Monday, August 15, 2011

Financial FICTION #4: Investments with high gross returns will automatically generate the most income

Financial FICTION #4: Investments with high gross returns will automatically generate the most income for you to spend.

This is one of the most unassuming yet deadly – if not the deadliest – mistakes that scores of retirement investors make, some under the guidance of financial advisors. Let me explain.

It’s no secret that everyone would like their investments to make the best possible gains, and to a very large extent, the rate of return on your investment contributes to that. However, the fact some seem to miss is that much, much more is involved than just your returns. By way of example, let’s say that you are faced with choosing between two investments, A or B, with potential yearly gross returns of 8 and 7 percent, respectively.
If you were to select Investment A over B, without first examining the costs associated with each of these alternatives, you might be making a terrible mistake because there are costs associated with investments, and those costs can significantly affect the final return. I must note that in the instance where all things are equal and both of these investments cost exactly the same, you would be correct to choose A over B. The thing is, that almost never is the case in reality. For the sake of this discussion, let’s assume that is the case, and the cost associated with both investments happens to be 1.5 percent a year. Investment A would therefore net 6.5 percent (8 minus 1.5) versus Investment B’s net return of 5.5 percent.

Now, get ready to learn what the overwhelming majority of conventional advisors completely disregard, which in turn leaves at a disadvantage countless numbers of hard-working folks who are simply trying to plan comfortable retirements.

All we have done up to this point (which is where most advisors end their analyses) is consider which of these two investments will accumulate the largest actual balance in your account. However, common sense tells us that you should really be focused on how much of that literal balance will actually belong to you to spend when you need it, and/or how much your heirs will actually get to spend when all is said and done. We’re talking about income taxes here.

The thing is, you will do your retirement lifestyle little justice if you do not factor in the tax efficiency of these investment options. If you think about it, taxes reduce the amount you will actually get to spend or leave behind, so NOT factoring them into your decision process is a rather unfortunate mistake. I can’t even begin to tell you how many folks sit across the desk from me on a daily basis who can’t believe that such an obvious thing could have eluded them for decades. Not to mention their vast disappointment to learn the results of this oversight.

Let’s pick up on Investments A and B, and say that A is a taxable investment, but B is a tax-free investment. So when you access your money from Investment A, you’ll need to pay income tax at the current rate; however, that is not the case for Investment B. Just to be clear, there are investment options in the U.S. Tax code that are completely and absolutely income-tax free, so I’m not discussing fantasy here. Now, assuming a combined (federal and state) marginal tax rate of just 25 percent, Investment A’s net-after-tax return would be 4.9 percent (that’s the after the 6.5 cost, minus 25 percent tax, which is 1.6). Remember, Investment B only netted a 5.5 percent return, but there’s no tax liability on it. Given the choices now, it’s pretty obvious, isn’t it? You’d want to go with Investment B, once you realize how we got here.

Now you understand why it’s so crucial that you factor tax efficiency into your choice of investments if you ever plan on retiring. By the way, I understand that there are always unknown variables in these kinds of evaluations, but that’s no excuse not to factor in tax efficiency, and those variables must not be confused with unrealistic expectations and/or assumptions.
Contact a financial professional at Laser Financial Group TODAY to schedule your confidential, completely complimentary – as in NO strings attached – appointment. We'll help you examine which investment options make the most sense for you, both in terms of returns and tax efficiency. 301.949.4449 or

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