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Missed Fortune – Learning From the Mistakes You Didn’t Make

Posted on | October 14, 2012

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Pay Attention To the Forecast

The economic forecast isn’t good. With the expiration of the Bush tax cuts at the end of this year and the imposition of new taxes to shore up increased government spending, taxes will be going up. These tax hikes will affect all of us, not just the rich.

Even the Congressional Budget Office says that most middle income Americans will end up paying about 29.6% more in income tax in the next two to three years than what they paid just last year. But there are other reasons to keep an eye on the forecast.

Inflation will be higher than it has been in recent memory. And market volatility and uncertainty are expected to continue as well.

When making your plans for weathering tough economic times, there are a few key principles that must be understood.

The first is the marvel of compound interest. Imagine that we were out playing golf and were to bet 25 cents on the first hole and then double our bet for each of the subsequent holes. Our bet on the final 18th hole would be $32,768. This illustrates the power of compounding at work.

To truly realize the miracle of compound interest, there is another marvel that must be understood. Our compounding must take place in a tax-favored environment. This means tax-free accumulation and not simply tax-deferred such as in an IRA or 401(k). Tax-free will mean 50 to 100% more money than deferring those taxes to a later time, especially with tax rates on the rise.

Remember than a single dollar, doubling every period for 20 consecutive periods, will increase to $1,048,000 but only if it’s tax-free. That same dollar doubling for 20 consecutive periods in a taxed-as-earned environment such as a CD, a savings account or a mutual fund will only amount to $27,000. That’s enough of a difference to justify learning how to accumulate your money in a tax-free environment.

Even if you saved up a million dollar nest egg, by deferring the payment of taxes, such as in an IRA or 401(k), the IRS will take at least a third of that money. This leaves you with just $660,000 to call your own.

Many Americans mistakenly assume they’ll be in a lower tax bracket once they retire, but they later find out that, without the deductions they once had, they’re paying a higher tax rate than during their peak earning years.

The bottom line is that you can have more net spendable income by using a tax-free vehicle than if you use a tax-deferred one.

Don’t Make These Mistakes

There are six common mistakes that cause people to miss out on money that they could have been putting toward retirement planning.

  1. They use short-term investments for long-range goals.
  2.  They use long-term investments for short-range goals.
  3. They keep large amounts of money sitting in the bank earning 1% interest.
  4. They use “crawl” investments like CDs and money markets that crawl toward the finish line.
  5. Sometimes they use “walk” investments like annuities that keep them walking toward the goal of financial independence.
  6. They use IRAs and 401(k)s to save for retirement without recognizing that these are less than optimal ways to save.

Among the key flaws with many of these approaches is that they lack liquidity, safety of principle, tax-free growth, and a predictable rate of return.

Folks who think they’ll wait until age 70 and a half and then take the minimum distribution in order to save on taxes will have a rude awakening. They’re not saving on taxes; but simply postponing and delaying the inevitable. This strategy will dramatically increase the amount of taxes they’re going to pay in the end.

Better to get it over and done with by repositioning that money into a tax-advantaged savings vehicle, paying the applicable taxes, and then having that money be tax-free from that day forward.

Along those same lines, getting out of debt by sending extra principal payments to the mortgage company is not a safe or liquid way to go. Those who do this are earning a zero rate of return by using this approach. Likewise, those who take out a 15-year mortgage may be making a $100,000 mistake.

Getting better results requires being willing to stop following the crowd and to learn and apply the strategies that produce liquid assets safely earning a predictable rate of return.

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*Life insurance policies are not investments and, accordingly, should not be purchased as an investment

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