Dump Your 401k

Dump Your 401k
Common Sense VS. Conventional Wisdom

 

Denver, CO - July 1, 2009 -

Americans are trapped by an economic model that treats conventional wisdom as common sense.
 
I define conventional wisdom (CW) as doing what everyone else is does and thinking what everyone else is thinks just because that is what they are doing and thinking.
 
I define common sense as simply being awake.  Common sense is paying attention to obvious realities and allowing yourself to be aware of what options and alternatives best serve you based on that reality.
 
Tax deductibility is an aspect of reality where we Americans have forsaken common sense to follow CW.  I'll explain what I mean, and then I'll give you an example.
 
CW tells us that we should contribute as much as we can to our 401(k) or its equivalent.  CW convinces us that we should at least take advantage of our employer matches in order to get the free money.
 
However, CW isn't concerned with how much we can afford.  CW doesn't provide guidelines that allow us to make informed decisions based on the common sense reality of our own lives.  Here's the case of Bob and Sally...
 
Bob and Sally have good jobs. Sally is a schoolteacher in a public system and Bob is a sales representative for a copier company.  Between them, they earn about $120,000.00 per year.
 
Sally and Bob believe they are doing the right thing by putting $10,000.00 each year into the mutual fund type investments in Bob's and Sally's defined contribution retirement plans (that includes the employer's matching contributions).
 
Since 1999, the amount in their retirement plans grew, shrank, grew again and shrank again.  They contributed $100,000.00 over the past decade and it is only worth about $98,000.00 today.
 
Their advisor wants to convince them that they should stay the course because in the long-term they will see the gains.
 
Here are other realities facing Bob and Sally that aren't apparent from the facts we've seen so far.

• Bob drives a new SUV and Sally drive a relatively new sedan.  Both are financed.  They owe about $50,000.00 on the two cars and have payments of over $1,200.00 per month and much of that is interest.  The insurance on the cars amounts to $250.00 per month.
• Bob and Sally each have their own credit card.  They use them to pay for vacations, purchases such as TV's and appliances, and entertainment.  They owe a balance on both credit cards.  The balance is just over $20,000.00.  The interest rate on the cards averages about 18%.  Each month they pay more than the minimum, but they tend to spend more than they pay and the balance they owe is increasing slightly each month.
• Bob and Sally have a $400,000.00 home with a conventional thirty-year mortgage for $320,000.00 at 6% interest.  Their payment of $2,500.00 includes taxes and insurance.
• Sally and Bob owe $32,000.00 on an equity line of credit also.  They used it to build a home-theater and finish their basement.
• Bob and Sally also follow CW and have an emergency fund of $40,000.00 in a savings account.

From the perspective of CW, Bob and Sally look pretty normal.  However, if we deconstruct their personal economy with the sledgehammer of common sense we'll discover another way of looking at their condition that makes more sense.
 
On the first venture into awareness, we can see that Bob and Sally's total debt is $102,000.00, excluding their mortgage.  Amazingly, their debt exceeds their total investment in their retirement accounts over the past decade.  We can also recognize that it is greater than the assets that remain in their retirement accounts.  One does not have to have a degree in logic to realize that the money they borrowed ended up funding those retirement accounts.
 
Moreover, their retirement accounts earned a negative rate of return over the past decade.  Worse, the interest on the money they borrowed averaged more than ten percent each and every year.  What does that mean?  It means that the retirement accounts would have to earn much more than ten percent in the future just to catch up to and to break even with the cost of the debt that Bob and Sally used to fund the retirement accounts in the first place.
 
If common sense considers the cost of borrowed money over that same decade, the picture becomes bleaker.  Bob and Sally shelled out almost $72,000.00 in interest payments in addition to creating more debt and experiencing a negative return on their invested money.
 
When you calculate the total, Bob and Sally used $174,000.00 to build an emergency fund of $40,000.00 and put $98,000.00 in their retirement accounts.  Even though the contributions to their retirement accounts allowed them about $25,000.00 in tax savings over the same period, they still end up in a negative position.
 
How about an alternative common sense approach?

Bob and Sally could have paid $10,000.00 each year as participating whole life insurance premiums[i] instead of opting for employer matches and tax deductions.  At the end of the period, the cash value of the policies would have been about $128,000.00 - $30,000.00 more than the retirement accounts...so much for the tax deduction.
 
Here's more.  Remember the $72,000.00 Sally and Bob paid in interest to banks?  By borrowing against the cash value of their life insurance policies and repaying those loans on the same terms they would have had to repay any other lender, Bob and Sally would have redirected interest back to their own policy and reduced and/or eliminated interest payments to others.  That would have saved tens of thousands of dollars.
 
In addition, Bob and Sally put $40,000.00 aside in an emergency fund.  If they added that money to the participating whole life insurance premium, the cash value of the policy would increase to about $180,000.00.
 
Consider also that Bob and Sally do not need permission to access the money in their policies.
 
Then again, Bob and Sally pay no penalties or taxes when they borrow money from their policies.
 
Here's another coup - growth of the money in Bob and Sally's policies is tax deferred, the same as in retirement accounts.  We know that the IRS taxes the income from retirement accounts.  However, Sally and Bob, with the help of their insurance and financial advisor/guide, can receive tax-free income from their policies for life.
 
There's a whole lot more, but that's all for today...except...
 
If Bob and Sally put their money into participating whole life policies...
 

• Both Bob and Sally would continue to drive new cars financed for about $50,000.00.  However, they would redirect the monthly payments of $1,200.00 back to their life insurance policies and would replenish the equity in those policies for use again in the future.
• Bob and Sally would continue to have credit cards for vacations, major purchases, and entertainment.  However, the balance on the credit cards would revert to $0.00 at the end of each month, and the 18% interest rate on each card would be irrelevant. 
• Bob and Sally's $400,000.00 home would still have a $320,000.00 conventional thirty-year mortgage at 6% with a payment of $2,500.00 including taxes and insurance.  However, in another few years, Bob and Sally would have enough money in their whole life policies to repay the mortgage and begin repaying themselves by redirecting the interest to their policies.
• Bob and Sally would not owe $32,000.00 on an equity line of credit that they used to remodel their basement.
• Bob and Sally would still keep about $100,000.00 cash in their policies as an emergency fund.

Conventional wisdom is not wisdom at all.
Investing in retirement plans (or anywhere else) is not saving.
 
Tax deductibility is a trap.  Don't fall in.

 

By Jeffrey Reeves MA