Taking a brief break on the mortgage posts…30 year vs 15 year to follow very soon.
I’d like to begin with a quote by Dave Ramsey and his Financial Peace book (full reference below) that is so unbelievably wrong it needs to be ripped out. Actually, Dave has proven perfectly with this quote why he holds NO financial licenses issued by any state because if he did then the governing authorities of those licenses would have to shut him down for major compliance violations.
A Quote From Dave Ramsey
“A Government Gift?”
“Billionaire J. Paul Getty says that one of the keys to building wealth is not to pay taxes on money until you use it. So you shouldn’t pay taxes on retirement dollars until you use them. You should always invest long term with pretax dollars. What if I gave you $2,000 each year and these were the conditions: You can earn all the interest you want on that $2,000 – and keep it – but you have to give the $2,000 for each year back to me when you are seventy years old. If you were thirty-five years old and we did that for thirty-five years at 12 percent, you would have $863,326. You do have to give me back $2,000 x 35 years or $70,000, but you still net $793,326. If you save $6,700 per year in a pretax investment like a 401(k) or SEPP (Simplified Employee Pension Plan), the above scenario would have occurred. If you bring that $6,700 per year home, it turns into $4,700 by the time Uncle Congress gets his greedy cut, so $2,000 of that money is Uncle Congress’s – which, if we invest pretax, we get to keep for free all those years. What a deal!
I have heard the ridiculous pitch that it is better to pay your taxes today because tax rates may be higher by the time you get to retirement. The only people who believe that argument do not understand the power of the present value of dollars or are life insurance salesmen.”
~(Dave Ramsey, Financial Peace Revisited, Penguin Group, page 154-155)
“Financial Idiots” – remember, that’s you
Boy if I could cuss this is where I’d do it. What a……joke.
If you’ve read any of my previous posts you’ll remember the conversation I had with Dave’s right-hand-man (who I can’t name since he’s a friend). I addressed this particular page in their book with him, and several other topics of equal concern, and he admitted that this was wrong. I guess we’ll see if it’s printed correctly next time around…I highly doubt it. Remember what that friend said at the end of our conversation concerning Dave’s followers? No? Well let me refresh your memory. He said this, “Kelly, you have to understand that 80% of our clients are financial idiots.”
Unfortunately, it appears he’s right in this situation because you’d have to be a financial idiot to believe the above paragraph is accurate. Honestly, I don’t understand why the SEC doesn’t require this to be corrected because it’s TOTALLY false.
Seriously, Are You That Gullible?
First, do you really believe the government only takes that which you put in? Are you so gullible to believe that the government will allow you to contribute $2,000, pay no tax on that $2,000, let it grow, and then only pay them back the $2,000 when it’s time to take it out? Unbelievable. You see, in reality, the government gets to take as much as it wants of the full account balance. How? They, Uncle Sam, get to decide what tax bracket you’ll be in at the time of withdrawal. The entire balance of $863,326 is at their mercy when it’s time for you to take it out. You don’t get to decide! You have no idea how much of your Qualified Plan (401k, SEPP, Traditional IRA, etc) is actually yours until that day comes.
Let’s say you happen to fall into a 30% tax bracket when you’re 70 years old. Okay, so how much of your 401(k) is the government’s in Dave’s example above? What’s 30% of $863,326? It’s $258,997.80! Not $70,000. You see, you haven’t paid taxes on any of it yet. You didn’t pay on the $2,000. You didn’t pay on the growth (tax deferred instead of taxable). But now you’re withdrawing and the government gets their share. The very fact that he, Dave Ramsey, claims you only have to pay back what you put in is utter stupidity and complete ignorance of how these financial instruments work but more importantly how the tax code works.
No Dave, There Is No Difference
Second, let’s address the pre-tax and post-tax issue. Read this one slow: there is no difference mathematically between pre-tax and post-tax dollars when invested. Dave would yell foul (he said above that “you should always use pre-tax dollars to invest long-term”). Actually he’d step out of his Christian teachings and call me names like he does all the time on his radio show – which really surprises me since the Bible tells us to call no one a fool…or an idiot for that matter. Maybe he has a different Bible than mine.
When I say, and I’ve said it over and over, that Dave can be proven wrong with math not opinion…well, this is another perfect example. Don’t believe me? Let’s allow the math to decide for us. I’ll even use his numbers from above.
If you invested $2,000 for 35 years and earned a 12% actual rate of return (remember, there’s a difference between average and actual rate of return) then your money would grow to $863,326. If you were in a 30% tax bracket at that time, and took a lump sum, you would have to pay the government $258,997.80 leaving you a balance of $604,328.20.
Now the “post-tax”: If you took that same $2,000 but were taxed 30% on it when you brought it home then you’d have $1,400 to invest. If you invested $1,400 each year for 35 years at an actual rate of return of 12%, guess how much you have at the end? $604,328.20. What? How can that be Dave? It’s math people.
