by David Bach
WHAT IS AN ANNUITY?
Here’s a broad definition of an annuity: It’s a contract between you and an insurance company whereby you pay a premium (you invest) in exchange for a variety of guaranteed payout options for a set period of time or for the remainder of your life. There are really two phases of annuities: the first phase, when you save and the contract accumulates and grows. The second phase, when you start to take money out, is called the distribution phase. What is critical to understand about all annuities is that they are insurance contracts. Any guarantee given to you on behalf of an annuity is backed by the strength of the issuing insurance company. Do not buy an annuity until you are clear on the quality of the insurance company.
FIXED INDEXED ANNUITIES
Fixed indexed annuities, which are often referred to as “FIAs,” are an insurance product that is tax-favored. In lay terms that means the money grows tax-free until you take it out (the technical term being “tax-deferred”). Fixed indexed annuities are more popular now than variable annuities by a magnitude of five to one. Today they dominate the annuity industry. In 2016 more than $117 billion went into FIAs compared to $25 billion in variable annuities. “Why?” you might ask. The answer is pretty simple. Fixed indexed annuities offer principal protection, the promise of no downside (i.e., you can’t lose money if the market goes down, and you participate in the market returns when it goes up). The catch to this is that you don’t participate in all of the market upside. The way the product works is that your return is attached to a predetermined index (such as the S&P 500); you may earn only 50 percent of the upside with a cap in a given year. This all depends on the individual product you invest in, which means the devil is in the details. So how does this even work? Remember, this is an insurance product. The FIA will first offer a guaranteed rate. The rate will be low, but potentially higher than or the same as an actual CD. Let’s say the rate is 3 percent. You will be guaranteed this rate of 3 percent annually. You can’t earn less than this 3 percent. But then the product is also tied to a market index. So, for example, if the FIA is tied to the S&P 500 and it goes up 10 percent and your participation rate is 50 percent, you’ll earn 5 percent (not the 10 percent of the full market return). And again, if the market goes down, you won’t see a decline in your investment and you will still earn 3 percent. You can use an FIA to later provide you with a guaranteed income for life if you elect to annuitize it, depending on the individual policy riders.
“What?!” you might exclaim. “David, this sounds too good to be true!” Yes, I know it does. It’s all about the details. Don’t worry, we will cover them right after we discuss variable annuities.
VARIABLE ANNUITIES
Variable annuities are also insurance contracts. The insurance company basically wraps an insurance policy around mutual funds (stocks, bonds, money-market funds, or a combination that you choose). These funds are called “subaccounts.” The “insurance wrapper,” as it is called, allows the money in the fund to grow tax-deferred, just like in a fixed indexed annuity. The big difference between a variable annuity and a fixed indexed annuity is that your returns are based on your subaccount selection and returns, and these accounts typically do not provide a fixed guarantee. They also do not provide the protection from a market downturn. What they do that fixed indexed annuities don’t do is provide you with the full return on your investment. Put simply, if you invest in an S&P 500 index fund inside the variable annuity and it goes up 16 percent in a year, you earn all of that. You’re not limiting your upside as you would be with an FIA.
THE UPSIDE AND DOWNSIDE OF ANNUITIES
The upside of annuities is that they are insurance products that can provide principal protection and tax deferral. And in some cases, depending on how you use the annuity, they can provide a guaranteed income stream for life and a long-term care benefit. It all truly depends on the annuity product. Principal protection and tax deferral benefits that annuities provide, however, are not free. Nothing in life is free. You know this by now. Let’s start with one big issue with annuities (both fixed and variable). First, the money grows tax-deferred (that’s really good), but the profits, when they are taken out of the annuity, are taxed as ordinary income as opposed to a long-term capital gain (that’s not so good) because ordinary income can be taxed at a higher rate depending on your income and tax rate. This is a very important point you need to consider before you invest. Second, when you invest in an annuity you’re locking up your money for the long term. You can’t take the money out before you reach age 59½ without paying a government penalty fee of 10 percent (the same as with an IRA). Third, there are lots of fees involved in getting the benefits and guarantees of the insurance. You must review the fees in detail before you invest. Fourth, the insurance is only as good as the insurance company covering it (so you must check their ratings and strength). Finally, there can be a surrender fee—you must pay if you sell your annuity or take any distributions above a certain level from it within a set time frame of the purchase date. The average annuity has a surrender fee time frame that may range from 7 to 12 years, and these fees can be substantial—upward of 7 to 10 percent, which declines over time. So make sure, when buying an annuity, to ask the person presenting it to you about all “internal fees” and “back-end” surrender fees or sales charges. Many annuities are now offering level fee structures that eliminate these long-duration surrender charges, so ask your financial advisor or insurance professional about these level-fee annuities if the deferred sales charge concerns you.
