Lies You’ve Heard About Compound Interest – Episode 131

This transcript was auto-generated and may contain errors.

[00:01] Welcome to the Prosperity Podcast, fresh alternative personal finance talk for independent thinkers who prosper outside of Wall Street. Here’s your hosts, bestselling author, Kim D.H. Butler and No BS Money Guy, Todd Strobel. Hey everybody, welcome to another edition of the Prosperity Podcast. This is No BS Money Guy, Todd Strobel. Once again, we have the president and founder of Partners for Prosperity and bestselling financial author, Kim Butler, with us today. And we’re going to be addressing some more of the financial planning lies or fallacies or whatever you want to say. And the sad part about this is that these are things that, you know, even the financial advisor community has taken for granted.

[00:48] And it’s been, I guess, sold to us so secretly that we don’t often question them. But today we’re going to question a couple more of these and we’re going to start out talking about compound interest and how it’s actually considered to be the eighth one of the world. So welcome, Kim. Well, thank you, Todd. Yeah, it is funny how everybody focuses on you’ve got a compound interest. And the conversation is really interesting today when interest is negligible, if not even possibly negative, and yet people in a taxable account were primarily talking about today. It’s not your IRAs and your 401Ks and your 403Bs and your pension environments, but taxable account like regular brokerage account. Every time you compound interest, which is typically what you do when you are reinvesting

[01:39] dividends or interest from bonds or capital gains from the growth, any time you compound, what you’re doing is obviously raising the amount of money that’s in the account, but you’re creating a tax. And so when that happens, and of course, it’s a tax that has to get paid that year, you are losing some of the money to the taxman. Now we can’t be letting the tax tail wag the financial dog, but it’s really important to understand that if you kept on that path, growing, compounding, reinvesting, growing, compounding, reinvesting, growing, compounding, reinvesting, not only would you get to a point where you couldn’t afford your tax bill, but you would get to a point where the management fees on said fund were so large that they too were undermining

[02:40] a large percentage of your growth. And both the taxes and the management fees come with something that is rarely talked about and that is opportunity cost. And most people are not familiar with this term at all. It’s something that we learned in economics 101 either in high school or college, but most of us have completely forgotten about it. And part of the reason we forget about it is number one, when we were trained this information or when we learned this information, it was typically applied to corporate environments and large corporations, big accounting firms, you know, they understand opportunity cost all the time, but individuals don’t tend to. And it’s because we don’t take that large economic principle and bring it down to

[03:34] our own personal economy. And what opportunity cost means is that if you at a particular year have to pay extra money to the government because your account grew, then you have now lost the opportunity to invest that money for the rest of your life. And the same is true of any money that you pay to your broker or your financial planner for management fees that you typically pay every single year, often even every quarter. Whatever money goes to management fees has now been lost to you for the rest of your life. That opportunity cost exists literally for the rest of your life. And the way that we calculate that is we say, OK, you have a tax bill or a management fee bill and you apply an interest rate to it.

[04:27] Opportunity cost is typically the best investment that you have out there. Now, some people will calculate it at just a flat four or five percent. And that’s fine, too. It still makes the point. So let’s say you paid ten thousand dollars in tax and, you know, and this was on an investment, you know, that you can’t ever get that money back. Well, that didn’t just cost you the ten thousand. Let’s say that the awesome investment that you had to pay the tax on was a ten percent deal. Or there could maybe it’s not that investment, but there could be another investment that you have that’s ten percent. Well, now, not only is it ten thousand, it’s ten thousand times ten percent for as many years as you’re going to live.

[05:09] That’s the true lost opportunity cost that is affecting this investment. And it’s not to say don’t invest because clearly we have to invest and if we grow those investments, we’re going to pay tax. We understand that. But you want to think about compounding or reinvesting because every time you’re compounding or reinvesting, you’re making the problem worse. And you would potentially be better to take that growth, the dividends, the interest, the capital gains. And again, remember, I’m talking about in a taxable account. I’m not talking about an IRA or 401k or 403b account. You’d be better to take that money, the growth, the interest, the dividends, capital gains and go do something else with it.

[05:56] Pay your life insurance premium, pay your pay to petitions rider, pay your car and your home insurance premium, go on vacation with it. I mean, do something else with that money. That means that the account will still grow because the underlying untaxed long term capital gain on the account, should there be one, will still grow for you. But you’ll behoove yourself by not reinvesting or compounding inside that taxable account. Did that make sense? Yeah, I think maybe we could make it just make a little more sense by saying if you had a hundred thousand dollar account that earns three percent, your account would be worth a hundred and three thousand dollars at the end of the year. But if you had to pay even 20 percent of that money back in

[06:44] taxes, your money has not only been reduced by that amount, but we have to look at the other secret tax too, which is inflation. Would that hundred and three thousand dollars less taxes buy more or less than it would have when I started? And if you’re not getting ahead, you’re behind. Absolutely. Well, and it’s interesting, too, in that people want to use an average tax rate like your accountant typically gives you, oh, you’re in a 17.3 percent average tax bracket. That is not accurate when we’re talking about taxes on investment dollars. Instead, you need to understand the concept of marginal tax bracket or rate and your marginal or your last dollar is taxed at your highest marginal rate. And so there is a tax table.