A No-Calculator-Needed Example
How about a simpler example so you don’t have to pull out your calculator to determine if my math is right or not. Let’s say that Brother A had $10,000 before tax to invest. He put it in an investment product that delivered an actual rate of return of 7.2%. In 10 years his money would double to $20,000 (Rule of 72). At the end of the 10 years if his taxes were 30% then $6,000 (20,000 x .30) would go to the IRS and he’d have a balance of $14,000. Congratulations, you followed Dave Ramsey’s advice and you apparently made the wise decision.
Let’s then say that Brother B also had $10,000 to invest but he decided to take the 30% tax hit at the beginning. He’d have $7,000 left over after paying the IRS $3,000 (10,000 x .30). Now, if he used the same investment account as Brother A and received a 7.2% actual return over the next 10 years then his account would also double. What would his balance be at the end? Pretty easy, $7,000 x 2 = $14,000.
Pre-tax and Post-tax are the EXACT SAME if the variables are the same (i.e. investment return and taxation). They are identical. So what then becomes the primary consideration when choosing these types of accounts? TAXATION! It is the number one issue. Dave, you said above that others who disagree with you “do not understand the power of the present value of dollars.” Uh, right. Pure stupidity. It has nothing do with that Mr. Ramsey. It has everything to do with MATH! My 5th grade son could prove this point.
If you are not educating yourself about the economic and social conditions of our country and the impact they will have on your dollar then you better start. These issues will be crucial when determining future taxation and it’s the taxation issue that has the biggest impact on your future dollars. Please, please start reading. The information exists.
You Never Avoid The Taxes Dave Ramsey
Again, what were the conditions in the above examples? The conditions simply assumed a 30% tax bracket for both and the same actual rate of return. Guess which option, pre-tax or post-tax, gets worse in an increasing tax environment? Come on. Pre-tax loses. Dave’s example, and advice, gets worse in an increasing tax environment. His quote at the end about those who believe taxes will be higher are giving a “ridiculous pitch”, I wonder if he still feels that way. I will say his book was published in 2003. Are any of you really under the impression economically that we are in a decreasing or flattening tax environment?
Outside of all the various conditions that are pointing to higher taxes, what is it that determines your tax bracket anyway? Your income. How many of you have incorporated into your financial plan to be at the lowest income bracket once you retire? I assume none of you. Yet Dave continues to sound off that you will be in a lower tax bracket which completely counters the economic conditions and your own lifestyle desires.
Now I understand why they refer to you followers as idiots because you’d have to live in a hole to think your taxes aren’t going up.
Anyone Think Taxes Are Going Down?
What if, when this person turns 70, the tax rate goes up to 35%? Not a huge hit or is it? Well, 35% going to the government would leave this follower of Dave a balance of $561,161.90. So he deferred at a 30% tax in order to pay at a 35%…genius planning. If he simply contributed along the way with his post-tax dollars of $1,400 then he’d still have the $604,328.20…because he already paid his taxes on this money. That’s a difference of $43,166.30. Now Dave, that simple decision could buy this retiree a new car. But if you would rather pay that to the government then go ahead.
Dave’s advice is not only wrong in regards to the rules established by the IRS but also from a mathematical position.
Am I saying that Qualified Plans are foolish? Not necessarily. If we were in a decreasing tax environment and you could defer taxes today at a higher rate and pay them later a lower rate then dump money into them (you would still have to understand that the government is in charge of this money along the way even in a decreasing tax environment). But that’s not the condition nor the situation our country is facing. We are NOT in a decreasing tax environment and the less money that you have at the control of the government (keep in mind they can change the rules on these accounts with a stroke of a pen) the better. YOU need to be in control and Qualified Plans like these give you ZERO control of your money. If you don ‘t believe that then please tell me how you are getting around the rules…millions of people would love to know.
It’s the Postponement of Taxes!
You must remember that Qualified Plans defer two things (we like to say “postpone” since that’s what they do): they postpone the tax AND postpone the tax calculation. It’s the second one that’s the killer. It’s the second one that makes the difference, that determines how much is yours, that determines if it’s a wise decision or not. Are you educating yourself about the second one or are you only falling for the whole “pre-tax is the best place to be” sales pitch?
Get Out Of My Church Dave
Sorry Dave Ramsey, but I believe it’s fair to say that if this is what you’re teaching then it is in fact you who is the “financial idiot”. Please stop sending this garbage into my church. You have deceived so many people out of hard earned investment dollars by putting them at risk with the IRS and the economy. For every dollar you’ve helped people save in their quest to be debt free you’ve lost again by this type of advice. Please sir, educate yourself…at the very least, have a financial professional review your book before you publish it so these types of mistakes can be caught.
If you feel my math is wrong or if you believe that Dave is right and you only have to give the government back what you put in then please let me know.
Kelly O’Connor – firstname.lastname@example.org
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