Book Notes: Spend ‘Til The End, Part 3(a)

The latest installment of our recent series, where we boil down others’ contrarian financial advice and let the dust settle where it may.

Part 3: Raising Your Living Standard

Lot of material here, so I will split it up into two parts. 3a is below and 3b will be next week.

Chapter 9: My Son, The Plumber

Who do you think has the higher lifetime living standard – doctor or plumber? You might be surprised. The authors run through a scenario, based on reasonably realistic assumptions, showing that over both lifetimes, a plumber’s standard of living could actually be higher than a doctor’s. After factoring in the cost of medical malpractice insurance, education, loan interest and a delayed start to prime earnings years compared to a plumber, who takes no loans and begins earning income even during his training, it’s at least closer than you might think…even if you find fault with a few of the assumptions.

Bottom line: don’t take your career for granted.

Also, don’t even bother trying to get a plumber to come over on a Saturday. And the PayScale.com site can be useful when figuring out what different careers pay in different areas.

Chapter 10: Does College Really Pay?

I’m keeping most of my notes from this section private, just so they can’t ever be used against me by daughters.

The real question while deciding to attend college is if a higher living standard is achieved over your lifetime given the costs associated with attending college (i.e. four years of tuition, room and food – and with no earnings coming in). Based on pure economics, going to an expensive college is far less beneficial than most people believe.

Chapter 11: Fire Your Job

Suppose you are married and both of you earn $17,500 or slightly over the minimum wage. If either one of you stopped working, you are actually more likely to raise your living standard. This is because (at the time the book was written) a combined household income of $35,000 disqualifies you from most tax credits and benefit programs like Medicaid. Reducing your income by half is more likely to enable you to qualify for all possible tax credits and benefits, and when combined with reduced taxes, your economic gain will likely be an amount close to the earnings you gave up.

The same logic applies to moderate and high income groups. If your earnings are towards the lower end of the tax bracket you fall in, it might make more sense to reduce your earnings to raise your living standard.

To be clear, the authors aren’t necessarily recommending this as a sound financial planning strategy (at least I don’t think they were) as much as they were highlighting this point: the government is guilty of malign neglect in determining the impact of a complex system of taxes and benefits on the work incentives of many Americans. In some cases people would actually have more spending power by not working. Nutty.

Moral of the story: knowing your effective tax bracket might help you easily raise your living standard.

Chapter 12: Location, Location

The following are the prices (pre-bubble, presumably) for similar houses in three very different locations:

Cedar Rapids, Iowa: $174,950
Tampa, Florida: $309,000
Seattle, Washington: $525,000

If you were a cold-blooded economist, in which home should you choose to live?

Yep. Living in Cedar Rapids raises your living standard 34% compared to Tampa and 78% compared to Seattle. That’s, um, kind of a big deal.

You could, however, argue that buying a house in Seattle or Tampa means leaving kids with higher assets or that it provides you with a safety net when it comes to paying medical bills. But if your kids get a better start in life, they are more likely to do better than you and may not require the assets at all. Besides, the major financial risk in your later years is nursing home expense rather than any illness. If you and/or your wife end up in a nursing home (one most likely to be covered by Medicaid), when the last spouse dies, most or all of your home equity will likely go to Uncle Sam, leaving your kids with nothing, anyways.

At this point I had to stop and give the kids the bad news. Then I made a margarita, went to the beach, and reminded myself why I don’t live in Cedar Rapids. Neither do the authors, by the way. So, again, might be another conclusion they made here that is more theoretically interesting than practically useful.

Chapter 13: Whether ‘Tis Wiser

Andrew and Jessica face a dilemna: to buy or rent a house in San Diego? Housing prices have fallen in the recent past but there could also be a sharp hike in the near future. (Reminder: this was written back when housing prices might actually go up again. Seriously. The authors were not drunk.) The same applies to mortgage interest rates.

Andrew and Jessica can never be sure of the correct time to buy a house. The most important consideration in buying a house is the certainty of living there for a very long time. If you are likely to move in the next five years, it’s not worth the risk.

Though renting the house rather than buying may look like greater savings, the opposite is true. Rather than renting, buying the house in San Diego leaves the couple with 4.6% higher living standard per year, despite the higher costs earlier. This is on account of the tax advantages of home ownership. Moreover, as time passes, the real value of mortgage payments fall due to inflation.

Another benefit is that if the house loses value, Andrew and Jessica’s living standard will increase rather than decrease. Why? Because of lower property taxes and subdued homeowner insurance premiums. Now the savings can be spent on things other than housing cost increases, although the net worth the two will leave to their kids will be lower. The opposite is true as well. If the value of their house rises, their living standard will take a hit, but the assets they leave for their kids will rise considerably. (Assuming they don’t end up in a nursing home, presumably.)

(Note: Unless your property taxes and insurance premiums are, in fact, lowered, this argument falls apart. I haven’t heard of any municipalities rolling recent property tax hikes back. And monkeys will fly before insurance companies lower premiums anytime soon.)

Bottom line: buying conveys lifetime tax breaks. It also entails higher short-term standard of living costs but lower long-term housing costs. But determining whether buying or renting offers the highest living standard for you requires careful analysis.

