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In This Issue: Resolve To Save, Or Live In SUV Battle Boredom With Small Caps Flex Facts: Tax Free Parking & Commuting
Resolve To Save, Or Live In SUV by Stephen J. Butler Willie Brown, the mayor of San Francisco, reflected an all-too-popular sentiment about money when he once said, "If you can't wear it or drive it, why own it." The late columnist Herb Caen was a good friend of the mayor's who also pointed out that Brown, for all of the political power he had wielded over the years, had few financial resources to show for it. Of course, in honest politics, this is the way it should be, and we should all be thankful that the mayor of San Francisco doesn't appear to have piled up any money. By comparison, a citizen of Miami once misunderstood when told that the mayor of that city was paid only $25,000. They replied, "He paid only $25,000 for that job? It's worth at least $250,000." A recent report from the National Bureau of Economic Research indicates that the rich have no money. Seriously. An extensive study illustrates that many high-income families have saved little or no money for retirement and that they own little wealth beyond just the equity in their homes. Paradoxically, many low-income households have substantial wealth. To the extent we should all be considering some New Year's financial resolutions, there may be a lesson in this research for all of us. Or, as our therapists might say, "Let's look at that." The fact that many people make a lot of money and save nothing should not come as news to us. What is remarkable is the extent to which this happens. It is like an epidemic. A recent popular book is "Rich Dad Poor Dad" by Robert Kiyosaki. This book illustrates the difference between a typical, well-educated management employee or professional versus a self-educated, street-smart entrepreneur who lives frugally and develops a successful business. The difference is overstated to make a point, but the bottom line is that a sense of entitlement affects the judgment of the person who has the tools to function well "within the system." They tend to spend what they make and are not inclined to sacrifice and save. The entrepreneur
or tradesperson who exercises financial discipline will An earlier book, "The Millionaire Next Door," by Thomas Stanley and William Danko, illustrated the same point but with more statistics and hypothetical examples. They even show which immigrant groups have been most successful at accumulating assets and what automobile the true millionaire is inclined to drive. For my part, I have spent the last 20 years setting up retirement plans for primarily small, closely held companies. This has provided me with first-hand exposure to a significant number of those "millionaires next door" who have socked away fortunes as a result of the prudent financial management of every-day companies. In my experience, few of the most successful had MBAs or the benefit of inheritance. The authors of "The Millionaire..." come to the same conclusion and back it up with statistics. The NBER paper is entitled "Choice, Chance and Wealth Dispersion at Retirement." This Herculean effort to identify the extent of the problem offers each of us an opportunity to determine how badly we have failed to prepare and to see how we compare with our respective income groups. The study divided all Americans up into 10 deciles based upon total lifetime incomes. It then compared how much had been saved, on the average, by each of the 10 groups. In the highest-paid group, 10 percent had saved nothing. The bottom 20 percent of each of the other nine groups had saved nothing or had negative net worth. If you've managed to save anything, regardless of your income, this report can make you feel pretty good. At least you're one up on 20 percent of your peers in your income group. Chance events like inheritance and/or the costs of health problems have been factored out of the statistics. Different investment success levels have been left in but have proven to have minimal effect on overall results. In the end, it all boils down to self discipline. The ability to do without today's gratification and to save for the future is what determines what people can successfully salt away. The study clearly shows that earning more money doesn't necessarily increase wealth. In our own experience, how much of any salary increases have we managed to religiously save and invest? So, here we are, finally, in the new millennium. It's time to take off the gloves and imagine that we're in basic training with a tough drill sergeant. A reader has written that he is 50 years old, self-employed and has $25,000 in an IRA. He wants to retire at 65. He will be able to get to the highest quadrant of his lifetime income peer group, but it will take some sacrifice. At a 10 percent average annual rate of return (the stock market average) his $25,000 should double twice in fifteen years to $100,000. Then, if he deposits a tax-deductible $10,000 per year into a retirement plan for himself (at a take-home pay cost of only $5,000 on the last $10,000 of gross taxable income) he will have another $325,000 in 15 years. Now, we're talking about serious retirement money approaching $500,000. Almost anyone can change some buying habits and save an additional $500 per month. For the self-employed who pay both employer and employee social security taxes, their tax rate starts at almost 15% percent before they even think about federal and state income taxes. This is why a tax-deductible $10,000 costs only $5,000 of what would have been spendable income. Moreover, the new maximum retirement plan contribution will now be $40,000 per year for self-employed people. It pays to put in those extra hours. If my reader has some good years and operates more profitably, he could easily contribute more than $10,000 and reach something closer to $1 million for his retirement nest egg. The most important benefit from cranking up the savings quotient is the message it sends to our children. Both books mentioned above are really about the lessons that children need to be taught about money. However, if our own feelings are conflicted in any way, the books may be helpful. We may learn more about our own attitude toward money by reflecting on whatever lessons we've been taught. If the message was along the lines of "if you can't wear it or drive it, it's not worth having" then we may be living in our SUVs at retirement.
