisors who are partners in a financial advisory practice.
As you are already aware if you read my blogs regularly, I do not make a practice of engaging in any personal attacks, whatsoever. I commend good work, but I also challenge what I consider to be incorrect guidance that will not serve people well.

After many years as a financial strategist specializing in retirement planning, it is my very strong opinion that these two advisors are giving preposterous advice to the people attending their boot camps.

At Least We Agree on Something!
Well, we agree in part, anyway – to the position that retirees' expenses tend to increase, rather than decrease. But, in the cases I have encountered, that has extended past just the first two years. So many people are made to believe that because they are retired, they will spend less. By whom? Financial professionals who sell them qualified plans. Read the blog I posted on April 20, 2009, for my real-life experience.

One of the claims these boot-camp leaders make is that people must pay off their mortgages: “That’s a non-negotiable must-do before retirement.”
Damn it, have they any idea that to do so means the retiree's ability to receive mortgage interest deductions under Internal Revenue Code (IRC) section 163, will be completely eliminated?! Has it ever occurred to them to wonder why wealthy people still have mortgages? The average millionaire has only 11 percent of home equity – meaning their home is mortgaged at 89 percent.
I'm guessing that part of the boot camp goes something like this: “Um, you must pay off your mortgage because we do not want you to have to pay any interest. It is a stupid expense that must be eliminated!”

Which means they probably have no idea of the very simple financial principle called arbitrage: so far as a debt nets you a positive cash flow and increases your net worth, you should take on as much as is possible for as long as you can. These gals' practice is part of the Wells Fargo product offering, which interestingly enough exists today because of arbitrage. Amazing, isn’t it?

Let me put this way: Instead of – wrongly – teaching people to think about how much interest they are paying with their mortgage, smart advisors teach their investor clients to look at what they are simultaneously giving up – earning interest – by eliminating their mortgage.
If you are still not convinced that it may be a very bad idea to pay off your mortgage early, you might want to check out the August 2006 report issued by the Federal Reserve Bank of Chicago, “The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings,” in which they conclude that by accelerating their mortgage payments instead of saving, homeowners are “making the wrong choice.”
I cannot help but wonder how those folks who paid off their homes because they believed this completely misguided advice feel now, after watching the collapse of the real estate market eat away all those hard-earned equity dollars over the past couple years.
401(k)-Type Plans?
More advice from the boot camp leaders: “What we are doing is essentially moving money from their nonqualified accounts to their qualified accounts.” Their reasoning? Retirees generally tend to fall into lower tax brackets.
This is an unbelievable and antiquated thought process. While almost every thinking person is looking for ways to make their income tax free by shifting to nonqualified accounts, some advisors are advocating the exact opposite. I meet retirees almost daily who followed this kind of porous advice – and although they have reduced their total income, they are being clobbered with taxes.
Most so-called financial experts do not understand the simple fact that taxes are calculated based on “taxable income,” and it is perfectly possible – and happens more often than you would ever think – to have a lower total income but the same or even higher taxable income. See the quick example below.

You see, when you have no dependents to claim, no qualified contributions, and no mortgage interest to leverage, thanks to bad advice, your taxable income is more likely to be in trouble.
If you live in this country and think that, for some reason, it is a good idea to postpone paying taxes until you're retired because you're hoping for lower tax rates at that time, you’re fooling yourself. The responses to this NYTimes story were so overwhelming that further comments were soon shut down. One of the comments on the story, however, sounds more like real-life to me, as a financial strategist:
My wife and I have been retired for a number of years, taking distributions from our retirement accounts and collecting social security. Taxes are a huge concern. We don't feel as if we are spending a lot, but we are in the same tax bracket as when we were working. Now, we don't have all those deductions any more. It helps that social security and $20K for each of us in retirement account distributions are not taxed by NYC/NY state. But the federal tax on distributions has me wondering. True, we got a tax deduction and company match when we made those contributions. But all the years of capital gains and dividends are being taxed at high ordinary rates. I would think twice about putting $44K a year into a retirement account, as your article suggests.
I say, “Bingo! That’s the real-life situation. No further comments.”
“They don’t need as much life insurance (if any at all)”
That’s what these financial advisors, and others just like them, blindly claim. All I can say is that I am really sorry for people who fall for such short-sighted advice. I would encourage these advisors and those like them to familiarize themselves with the IRC, Sections 72(e), 7702, and 101 and stop helping their clients waste money in unnecessary taxes.

Why in the world would they defer very simple tax estimates (like potential taxes on a taxable income of such-and-such dollars) to accountants? I know they are not tax people – but that’s not the issue here. We’re not talking about the rocket-science of tax law. Every year, the IRS publishes tax thresholds for various taxable incomes. Using a simple calculator, an ordinary citizen can get just a general idea of what he or she will owe.

In fairness, I’d like to suggest that these boot camp gals include a new, really simple ninth module.

Let's go with their own example, used in the story, of a couple making $150,000 per year. Let's make two simple assumptions: they max-fund their 401(k)s with $44,000 and have a deductible mortgage interest of $14,000 per year. With all other things remaining constant, they would have a taxable income of $92,000 ($150,000, less $44,000, less $14,000). Based on 2009 brackets, the tax liability on a $92,000 taxable income is approximately $15,375.

Now, fast forward to their retirement. They have a reduced income of 70 percent of their pre-retirement income, which is now $105,000. Their taxable income, with no mortgage interest deduction (thanks to the boot camp advice) and 401(k) contributions, is $105,000. Using the same 2009 bracket, their income tax would be about $18,625.

And remember that since the 401(k) is considered “portfolio” income, it may expose up to 85 percent of their Social Security benefits to income tax as well. Weird, huh? You don’t have to be an accountant to own a calculator and be able to get a general gauge of your potential future taxes.

Read that retiree’s above comments again. That sounds a lot like the kind of issue I have to help my clients dig themselves out of on a daily basis. If you are facing similar challenges, please call our office at (301) 949-4449 or click here to request a FREE consultation. I will do my best to personally consult with you if you contacted us because of this blog.

An Open Invitation

I went to the NYTimes website to voice my strong dissent to the advice being dished out in this article, but was unable to do so because after just 21 comments – most of which were critical – the newspaper closed the comments section. You have to wonder why, in this day and age, that would happen. But I did not give up. I phoned and spoke with a person who promised they would get their boss to have the journalist call me back. Unfortunately, this has not happened yet.

Here's my invitation. I would personally love to publicly debate these boot camp investment advisors, or any other advisor/expert following this misguided school of thought and espousing that people should max-fund qualified plans, pay off their mortgages quickly, and cancel their life insurance in retirement.
Any way you look at it, this advice is simply WRONG! WRONG!! WRONG!!!

1 comment:

  1. I retired 3 years ago and my situation is similar to the guy in you quoted. All we know and were told about is what we followed. But I guess that does not mean we were told about what would be best for us.

    I think your break down makes sense and we need to change our plans -if it's not too late.


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