Chapter 14: Pay it Down, Way Down

To truly appreciate the winners and losers when it comes to the tax benefits of owning a home, we will consider three men – Armand, Bart and Chuck.

Armand makes $60,000 a year and has just bought a $180,000 house. Much to his sorrow, he learns that his first year tax savings from deducting mortgage interest is a miniscule $224. Also, his tax savings will disappear after the fifth year, leaving him with a cumulative tax benefit of $616. Due to these tax savings, his family’s living standard has improved only by a piddly 0.75%.

The societal benefit of the mortgage interest tax break is small because you only benefit if you itemize your deductions. A majority of low income households don’t.

Armand’s friend Bart makes $150,000 and has just bought a house for $400,000. The tax deduction for Bart and his wife is $4,098 in the first year and it continues for the next 25 years, making their total tax savings $64,092. The tax break effectively increases their living standard by 3.8%.

Chuck makes $400,000 a year and has bought a house for a whoping $1 million. Chuck and his wife enjoy a tax break of $18,821 annually for the next thirty years, raising their living standard by a handsome 45.1%. Now say his wife inherits $500 million dollars. Their smartest and safest option is paying off their mortgage, despite those tax savings. This is because Chuck would effectively save 2.5% in interest (assuming he pays 7% on the mortgage and earns 4.5% from interest on bond investments). Paying off his mortgage effectively increases his family’s living standard by 0.7% each year afterward.

In summary, those who really gain from deducting mortgage interest are the rich or upper class. The real tax advantage of home ownership has nothing to do with whether or not you have a mortgage on your home – it comes from not having to pay taxes on the rental income and services you earn and received on your house. (Economists call this implicit rent.) So, even those with no mortgage enjoy a tax break of sorts. The authors reiterate that paying off your mortgage is one of the smartest and safest investments you can make.

Chapter 15: Does it Pay to Play?

A simple way to raise your living standard is to proactively decide when and how much to pay in taxes. (Within bounds, of course.) Contributing to 401(k)s and IRAs allows you to postpone taxes, while contributing to Roth 401(k)s and Roth IRAs means you pay no tax on withdrawals, ever.

However, contributing to these plans is difficult for liquidity crunched households – and that represents about 2/3 of America. Making an effort to contribute could mean a significantly lower living standard in the present. For example, a 30 year old married couple earning $100K and contributing 6% until the age of 51 would see a 10.2% reduction in their living standard to get a 20.8% hike thereafter. The pinch in the short-run is big, but the long term gains are even bigger.

The best way to compare the returns of 401(k)s and Roth 401(k)s is to determine their impact on your long term living standard. Generally speaking, contributing to 401(k)s is slightly more beneficial than contributing to Roth 401(k)s, but there can be exceptions to this rule. If you are a 60 year old who is not borrowing-constrained, contributing to either plan gives you the same return; it provides an immediate 0.4% gain in living standard. Other exceptions may arise due to differences in age, earnings and marital status. Speaking purely in terms of net present value, however, at any age, everyone benefits from contributing to either of these 401(k) plans.

The other point to consider while looking at these plans is that money from Roth plans is completely tax free. With the exception of low income groups, contributing to Roth plans is safer as it protects you from tax hikes.

Figuring out whether to contribute to a regular 401(k) or IRA or their Roth counterparts can make you nuts. Ignoring future tax hikes, the regular route seems best – particularly for high earners. If tax hikes are on the way, though, the Roth makes more sense.

The authors give this advice (as they’re pretty confident tax hikes are coming): contribute to regular and Roth 401(k)s with a 40-60 split, but only after you’ve maximized your employer’s match. As explained previously, that match is free money, so even if you have to starve to contribute in an employer’s matching plan, it will be worth it.

Chapter 16: Converting

Conventional financial wisdom says its better to defer your taxes and earn interest on savings. Conventional wisdom also says it’s a bad idea to convert all your 401(k) or Traditional IRA money into a Roth IRA, since you would have to pay taxes immediately. However, the authors calculate that doing just that increases your living standard permanently by 5%.

Converting may allow you to take your 401(k)/Traditional IRA money out at a significantly lower tax bracket if you’re being hit by the AMT. Moreover, converting to a Roth before collecting Social Security reduces your taxable income and limits the taxes paid on Social Security benefits. These two benefits more than offset the gain of deferring taxes and earning interest on those savings.

Starting in 2010, anyone can convert their 401(k), regular IRA or comparable tax deferred retirement account money into a Roth IRA. That’s great news. However, converting is not necessarily a good idea for everyone.

A low income household, for example, will not pay taxes in retirement, so future tax rates don’t affect them at all and the need to convert is gone. Middle income households stand to reduce their living standard if their regular federal income tax rate is lower than the AMT rate (assuming the tax rates stay fixed). If the tax rates increase by 15%, then middle income households will see a 1.5% to 6% hike in their standard of living.

Obviously, future tax policy has a big impact on the benefits (or lack thereof) in converting to a Roth IRA.

That’s it for now. More Book Notes next week.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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