by Stephen J. Butler Years ago, when my mother wanted to make a point, she would clip something from the newspaper whenever possible to provide the authoritative "third-party" source for her advice. Looking back at that subtle form of manipulation, I think it can be a more effective tactic than direct confrontation. With the holidays just around the corner and young people getting together with parents, I thought I should update my "Advice for Young People" column in hopes that it may lead to scintillating conversation during commercial breaks. A young person new to the work force needs to be coming to terms with six basic issues:
And, finally,
First, you need to understand taxes. A surprising number of life's decisions hinge on a basic understanding of marginal tax brackets -- what you pay in taxes on the last few dollars of income. Yet, the average young person (and some older wage-earners) are clueless on the subject. The average single young worker in California makes enough so that the last few dollars of income are taxed at least 25 percent. People make the mistake of taking total taxes paid and dividing by total income to estimate their "tax bracket." It may be that you pay as low as 10 percent or 15 percent of your total income in taxes. For most decisions, this percentage is meaningless. Why? Because most financial decisions bump taxable income up a little or down a little. We take a new job, or stay put for a $200 per month raise. A raise, by definition, is the last few dollars of our income. It will be taxed at the highest level of taxes we are charged. If you create a tax table that combines federal and state income taxes with Social Security and Medicare taxes, it will show that a single person's adjusted gross earnings that fall between $26,000 and $36,000 per year are taxed at 42 percent. Any dollars over $36,000 are taxed at more than 45 percent, and it just gets worse after that. This explains why, when we receive a raise, our "take-home pay" rises by far less than what we understood to be our gross increase in income. Young married couples experience the infamous marriage penalty. Married couples must combine their incomes for tax purposes, which means that a couple's combined adjusted gross income that falls above about $44,000 will be taxed at 42 percent. If a couple with one working spouse makes $44,000 and the other spouse decides to go to work, the additional income will be taxed at a staggering 45 percent. Why do taxes work this way? The federal government seeks to collect an average of about 17 percent from all of us. However, on the first $20,000 or so, they collect very little because the rate is low and there are many exemptions. If they get next to nothing on the first $20,000, they need 34 percent or more on the remainder to reach an average 17 percent. That's why all the talk about a flat tax hammered on 17 percent as the magic number. Then, we have to add state income and Social Security taxes. As I said, many decisions in life add or subtract to total taxable income. An informed decision needs to consider how much of that additional income will disappear in taxes. Or, conversely, how much of this tax-deductible (income reducing) expenditure or investment will be paid with money that would "otherwise" have disappeared in taxes. When we contribute to 401(k)s or IRAs, we remove from taxable income the last few dollars that would have been taxed at the highest possible rate. When we pay house payments instead of rent payments, we reduce taxable income because mortgage interest and property taxes are tax deductible. Rent is not. When we take a new job because it pays $5,000 more a year, we need to know that, after taxes, we will probably only have an additional $3,000 of spendable income. That $5,000 gets taxed at the highest possible rate. If your income drops because you cut back on work hours to go back to school, you may not be giving up that much after-tax income. What you gave up were those last dollars taxed at the "confiscatory" rate we have been talking about. When you calculate taxes this year, experiment with a few hypothetical income levels and see for yourself how much you pay on the last few bucks you earn. Remember to include all four taxes: federal, state, Social Security and Medicare. Owning a home creates tremendous tax benefits and financial leverage. In a simple example, the down payment of $20,000 on a $100,000 condominium buys an asset that could double in value over ten years if it appreciates at a rate of 7 percent per year. Ten years later, you sell the condo for $200,000 and pay back the $80,000 mortgage. You can keep the entire $120,000 profit you just made on your $20,000 down payment. Moreover, you do not pay taxes on this profit if you use the money to buy your next house. Meanwhile,
