Conventional Wisdom versus Common Sense
Americans are trapped in a financial paradigm that misconstrues conventional wisdom as common sense.
Conventional wisdom is doing what everyone else is doing and thinking what everyone else is thinking just because that's what they're doing and thinking. Common sense is simply being awake: paying attention to everyday reality and being aware of the options and alternatives that best serve you within that reality.
Tax deductibility is one of those areas where we Americans have forsaken reality and common sense to follow conventional wisdom. Let me explain and then I'll give a few examples.
Conventional wisdom (CW) tells us that it makes sense to contribute at least as much as we can "afford" to our 401(k)'s and IRA's. CW tells us that we should at least contribute as much as our employer matches in order to get the free money.
However, CW doesn't tell us how much we can afford. CW doesn't give us guidelines that allow us to make reasonable common sense decisions based on the reality of our own lives.
Bob and Sally both work; Bob as a sales representative for a computer manufacturer and Sally is a schoolteacher. Their combined incomes equal about $120,000.00 per year. They are convinced that they are doing the right thing by putting $10,000.00 each year, including the matching employer contributions, into the mutual fund type investments in Bob's and Sally's defined contribution retirement plans.
Over the past several years the amounts in their retirement plans has grown, then shrunk, grown again and shrunk again. The $100,000.00 they contributed over the past ten years is now only worth about $98,000.00. Their advisor continues to tell them that they should stay the course because over time they will see the gains.
Here are some other aspects of Bob's and Sally's realities that aren't apparent based on the few facts related so far.
Both Bob and Sally drive relatively new cars that they financed. They owe about $50,000.00 on the cars. Their payments are over $1,200.00 per month and much of that is interest. The insurance on the cars is another $150.00 per month.
Bob and Sally each have credit cards that they use for vacations, major purchases, and spontaneous outings. The combined balance on the credit cards is just over $20,000.00, and the interest rate on each card is 18%. They pay more than the minimum each month but they also tend to spend more than they pay so the balance they owe is growing.
Bob and Sally have a conventional thirty-year mortgage for $320,000.00 at 6% with a payment of $2,500.00 including taxes and insurance.
In addition, they owe $32,000.00 on an equity line of credit that they used to create a home-theater in their basement.
Bob and Sally also follow CW and have $40,000.00 in savings as their emergency fund.
Bob and Sally look pretty normal from the perspective of CW. Let's deconstruct their personal economy with the sledgehammer of common sense and see if there is another approach to their situation that would make more sense.
The first foray into awareness allows us to recognize that Bob and Sally's total debt, excluding their mortgage, is $102,000.00. That means their debt is greater than their total investment in their retirement accounts over the past ten years and greater than the assets that remain invested in those retirement accounts. It doesn't take a degree in logic to recognize that the money that they borrowed allowed the funding of those retirement accounts.
In addition, the money that is in their retirement accounts earned a negative rate of return over the past ten years while the interest on their borrowed money averaged over ten percent. That means that the money in the retirement accounts would have to earn significantly more than ten percent in the future just to break even with the cost of the debt that Bob and Sally used to fund the retirement accounts in the first place.
When common sense looks at the cost of borrowed money over that same ten-year period, the picture is even bleaker. Bob and Sally paid almost $52,000.00 interest in addition to the outstanding debt and the negative return on their invested money. When you add it all up, Bob and Sally borrowed and spent $154,000.00 to fund the $98,000.00 in their retirement accounts and the $40,000.00 in their emergency fund. Granted, the contributions to their retirement accounts garnered them about $25,000.00 in tax deductions over the same period but that still leaves them in a very negative position.
Consider this common sense alternative.
Bob and Sally could have put $10,000.00 each year into participating whole life insurance contracts[i] instead of chasing employer matches and tax deductions. At the end of the period, the cash value of the policies would have been about $128,000.00.
There's more. Remember the $52,000.00 in interest paid to banks for credit cards, auto loans, and equity lines of credit? By borrowing against the cash value of their life insurance policies and repaying those loans, 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 them tens of thousands of dollars.
There's more. Bob and Sally would still have the $40,000.00 in emergency funds. Had they included that money as part of the participating whole life insurance premium, the cash value of the policy would be about $180,000.00.
There's more. Bob and Sally do not need permission to access the money in their policies.
There's more. Bob and Sally pay no penalties or taxes when they borrow money from their policies.
There's more. The growth of the money in Bob and Sally's policies is tax deferred, just as it is in retirement accounts.
However, the IRS taxes the income from retirement accounts and it is fair to suggest that the IRS will raise tax rates on that income in the future.
Contrast that with the fact that Bob and Sally, with the help of their insurance and financial advisor/guide, can convert their whole life policies' cash values into tax-free income for life and still preserve the legacy value of the inherent death benefit.
There's more...but that‘s enough for now.
Had Bob and Sally put their money into participating whole life insurance instead of tax-deductible retirement plans...
Both Bob and Sally would still drive relatively new cars that they financed. They would still owe about $50,000.00 on the cars. However, they would direct their payments of over $1,200.00 per month to their life insurance policies to replenish those policies for use again in the future.
Bob and Sally each have credit cards that they use for vacations, major purchases, and spontaneous outings. The combined balance on the credit cards would be $0.00, and the 18% interest rate on each card would be irrelevant.
Bob and Sally would still have a conventional thirty-year mortgage for $320,000.00 at 6% with a payment of $2,500.00 including taxes and insurance. However, in about ten more years they would have enough cash value in their policies to repay the mortgage and begin 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 create a home-theater in their basement.
Bob and Sally would have about $100,000.00 cash value available in their policies as their emergency fund.
Conventional wisdom is not wisdom at all.
Investing in retirement plans is not saving.
Tax deductibility is a trap. Don't fall in.
[i] Mass Mutual High Early Cash Value policies