As you move through life, you make mistakes. Someone once told me, "Another name for something that hurts like hell is a learning experience". Most of us remember the pain caused by our mistakes and while many of us try to keep our children from making the same mistakes, all too often, they, like we did, have to learn the hard way.
One type of mistake many people make is paying too much to the financial industry and/or the IRS due to bad financial decisions. Let's take a look at a few such decisions:
Paying a Financial Advisor a Lot of Money for Very Little
I started this blog not long after receiving a substantial inheritance. All of the sudden I had a lot (to me) of money to invest and I wanted to do it right. While I started researching various options, the CPA who did our taxes convinced me that hiring him as a financial advisor would be a smart move. As a result of saying "yes" to him, I learned about a lot of different costs:
The Tax Cost of Selling Investments
Most of the money we put with the financial advisor was in retirement accounts; however there was a sum of money in a taxable mutual fund account that had been there for over fifteen years. When the financial advisor moved that money to his firm, he sold the mutual fund, creating a taxable event. All that profit over all those years was now taxable income.
Before switching from one investment to another, consider the tax consequences and whether they are worth it. If you lose 15% of your investment to taxes to gain 1% a year in gains, it will take over 15 years to make up what you lost in taxes.
The Cost of Market Timing
While the fault of no one in particular, there was a lag between the day our old investments were liquidated and the day the financial advisor bought new ones, and because of market movement, it meant that we lost money. In other words, the market was "low" when we sold, and then went up before our money was reinvested. Shortly after that money was put in new investments, it went down again. The money was invested in August, 2014. A portfolio I put into Morningstar shows that, looking strictly at share price and not counting dividends, the mutual fund shares purchased that day are still worth 6% less that what we paid for them.
If switching to a financial advisor or broker means liquidating a large amount of money and then reinvesting it all at one time, this is a real risk. While it may not take you as long to recover as it has taken us, dollar-cost averaging is a proven way to reduce risk, and taking "all" of your money out of account 1 and moving it to account 2 means buying market risk. Consider only giving the new company new money, especially until they have proven themselves.
The Cost of Mutual Fund Expenses
Mutual funds have expense ratios. Someone has to pay the people who are running the fund, and those people are the investors. I don't work for nothing and I don't expect others to work for nothing. However, before investing in a mutual fund, compare its expenses with those of its peers. While you may think it is worth it to be in the hot fund that is making money this year, the odds are that if not next year, then the year after that, the fund will find itself back in the pack.
The Cost of the Financial Planner
As I said above, I don't work for nothing and I don't expect other people to work for nothing either. However, I do expect people who work for me to produce value commensurate with the cost. In order to evaluate the cost of a financial advisor you are considering, write down the following:
- Why do you want a financial advisor? I know it seems basic, but there is a reason you are considering hiring someone. What is it? If you tell me you want to fix up your house and I send a plumber over, that's great, if the pipes need work. If you want someone to run electrical wires, then I haven't helped. Do you want someone to pick investments? Help you budget? Give you tax advice? If you don't know what you want, figuring out if you get your money's worth is tough.
- Without consulting anyone about the cost, think about what YOU think that service is worth. I'd love for you to come clean my house, and I'd be glad to pay you $10 a week to do it. $100? Nope. The fact that it would cost closer to $100 per week than $10 per week for a housekeeping service is why my kids clean my house (I have to feed them anyway).
When you interview a potential financial advisor, go through your "want" list. Is that what s/he does? If not, keep looking. Tell them you have $X dollars to invest and ask what your yearly fee would be. Ask in dollars and cents and if you get all sorts of ifs...percentage...variable, and can't pin them down to a number assuming a certain account value, move on. Realize that 1% of $100,000 is $1,000 and ask yourself if you'd be willing to write someone a check for $1,000 for the service you are trying to buy.
Other finacial planners are commissioned sales people. Again, give some if/then scenarios and find out what you will end up paying them and decide if it is worth it.
In my opinion, and I'm not a financial professional and you take my advice at your own risk (but you aren't paying for it either) most people should invest in a diversified mutual fund portfolio and if you don't want to pick that portfolio yourself, go to one of the big companies (Vanguard, Fidelity, T Rowe Price are three) and buy a target date fund. This is a mutual made of mutual funds and is rebalanced to the level appropriate to your target retirement date.
The Cost of Changing Your Mind
When we hired a financial advisor we did not realize how much it would cost us to change our mind. When we moved away from using HD Vest to manage our investments, they charged us $90 per account to close our accounts, and we had three accounts with them (my husband and I each had an IRA and we had a taxable account). Each of those accounts was invested in 22 different mutual funds.
While I don't know what it would have cost to have HD Vest liquidate the account and send us the cash, moving the account, with all those mutual funds, to Vanguard means that we will pay $20 each to sell them--in other words, whether we sell those funds today, tomorrow or ten years from now, we will get hit with a $20 per fund per account fee. In other words, it will cost us a total of $1,320.00 to get our money.
If you want to move your invesments from one place to another, find out all the fees involved and see whether you are better off liquidating or moving securities. Even better, before you put money somewhere, find out what it will cost to move it elsewhere.
Paying the Tax Man too Much Money
Your retirement savings belong in a retirement account--either your work-based 401(k), 403 (b) or other tax-deferred account or in an IRA. Keeping long-term savings in other types of accounts just means more income for Uncle Sam. Keep these things in mind:
Roth IRA
The money you put into a Roth IRA is taxed before you put it in, but the earnings are tax free and you can withdraw your contributions at any time. If you are young, this type of account gives you the flexibility to save for retirement while still keeping the money accessible, if necessary for expenses like college tuition or a new car.
Regular IRA or Work-Based Plan
These allow a current tax deduction on your contributions and allow investments to grow tax-deferred. You'll pay taxes on this account when you withdraw the money. In a standard account, if you buy a stock for $10 and sell it for $20, you pay capital gaines taxes on the $10 differences. In an IRA, you get to reinvest the who twenty.
Regular Account
For various reasons you may want to have some stocks or bonds in a regular account. The trick to minimizing taxes is generally to minimize transactions. Going back to the stock we bought for $10 and is now worth $20. If you sell it, you create a taxable event. If you have a good reason to sell, go ahead, but realize what you are doing, and the consequence.
Some stocks are purchased because you expect a long term increase in value; others are purchased because they pay dividends. Taxable accounts are better for growth stocks; you keep more of the income from income stocks if they are in a retirement account.
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