Then the economy softens.
Home sales slow just as the couple's income disappears. They sell what they can to make the mortgage payments. Then they put the house up for sale.
But it doesn't sell.
Nine months later, the house is sold at foreclosure to the mortgage lender. The couple's equity has disappeared. Their credit is shot. The $30,000 loss the lender eventually took selling the house appears on the couple's credit report for the next seven years.
That experience, discussed in his book "Missed Fortune 101" (Warner Business, $24), made a deep mark on Douglas R. Andrew. If he had his way, none of us would have any equity in our homes. We'd borrow every possible dime from our homes, preferably with interest-only mortgages, and we'd invest the money in safe, accessible assets. We wouldn't keep any money in 401(k) or traditional IRA accounts, either. And if we had money in those accounts, we'd figure out how to drain them without any tax consequences.
Indeed, Mr. Andrew will show us exactly how to do this through seminars advertised in major newspapers. Readers have sent me the ads: "Withdraw up to $60,000 annually from Your IRA or 401(k) with No Tax Consequence."
Ads like this get your attention if you've got a bunch of money in tax deferred plans, own your house outright, and have virtually no debt. Your life is a "taxable event" waiting to happen.
Mr. Andrew seems to offer the answer.
Here it is, in a nutshell: Liberate your trapped home equity by selling your home. Buy a new one with a large mortgage. Invest the liberated equity in a life insurance policy that is fully funded as quickly as possible. Let the interest deductions on your new mortgage offset withdrawals from your qualified plans. Finally, borrow the annual yield on your life insurance cash value, tax-free.
The book, which ranked 391 on the Amazon sales list when I checked, is one of the most interesting books on insurance I've read in years. I would love it if everyone could convert their taxable retirement savings into tax-free savings. After all, I'm the guy who has been harping on the taxation of Social Security benefits and the inevitable rise of future tax rates.
Unfortunately, those who attend the advertised seminars are likely to be very disappointed if they act on Mr. Andrew's suggestions.
Why? There is a gigantic gap between his smooth projections and what real people are likely to experience. Call it "the devil is in the details" factor. The gap is so large, many could go from having highly taxable retirement assets to having no assets at all.
The arguments in "Missed Fortune 10" have four major faults.
---Sometimes Ignored the Time Value of Money. When someone tells me, as Mr. Andrew does on page 43, that I will pay out more in taxes when I retire than I ever deferred using qualified plans while working, I worry. You can't compare dollars of taxes saved in 1970 with dollars of taxes paid in 2010. It's bad financial reasoning.
---Overstated tax benefits. Every illustration in the book is based on a 33 percent state and federal tax rate. In fact, few face such tax rates. Certainly, the Prudents, the $70,000-a-year couple on page 161, don't face a 33 percent tax rate. They face a 15 percent federal tax rate plus a possible state income tax. The difference has consequences. If you pay $6,000 in deductible mortgage interest its net cost is only $4,000 after 33 percent tax benefits. But the net cost is $4,500 at 25 percent and $5,100 at 15 percent. Big difference. The smaller the tax rate, the smaller the benefit of moving your investment to a tax-free investment.
---Unlikely returns on policy cash values. Given the choice, many people would choose to have a large mortgage and money to invest rather than a smaller mortgage and no money to invest. They make that choice because they believe it is easy to earn more than the mortgage rate. In fact, with mortgage rates approaching 6 percent, it is difficult to find yields over 4 percent. Very few insurance companies are crediting more than 6 percent to policy cash values.
--- Zero consideration of the down side. When we take out a mortgage, we sign a contract to pay interest for up to 30 years, at whatever the rate. When we invest in an insurance contract, the insurance company only guarantees a return of 2 or 3 percent. The policy illustration may show a higher rate, but the guaranteed rate is 2 or 3 percent. As a result, your ultimate tax free income may be far less than expected. Indeed, it may be zero. This possibility is not mentioned in the book.
Coming Tuesday: We Take Missed Fortune to the Reality Lab
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.
AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.