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Missed Fortune – Moving With Confidence Through a Rough Economy

Posted on | September 16, 2012

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The Forecast Calls for Higher Taxes

The economic forecast isn’t encouraging. The Bush tax cuts are set to expire at the end of this year and new taxes will likely be levied in order to shore up increased government spending. To put it bluntly, taxes are headed higher than ever. These tax hikes will affect every U.S. taxpayer, not just the rich.

The Congressional Budget Office predicts that middle income Americans will be paying about 29.6% more in income tax in the next few three years than they paid just last year. But there’s more bad news in this forecast.

Inflation will be higher than it has been for the past 20 years. And market volatility and uncertainty are also expected to continue.

Before we examine into the best likely solution for riding out tough economic times, we must understand a few key principles.

The first principle is the marvel of compound interest. If you were playing a round of golf and you bet 25 cents on the first hole and then progressively doubled that bet for each of the next holes, your bet on that final 18th hole would be $32,768. This is the miracle of compounding at work.

But in order for the wonder of compound interest to be fully realized, there is another marvel we must understand. This compounding should take place in a tax-favored environment. This means that the money grows tax-free instead of simply tax-deferred such as in an IRA or 401(k). Tax-free can mean 50 to 100% more money at retirement than if we put off paying those taxes to a later date where we anticipate being in a lower tax bracket. This is a big gamble, especially with tax rates on the rise.

Remember that a single dollar, doubling every period for 20 consecutive periods, can grow 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 like a CD, a savings account or mutual fund will only amount to $27,000. That difference alone should justify learning how to start your money accumulating in a tax-free environment.

Even if you build up a million dollar nest, with deferred taxes, like those in an IRA or 401(k), the IRS will be claiming at least a third of that money in taxes. That leaves you with just $660,000 that you can actually spend. And remember, that’s not even taking inflation into account.

Too many Americans assume they’ll be in a lower tax bracket after they retire, but then 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.

Stop Making the Same 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 understanding that these are not the best way 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 plan on waiting until age 70 and a half and then taking minimum distribution in order to save on taxes are in for a rude awakening. They’re not saving on their taxes; you’re simply postponing and delaying the inevitable. Such a strategy will dramatically increase the amount of taxes they’re going to pay in the end.

They could have got it over and done with by repositioning that money into a better savings vehicle, paying the applicable taxes, and having that money be tax-free from that day forward.

By the same token, 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 have a 15-year mortgage may be making a $100,000 mistake.

To get better results than you’re currently getting requires being willing to learn and apply the proper strategies to make that happen.

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

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