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Three Questions That Will Change How You Save Money

My clients live all over the world, and come from all walks of life. Their jobs range from tax accountants to teachers, from lawyers to longshoremen. Many own their own busi­ness in a myriad of different industries. But every single one of them has given the same answer to a couple of questions I ask.

The first question is “Do you think taxes are going up or down in the future?” I haven’t yet had anyone tell me they think their tax bill is going to be lower in the future than it is right now.

The second question follows: “Let’s look at the Tax Advantage Table. Please tell me in what order you’d rank these categories in terms of the most desirable types of money to receive as income.

1) Free Money

2) Tax-free money

3) Tax-deferred money

4) Taxable money

Again, everyone I have ever spoken with puts them in the order listed above. They all agree that free money is better than tax-free, tax-free is better that tax-deferred, and tax-deferred is better than taxable money.

Let’s assume for a minute that you agree with this assessment and put those 4 categories in the same order. Now let’s drill down exactly the types of things that fall under each of those categories:

1) Free money: gifts, inheritance, life insurance death benefits, and 401(k) MATCH (only the match portion of the 401 is free)

2) Tax-free money: ROTH, municipal bonds, Cash Value Life Insurance

3) Tax-deferred: 401(k), IRA, SEP, Simple, 403B, SEP, TSP

4) Taxable money: Stocks, Real Estate, Mutual Funds

Now look at the types of accounts you have invested in to build your wealth, or to save money for retirement. This is where it gets interesting.

We all can hope for some money from category #1, but we don’t really have much control over that – whether or not we get a gift, inheritance, or match for our 401(k) contributions is largely up to other people.

So the next best thing we can invest in are those things listed in category #2. But al­though most people agree in the order of categories, they invest their money in the #3 category almost exclusively, skipping over the #2 category entirely.

Now for question 3:

There are only 2 types of “buckets” we can draw money from during retirement: tax­able and tax free. Which would you rather draw from? I’m guessing you said tax free.

So let’s take a closer look at the things that fall in each bucket:

Some of these are great investments, and all have their place, but all of these invest­ments are subject to either capital gains taxes or ordinary income taxes. And where do you think most people have the majority of their retirement accounts stationed? Most people, before meeting with me, have it sitting in a 401(k). So, if you are re­quired to pay taxes when you take the money out for retirement, and you believe that taxes are going up – in other words, you’ll be paying more taxes on a larger amount of money – do you really think you’re going to save a lot on taxes in a 401(k)?

Is there a better option? Let’s look at the items in the tax free bucket.

Municipal bonds aren’t right for most folks for many reasons, so we really only have 2 choices in this category: ROTH IRA accounts and Cash Value LIfe Insurance.

The ROTH IRA is a fantastic vehicle, and I encourage almost every client to have one. But there are some constraints you need to be aware of, including income limits, contribution limits (usually $5,500), IRS penalties for pulling money out before age 591/2, and risk of loss of your principal since ROTH’s are almost always tied to mutual funds.

Finally there is Cash Value Life Insurance. Almost all of my clients prefer this option because none of the limitations of the ROTH apply in these types of ac­counts. No income or contribution limits, no age penalty, no market risk for your principal.

What percentage of your wealth is in category #2? What percentage do you want to be in that category?

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