Dump your 401(k): Common sense vs. conventional wisdom
By Jeffrey Reeves MA
Americans are trapped by an economic model that treats conventional wisdom as common sense. I define conventional wisdom (CW) as doing what everyone else does and thinking what everyone else thinks just because that is what they are doing and thinking. Meanwhile, 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. 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 take advantage of our employer's matching contributions 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.
Let's review a case study involving 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 per year. Sally and Bob believe they are doing the right thing by putting $10,000 each year into the mutual fund-type investments in Bob 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 throughout the past decade, and it's only worth about $98,000 today. However, their advisor wants to convince them that they should stay the course because in the long term, they'll see the gains.
Here are some other realities facing Bob and Sally that aren't apparent from the facts we've learned so far:
- Bob drives a new SUV and Sally drives a relatively new sedan. Both are financed. They owe about $50,000 on the two cars and have payments of more than $1,200 per month -- and much of that is interest. The insurance on the cars amounts to $150 per month.
- Bob and Sally each have their own credit card. They use them to pay for vacations, purchases such as TVs and appliances, and entertainment. They owe a balance on both credit cards. The balance is slightly more than $20,000. The interest rate on the cards averages about 18 percent. 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 home with a conventional 30-year mortgage for $320,000 at 6 percent interest. Their payment of $2,500 includes taxes and insurance.
- Sally and Bob also owe $32,000 on an equity line of credit. 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 in a savings account.
On the first venture into awareness, we can see that Bob and Sally's total debt is $102,000, excluding their mortgage. Amazingly, their debt exceeds the total investment in their retirement accounts throughout the past decade. We can also recognize that their debt 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 have earned a negative rate of return throughout the past decade. Worse yet, the interest on the money they borrowed averaged more than 10 percent each and every year. What does that mean? It means that the retirement accounts would have to earn much more than 10 percent in the future just to catch up to and 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 throughout that same decade, the picture becomes even bleaker: Bob and Sally shelled out almost $72,000 in interest payments, created more debt and experienced a negative return on their invested money.
When you calculate the total, Bob and Sally used $174,000 to build an emergency fund of $40,000 and put $98,000 into their retirement accounts. Even though the contributions to their retirement accounts allowed them about $25,000 in tax savings throughout the same period, they still ended up in a negative position.
How about an alternative, common-sense approach?
Bob and Sally could have paid $10,000 each year in participating whole life insurance premiums 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 -- $30,000 more than the retirement accounts... so much for the tax deduction.
Here's more: Remember the $72,000 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 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.
Also consider 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 boon -- 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.
If Bob and Sally put their money into participating whole life policies:
- Both Bob and Sally would continue to drive new cars that are financed for about $50,000. However, the monthly payments of $1,200 would be redirected into their life insurance policies and would replenish 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 at the end of each month, and the 18 percent interest rate on each card would be irrelevant.
- Bob and Sally's $400,000 home would still have a $320,000 conventional 30-year mortgage at 6 percent with a payment of $2,500 -- 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 on an equity line of credit they used to remodel their basement.
- Bob and Sally would be able to keep about $100,000 cash in their policies as an emergency fund.
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