if you can afford $1,000 per month in rent, you can now afford
$1,500 in house payments, because $500 of that $1,500 will be
paid with money you are otherwise paying in taxes. House payments,
in the early years of a mortgage, are almost entirely tax deductible
because they consist of interest and property taxes. They reduce
your income for tax calculation purposes. In this example, a
couple that pays $18,000 a year in house payments is saving
at least $6,000 in income taxes. In other words, the government
is effectively paying $6,000 of your annual house payment. Figure it this way: $600 per month for 40 years at 12 percent builds to $7 million. A $600 contribution will cost most people about $400 in take-home pay, because $200 of the $600 is money that otherwise would have disappeared in taxes. And, $400 a month is less than the lease and insurance payments on a new car; keep the "clunker" and in just 10 years, the $600 per month will have accumulated to $140,000. How do you invest this money? It doesn't matter. Forty years of time will correct any mistakes you make today. Any strategy that includes a mix of common stock mutual funds will work fine. Just do it. In fact, pray that the market plummets. When you invest regularly each pay period you are dollar-cost averaging. This mechanism keeps us buying stocks automatically at bargain prices during a downturn. Need money to go back to college or graduate school? Wait until you begin the calendar year during which you will not be working, and consider living on a portion of your retirement money. You will pay a penalty on what you spend, but if you're back in school full time, it will be your only income in that calendar year, and your tax will be minimal. Just don't take any more than the subsistence income that student life dictates. When it comes to health insurance, moving from job to job and/or back to school leaves you dangerously exposed to the possibility of no coverage. Nobody in America today can afford to be in this situation. The trick is to get a cheap, high-deductible policy, because the cardinal rule of smart insurance buying is to never insure something you can afford to pay for yourself. We can all somehow manage to round up $2,000 to pay medical bills, but $50,000 to $500,000 for a real serious illness or disease would wipe us, or our parents, completely out. On the Web site www.ehealthinsurance.com there are policies available with high deductibles (the amount you would pay) but beyond the deductible, the coverage is extensive, with low premiums in the $20- to $30-per-month range. For older employees with families, this approach is a good alternative for covering dependents in situations where the employer does not pay for dependent coverage at the prohibitive rates of the company group health plan. With insurance rates increasing by 25 percent or more this may be a good time to evaluate this option. A final piece of advice. When you watch the dimes, the dollars take care of themselves. Small amounts of daily expenditures become big ticket items over time. Don't get me started on the costs of bottled water, coffee at $1.50 per cup, $8 movies and all the other opportunities to spend unnecessary amounts adding up to $500 per month or more. Saving $10 per day adds up to $3,650 after-tax dollars per year. This allows us to afford about a $5,000 pre-tax 401(k) contribution! Writing
down every dime spent is one of the first defensive moves against
runaway spending habits. Learn how to create and stick to a
budget. Money is a way to store energy. If you understand it,
spend it wisely and save it up, the day will come when you can
use that "energy" in place of having to work for a
living.