So which type of annuity is right for you? It depends on you. Neither may be right for you. I can tell you that my annuity preference now is for the fixed indexed annuity over the variable annuity. I will happily take part of the upside of the index to protect myself on the downside of the markets. Just as I would choose indexed universal life insurance over variable universal life insurance, I would opt for an FIA vs. a VA today. The game of investing is always changing, with new products and new tax rules, which is why I wrote this update, and why you’re reading it. You have to stay current on what is available. And by reading this update, you are.
Phew! We’ve covered a lot of ground in this chapter. Given all the recommendations I’ve made about how to invest your dream-basket funds, I’m sure your head must be spinning. But remember—it really isn’t that complicated. You don’t have to do this all at once. For the most part, smart investing is simply a matter of knowing what steps to take and in what order.
The fact is, being able to fund your dreams is a lot like opening a safe. Unless you know what numbers to turn to and how, you’ll never get inside. With the right combination, however, the world’s strongest safe can be opened with very little effort. The two of you now know the combination to your financial safe. Use the tools I have given you, in the right order, and your dreams can become a reality.
STEP 8
LEARN TO AVOID
THE TEN BIGGEST
FINANCIAL
MISTAKES
COUPLES MAKE
In this step, we’re going to look at the 10 biggest mistakes couples make with their finances—and sometimes with their relationships. By learning what these mistakes are, you can save yourselves considerable heartache…and a lot of money. I’ll warn you now that some of these mistakes will seem so obvious to you that you may find yourself saying, “Well, I knew that was dumb.” But remember—knowing something is dumb and not doing it are two different things.
What I’d like the two of you to do with these 10 biggest mistakes is study them carefully and really discuss them with each other. If it turns out that you’re making some of them yourselves, don’t beat yourselves up over it. Rather, be happy you’ve learned something new that could conceivably save—or make—the two of you a fortune. In any case, the key is to take action. I don’t want you just to nod in agreement and then do nothing. If you spot a mistake you’ve been making, correct it. If you come across a solution to a problem that hadn’t occurred to you, start u
sing it.
With that in mind, let’s jump right in.
MISTAKE NO. 1
Having a 30-year mortgage.
Thirty-year mortgages are probably the most popular form of home financing around. They are also, in my opinion, the single biggest financial mistake people make in this country. In fact, I think 30-year mortgages are worse than a mistake. I think they are a scam—an outrageous scam pushed nationwide by both the banks and the government.
What’s my problem with 30-year mortgages? It’s simple. Say you purchase a home with a $250,000 mortgage that you pay off over a 30-year period. Say the interest rate is 4.5 percent a year and your monthly mortgage payment is $1,266. When all is said and done, you actually will have given the bank nearly $456,000. That’s almost twice the original loan amount. Why did you fork over all that extra money? The answer, of course, is that in addition to repaying the $250,000 principal, you were also obligated to pay the bank $206,000 in interest charges.
In all fairness, banks are in business to make money. They like to sell 30-year mortgages not because 30-year mortgages are necessarily a good deal for you but because they are very, very profitable for them.
Now, I also said that the government benefits when you buy a 30-year mortgage. How does that work? Well, to begin with, it was the government that had to decide to make mortgage interest tax-deductible, right? Do you think the government said, “Geez, let’s make the lives of Americans easier by allowing them to deduct a good chunk of their mortgage payments”? Maybe…but, then again, maybe not.
Maybe the government’s experts looked at the math and saw that encouraging people to take out 30-year mortgages would be a good thing for the government. After all, if you and your partner have a mortgage that you pay off over 30 years, guess when the two of you will most likely retire? You’ll retire when you reach your sixties—which just happens to be precisely when the government wants you to retire.
Why doesn’t the government want you to retire earlier than that—say, in your late forties or early fifties? Because when we retire, most of us sharply reduce the amount of income and Social Security taxes we pay. So if everyone started retiring early, the government might have a tax-revenue crisis on its hands.
Now, don’t get me wrong. I’m not antigovernment, nor am I suggesting that the banks and Washington are engaged in some sort of conspiracy. Their policy here makes good business sense for both of them. But here’s the important thing: what’s good for them is not always good for you or me.
TAKE YOUR 30-YEAR MORTGAGE AND…SAVE $40,000 OR MORE!
If you’ve already got a 30-year mortgage, what I suggest is that you…keep it. That’s right. You can keep the 30-year mortgage you’ve got, and if you ever get a new mortgage, you should probably get one with a 30-year term as well. The fact is, 30-year mortgages give you a ton of flexibility.
By this point, I’m sure you’re thinking that I’ve gone nuts or you accidentally skipped a page or two somewhere. Wasn’t I just going on about how terrible 30-year mortgages are? And now I’m saying you should keep yours—and maybe even get a new one?
Well, here’s the trick. By all means, take out a 30-year mortgage, but under no circumstances should you take the full 30 years to repay it. If you do, you’ll just be wasting all that time and money on interest. A much smarter decision is to pay off your 30-year mortgage early.
