Obstacles that Could Keep You from Your Financial Goals
- Wednesday, March 03, 2010
Growing up, I watched the hardest working man I knew, my grandfather, lose his entire life savings. He worked three jobs to put food on the table for his wife and seven children. He often worked any job he could find just to help his family out. He did this for over 30 years before he retired with significant health problems. Despite his lack of investment knowledge, he was a diligent saver and managed to scrape together over $500,000 for retirement. What seemed to be more than enough money to last throughout retirement turned out to be far less than he truly needed. While I don't have all the answers to your specific financial situation, let's look at what my grandfather did wrong to gain better insights into how we should prepare for the future.
Three factors my grandfather ignored:
My grandfather's first obstacle came in the form of taxes. He kept much of his money in IRAs. This meant he had to pay taxes every time he withdrew money. He also had some CDs which were taxed every single year. When he invested money, he paid income taxes on the interest he earned. He also paid income taxes and capital gains on a few shares of stock he owned. In short, taxes ate away at his returns.
Think about this. If you earn 5% interest on a CD and pay 20% in taxes, your after-tax rate of return is only 4%. You lose 1% to taxes. If you pay state taxes, your return gets eroded even further. Too many fail to properly account for taxes. They assume they will be in a lower tax bracket when they retire. This is rarely a correct assumption. Many retirees are at the same or higher tax bracket when they retire.
Thanks to inflation, my grandfather watched his purchasing power slowly erode. Even as his nest egg grew, his dollars bought less and less. Inflation, which is measured by the consumer price index (CPI), has been remarkably consistent at 3.2% since 1926 (source: Bureau of Labor Statistics). This means each year, goods and services generally increase by 3.2% in price. Put another way: every dollar is worth 96.8 cents at the end of each year.
Some year's inflation rates are higher and some year's are lower. So how do you successfully prepare for your long-term financial goals? The key is to get ahead of both inflation and taxes. This means any investment you choose, other than emergency funds, should be in instruments that can earn at least 5% or better! If an investment is earning less, you are losing money on that investment. Playing the money game to "not lose" is not a good way to win. Play the game to win, and you will come out on top.
When my grandfather thought he was investing in a risk-free investment through his certificate of deposit (CD), he assumed he was making a wise decision. Instead, he was merely playing not to lose. What he failed to calculate is that CD's historically pay 3.1% interest annually (source: Bankrate.com). For every hundred thousand dollars he put in a CD, he earned $3,100 in interest. But after paying for taxes (let's assume 30%), he was left with $2,170 or a 2.17% rate of return. However after inflation of 3.2%, he is left with an annual return of -1.03%. Typically, the only true guarantee of a CD is that it will not outpace inflation and taxes. Unfortunately, my grandfather learned the hard way!
You may say losing 1% per year is better than losing 38% in one year by investing in the stock market. You're right: that one year you would have been better off in a CD versus the stock market. However, if you lose 1% per year for 25 years, you lose more than one quarter of your nest egg before you even spend a dime.
I don't want to be overly simplistic here. I am not saying to run out and invest in the most aggressive stocks you can find. Consider David. David came to see me in 2002. He had been burned by the stock market. He retired in 1999 with over $1 million and placed the majority of his investments in technology stocks. He figured he could withdraw $50,000 a year for the rest of his life. At 5% withdrawal rate, how could he go wrong? David invested too aggressively and his million-dollar portfolio soon became a $500,000 portfolio during the technology collapse from 2000-2003. Still, he kept taking his $50,000 per year withdrawal (now a 10% withdrawal rate).
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