Battle Boredom With Small Caps by Stephen J. Butler Tom Wolfe, the novelist, pointed out in a recent essay that kids who supposedly have attention deficit disorder have no trouble playing videogames for hour after hour. These kids (most are boys) may pose problems for teachers and parents, but Wolfe suggests that the issue is not caused by an inability to concentrate. Speaking for an earlier generation, Johnny Carson described his problem as one of having "a low threshold of boredom." Boredom is a real factor for investors. The stock market of the 2000s has lost the entertainment value and stimulation it provided in the 1990s. It was marvelous fun to invest in Cisco, Lucent or a growth-oriented mutual fund -- or even an S&P 500 index fund -- and watch these investments double and triple over short periods of time. Now, we can barely stand to open the statement envelopes or boot up the computer to check our balances. The only funds doing well are the same value funds we shunned back when they were losing money and their managers were being ridiculed or fired. There were articles suggesting that the ultimate value investor, Warren Buffett, had "lost it" and that he "didn't get it" when it came to the new economy. Value funds are indeed boring. The investment world's answer to ice fishing leaves us fidgeting in our seats. Value investing means locating companies that have hidden value and then waiting, sometimes years, for a stock's price to rise. Buffett has said that his ideal holding time "is forever." In contrast, growth funds seemed so exciting. They offered instant gratification because you were effectively a "momentum" investor. You bought a stock (or your mutual fund did) because it was already going up in value. This created a self-fulfilling prophesy. Everyone of the growth fund persuasion had screening software that would identify the same fast-moving stocks and the feeding frenzy was launched. Herman Melville, in Moby Dick, describes how sharks eat captured whales by taking bites "the size of human heads." The analogy fits our more recent experience with growth funds. Those who long with nostalgia for the better times of growth funds will likely find it first in the small capitalization company arena. Small companies traditionally have lead the market out of declines because they can outmaneuver larger organizations. Small companies can cut back expenses quickly when times are tough. There is a greater cause and effect relationship between employees and the product or service for sale. In large companies, by comparison, the situation was described best in the 1950s-era classic, "The Man in the Gray Flannel Suit." The prevailing fear in the life of a large company manager was the discovery that he (and they were almost all men) didn't do anything of value. GE's Jack Welch made the fear come true when he insisted that all GE departments fire the least valuable 10 percent of their employees each year. In establishing what became the most difficult career demand for surviving managers at GE, Welch made the company an engine of success. Companies like GE and Tyco International have demonstrated this ability, but most big outfits lack the organizational discipline. A director of a major paper company once dismissed the success of a competitor by saying, "All that those people care about is profits." In smaller
companies, the cause and effect between employees and profits
is hard-wired. Lacking that sea of money on which big companies
float, small companies have dramatically less margin for error.
This explains why small cap stocks historically have lead the
stock market out of a decline. In just the past month, as a
matter of fact, small company funds have increased by about
5 percent. If you are bored with market performance and looking for a return to the stimulation of the Roaring '90s, it may be time for moving money into small-company growth funds. These are the ones that have taken the biggest beating over the past 18 months. The cyclical trends are in their favor. Also, they offer an opportunity for those investors who re-balance their portfolios periodically. These small company funds, if we had them at all, now command a smaller percentage of our portfolios than when they enjoyed so much attention at the end of '99. There are good no-load small-cap funds offered at low costs by such reputable institutions as Vanguard, Schwab and T. Rowe Price. Re-balancing, remember, is a form of dollar-cost averaging. To sell what has been a winner and buy what has languished is a strategy that can reduce risk and improve performance. A rule of thumb also says that the time to buy last year's best-performing fund is two years later. When it comes to small company funds, we're almost there again. The nice
thing about being adults is that we don't have to sit quietly
in our seats. If we get bored, it is perfectly acceptable to
act out and invest in some small cap funds or even a technology
fund. Whatever turns us on. It may take longer than we can comfortably
stand, but these small company funds will rise again.
By Rich Eaton Spending
Wisely Pay Yourself
First Get a
Life Look
At It This Way
by Rich Eaton Understand
Each and Have Both
This column focuses on the savings component of your wealth building program. Savings programs provide money for emergencies, a source of living expense if a job is lost, short term goals such as a down payment on a house or car, and so on. The general rule is that you should always have at least 6 months’ living expense accumulated in savings to provide a measure of financial security in hard times. As you will see from the rates, savings programs are definitely not wealth builders. Bank
Savings Accounts Certificates
of Deposit Bank
Money Market Accounts and Money Market Mutual Funds
By Rich Eaton INDEXES Fixed
Mortgage Home Equity Loan – 7.1% New Car, 48 Month Loan – 7.05% INTERNET
SITES www.lendingtree.com DOW JONES
AVERAGES
Flex
Facts: Compliance Corner by Michelle L. King Many employers are being told that they can set up a plan whereby they take a deduction from employees' pay to cover monthly premium costs. The deduction is taken before any income taxes are calculated. Then, the Employer reimburses the employees for the premium deduction amount on a tax-free basis. This sounds like a great plan, because the employer will save payroll taxes and the employee will get their premiums covered with tax-free dollars. Although this sounds very similar to a Flexible Benefit Plan or a Premium Only Section 125 Plan, it is just different enough to cause a compliance problem. These plans are marketed as a way to take advantage of Internal Revenue Code Sections 105 & 106, the problem is that this plan design negates key components of both code sections. If your employer has this type of arrangement in place, or is considering such an arrangement, they should look at it again. This type of arrangement (pre-tax deduction and tax-free reimbursement of the same expense) may subject the Employer to stiff withholding and reporting penalties for failing to pay and report the proper amount of income and employment taxes. A better idea - A Section 125 plan that allows pre-tax deductions for premium amounts, and a Medical Reimbursement Account for Non-Premium medical expenses. This is a legal way for the employer to save those same payroll taxes, and for the employee to pay less in income taxes. If you need clarification of how the Flexible Benefit Plan differs from the scenario above, or if you just want more information on implementing a Flexible Benefit Plan, feel free to contact me, Michelle L. King, Director of Flexible Benefits at Pension Dynamics Corporation at (925) 299-8088 ext. 112 or send me an e-mail at mking@pensiondynamics.com.