To do this, pull out your mortgage payment book and review what your last payment was. Now take that number and add 10 percent to it. That’s how much you’re going to send the bank next month, and every month thereafter. In other words, if you were paying $1,000 a month before, from now on you’re going to be paying $1,100 a month. Inform the bank that you are doing this and that you want the extra $100 a month to be applied to the principal (not the interest).
If you keep this up, you’ll wind up paying off your 30-year mortgage in about 25 years. Increase your monthly payment by 20 percent, and you’ll have that mortgage retired in about 22 years (depending on the type of mortgage)! In short, this is a simple idea that can easily save you tens—if not hundreds—of thousands of dollars in interest over the lifetime of your mortgage. In the example I went over on the $250,000 mortgage at 4.5 percent with a monthly mortgage payment of $1,266 a month, just adding $126 a month EXTRA toward the principal would pay that mortgage off five years sooner, saving you $39,933! Make two extra payments of $126 and you would save $63,421! Reread that. That’s like two months of your Latte Factor! Right? Two months of coffee at home a year, and you’ve paid your home off eight years faster and saved $63,421. Now tell me this book wasn’t worth the 15 bucks or less you spent on it!
If you’re at all confused by this, call your bank or mortgage company and tell them you want to pay off your mortgage earlier than the schedule calls for. Ask them exactly how much extra a month you would have to send them in order to pay off your mortgage in 15, 20, and 25 years. Make sure to ask if there are any penalties for paying off your mortgage earlier (chances are, the answer is no). Then ask them to send this information to you in writing. Most likely, they’ll be happy to help you, and in any case, it shouldn’t take them very long to do the calculations.
I ran all these numbers on a nice noncluttered website that doesn’t bug you with ads. It’s www.mortgagecalculators.info. Go run your numbers.
3 MORE TRICKS TO PAY OFF YOUR MORTGAGE EARLY
Set up a bi-weekly mortgage. I love this approach and wrote about it in detail in The Automatic Millionaire. I also discussed it on Oprah and it blew people away (it still amazes me people don’t know about this mortgage hack). The powerful idea is that rather than paying your mortgage once a month you split your mortgage payment in half and make two payments a month. So in the previous example, you have a $250,000 mortgage with a 4.5 percent interest rate and your monthly payment is $1,266.71. Instead of making the payment of $1,266.71 once a month, you pay $633.36 every two weeks. By doing this you will pay your home off in 25 years and seven months and save $34,834. It’s not quite as good as the system I gave you before, BUT in the real world it works better. Why? Because most likely you are paid every two weeks, so it’s much easier on your cash flow and family budget to pay your mortgage every two weeks. Secondly, with a bi-weekly mortgage it’s all done for you—automatically! You don’t need to write the checks, track it yourself, or even think about it.
The only trick to this, however, is how to set it up. You can’t just do this one yourself. You need to reach out to your bank and see if they offer a bi-weekly payment plan. Many banks now do. Some banks charge a small fee (which I think is still worth it).
Make one extra payment a year. I’m sure you have heard of this one. Almost no one does it. But if you do, do it and you have the extra payment applied to pay down the principal (make sure the bank does this correctly) then you will pay your mortgage off four years sooner and save $32,151.
Switch your 30-year to a 15-year mortgage. With interest rates still near record low levels, this one is also really worth considering. Take the $250,000 mortgage example. A 30-year mortgage at 4.5 percent will have a monthly mortgage payment of $1,266. What if you switch it to a 15-year mortgage? Assuming the same rate of interest (it will actually be lower because with a 15-year loan you will get a discount, but let’s leave it the same for this example). At 4.5 percent, your payment will now be $1,912. That’s $646 more a month, which is a lot, I know. It’s precisely $21 a day more. BUT you will now pay off your home in 15 years and save $112,000!
One thing to keep in mind: when you make these extra mortgage payments, pay close attention to your monthly statements. Banks often don’t credit mortgage accounts properly. I’ve had it happen twice with my own mortgage. In one case, we had been making extra payments for eight months—without a penny of it ever being credited against our principal. When we finally noticed, the bank said it thought the extra payments were meant to cover future interest we might owe. Can you believe that? It took us three months to sort things out. The mo
ral: even if you’re not making extra payments, watch your mortgage statement like a hawk!
THE BIG TAX WRITE-OFF MYTH
I know some of you are probably thinking that I’ve ignored one of the most important aspects of paying off a mortgage—the fact that mortgage interest is tax-deductible.
You probably think 30-year mortgages are great write-offs because some accountant or financial advisor or well-meaning friend told you they were. And that’s not totally crazy. On average, for every $100,000 in mortgage interest you pay, your tax bill will be reduced by $28,500 (28.5 percent being the federal tax bracket of the average citizen). But so what? Since when is it worth spending $100,000 in interest extra over the life of your mortgage in order to save $28,500 in tax payments?