[07:42] You can grab it on Google. And it says for the first X dollars of income, you’re going to get taxed at X percent and then the next Y dollars of income that’s taxed at Y percent and then Z dollars of income at a higher amount or tax at Z rate. And so this marginal rate, if you get some investment income, it’s taxed at Z. It’s not taxed at X or Y, nor is it taxed at an average of the three of them. It is taxed at Z. Or if you are even a higher income earner, it could be double A, double B, double C as we keep on going up the list. I should have started with an earlier letter in the alphabet. Isn’t it interesting how, you know, so many times our message to our clients is that when we’re talking about

[08:32] the income that you earn, we would love to see you in the highest human tax bracket possible. But when it comes to your savings and investments, let’s be a little smarter. Absolutely. That’s well said. And this is learning that we’re trying to provide for our clients. There’s a great book that we’ve written called Busting the Financial Planning Lies, which is essentially that’s on Amazon and it’s what we’ve been going through in the last few podcasts. And we were about halfway through. There’s a lot of financial planning lies to bust. But if you’d like to grab something of a little little lighter read, we have an ebook available for free on our website partners. Number four, prosperity.com slash ebook.

[09:17] There’s an audio version as well as a PDF and it’s an immediate download and it goes over some of these issues so that you can take your time, read them. There’s some calculators in there proving them and it will help you get a better understanding of some of the things that you need to know about building and protecting your own personal economy. Isn’t it interesting? I mean, would you ever be offered a $200,000 job when you have a $100,000 job and say, no, I don’t want to do that because I don’t want to pay the taxes. It’s a good way to look at it. But yet, like I said, when it comes to the investment side, particularly, I think at this moment, we’re talking about the ability to grow your money at what would you say, four to five

[10:07] percent safely inside a whole life policy? Absolutely. And as you know, we like to call that savings, not investing. And then, of course, investing is the double digits that we talk about all the time that are more fully explained in the financial planning has failed book. Super. What if you would maybe just go into a little bit more detail on how and why a whole life policy can pay the numbers that it does and still be in a non-taxable environment? Well, the whole life product is really designed to be your emergency opportunity fund, and it is earning the rate of return that it is because of the dividends that the insurance company pays and the profit model that the insurance companies use.

[10:57] Now, these are mutual insurance industry companies, mutual companies, meaning they’re owned by the policyholders. They’re life insurance companies only. They don’t do car and home insurance. And their model is to accept premiums for term insurance and whole life insurance. And as many people are well aware, term insurance death benefits for which the insurance company is accepting premiums are rarely paid out. And so it’s a really nice business model for insurance companies. And then, of course, they do invest those profits. And because an insurance company literally looks at 100 year timeframes, holding something like a 30 year bond for the entire 30 years is normal for them. Now they do a few mortgage investments and

[11:47] they do some small business investments and they even have a very small percentage of their money in the stock market, but it’s a completely different approach to investing when you can truly have at least a 30 year point of view, if not longer. And you are not beholden to public quarterly announcements about how well your business is doing. So insurance companies as a general rule of thumb are able to have a better structure for investing dollars than those of us in the public realm. And I mean, to me, this is just absolutely fascinating because we talk about how we expect our money in the stock market to somehow another magically grow. And when we’re talking about the insurance business, it’s not magic.

[12:37] It’s a 150 year proven track record of reliability. Absolutely. And when we look at where interest trades are today and we compare the 4% ish that you could get at a life insurance company on liquid dollars as cash value of life insurance to the less than 1%. And as you brought up taxable at a bank versus at the insurance company, because it’s inside life insurance, it’s tax deferred. And if you never cancel the policy, then it won’t be taxed unless you’re taking out more than you’re gained. So you’ve got a 4% tax deferred rate compared to a less than 1% taxable rate. And that’s where the comparison should be. You don’t want to compare the 4% of the life insurance company to your 10% investment because life insurance is

[13:30] liquid and so we don’t call it an investment and the proper thing to compare it to is a savings account at a bank or a money market account at a brokerage firm. And again, the interest rate is higher than the bank across the board and traditionally. So if we do see interest rates double, we could still expect the higher rate of return at the life insurance company, couldn’t we? That’s correct. They’re going to go with the market. And when I say that it’s the economy’s market, not the stock market. So if the stock market has a crash, your life insurance cash values will remain unaffected. But if our economy starts increasing its interest rates again, then your life insurance dividends and the growth of your

[14:17] cash value will increase and improve as well. So it’s like you have all the upside and really none of the down. I mean, those well said those monies are locked in every single year and it cannot go down like what we saw in most everything else in 2008. Correct. Super. Well, this is no BS money guy, Todd Strobel. I know we kind of went a little long winded and got a little technical today, but again, I compliment Kim Butler for teaching our podcast listeners how to ask the proper questions, not rely on answers, but how to seek knowledge. And I will continue to support her on her mission to do that. Special thanks to Kim Butler and we’ll see y’all again soon. Thank you for listening to the Prosperity podcast to take

[15:08] control of your money and have it work for you. Visit us at partnersforprosperity.com. If you liked this episode, make sure you subscribe and leave a review.