Flex
Facts: Tax Free Parking & Commuting by Michelle L. King If you are paying to park your vehicle, or if you are using public transportation/Van Pooling to get to work, you could be paying less in taxes! The IRS now allows Employers to set up salary reduction “spending accounts” so employees can use pre-tax dollars to pay for public transportation or van pool, and parking for their primary place of employment. Once the plan is in place, you (as the employee) would elect to have a set amount withheld from your pay each month. This deduction would be taken before taxes are calculated. When you have to pay for your next BART ticket, bus pass, or pay the garage for your parking space, you would send in a claim and be reimbursed from the funds you have had withheld. The best part is that taxes need never be paid (state or federal). Not when the money is withheld from your paycheck, and not when you get it back to cover your expenses! This means a 35-45% savings for most employees in California. Current maximum limits are $100/Month for commuting expenses* and $180/Month for parking**. Unlike other tax-exempt programs there are no special limitations for Corporate Officers or “Highly Paid” Employees. Everyone can participate! Unlike traditional Section 125/Flexible Benefit Plans, the Tax-Free Parking and Commuter plans have no Use-It-Or-Loose-It rule. Unused balances roll-over and are available to you for reimbursement of expenses in future months/years. You also have the freedom to change your elected deductions during the year. This plan can be used in conjunction with, or in place of, current Commuter Checks programs. If your company does not already offer this benefit—maybe they are not aware of your interest. You should be asking them about it! Pension Dynamics Corporation is happy to share more information with your decision makers. They can call me, Michelle L. King, Director of Flexible Benefits at Pension Dynamics Corporation at (925) 299-8088 ext. 112 or send me an e-mail at mking@pensiondynamics.com *Public
transit or approved car/van pooling
Flex
Facts: Rising Costs by Michelle L. King A survey conducted late last year (Dec. 2001) by the National Business Coalition on Health showed that 80% of employers were considering increasing employee paid premium amounts to help absorb the double digit rise in health care costs. Of the employers surveyed 75% also said that they anticipated moving to higher deductible and higher co-payment health plans to help control the costs. This means you will need to be prepared to play a larger roll in your health care coverage in the coming years. It is important to read the materials that are distributed during open enrollment for your Medical Plans. This is not a time to assume that your coverage will remain the same. Even though the plan name may look the same as it always has, there are often subtle changes in coverage and co-payment amounts. If your family has even minor health issues, you may need to consider ways to control your costs. How can you do that? Look into the special programs offered by your insurance carrier such as "mail away" prescription programs for routine medications. Check your policies for discount programs for Vision and Dental programs, and take a closer look at your spouses coverage through their employer. If you haven't before, you may want to consider participating in your employer's Flexible Benefit Plan (pre-tax premium and medical expense reimbursement plans). Just remember that mid-year changes to your insurance coverage do not allow you to make changes to your Medical Reimbursement Account election for the current plan year. But you can start planning for the next open enrollment! If your out of pocket expenses are starting to climb, and your employer doesn't have a Flexible Benefit Plan in place (or only has the Premium portion but not the spending accounts) you may want ask them to consider making a change. Pension
Dynamics Corporation is happy to share more information with
your decision makers. They can call me, Michelle L. King, Director
of Flexible Benefits at (925) 299-8088 ext.
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