Editor’s note: This is part one of a four-part series exploring financial fact vs fiction. Each article will examine five of the top 20 most common financial myths — from investments to retirement and Social Security to life insurance.
How do most people learn the basics of finance?
Since several states are only now starting to require mandatory financial education, many American adults have learned about budgeting, saving, investing and taxes either by trial and error or by listening to advice from friends and family.
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While Uncle Fred or Aunt Sally may have the best of intentions, the financial aphorisms of the past — “a penny saved is a penny earned” — don’t always ring true, or are at least due for an update (after all, pennies are about to go the way of the dodo).
To help you decipher financial fact from fiction, I’m putting together a series of articles about the top 20 most common financial myths, addressing everything from investments to retirement and Social Security to life insurance.
Here are the first five:
1. Paying off a 5% mortgage is equivalent to buying a 5% annual-return investment product
Some people who come into an unexpected windfall may be tempted to pay off the remainder of their mortgage, thinking they’ll save 5% per year on interest.
But because of the way mortgages work — with most people paying a larger share of interest at the beginning of the loan period — a homeowner with 10 years left on a 30-year mortgage won’t realize 5% in annual return savings. It may be only 2% or 3% savings.
Before you use a lump sum to pay off a mortgage, consider two issues: financial flexibility and risk.
If you use a large sum of money to pay off a loan, you may not have cash reserves for an unexpected situation such as a health scare or furnace replacement. How important is financial flexibility to you?
Conversely, since paying off a mortgage at whatever interest rate saves money, it’s important to think about an investment’s risk profile when comparing.
Unless you’re putting the money into a certificate of deposit (CD) or a money market account, you will potentially be taking on more risk than paying off a loan.
2. Doing a Roth IRA conversion from a traditional IRA reduces taxes and saves money
With traditional IRAs, contributions are tax-deductible, meaning you can deduct the contribution from your income when filing taxes, but when IRA distributions are eventually taken out during retirement, they’re taxed as ordinary income.
Roth IRAs flip the equation, with contributions being made after-tax (i.e., no deduction), but distributions coming out tax-free in retirement, as long as you’re at least 59½ years old and your Roth IRA was put in place five or more years ago.
When you convert a traditional IRA to a Roth IRA, you might be able to save money on future taxes. But you might not.
Unless you have a pile of cash sitting around to pay the tax bill, which is due when you complete the Roth conversion, you’ll have to use traditional IRA distributions, which means you pay taxes on the amount distributed and, possibly, an early-withdrawal penalty, and thus can expect to get only about 50 cents to 70 cents on the dollar.
That’s not to say it never makes sense to convert to a Roth IRA. There are two factors to consider: age and income.
If you’re only 30 years old and have 50 more years to earn compound interest, it might make sense, especially if you aren’t currently in a high tax bracket.
But most people consider doing a conversion only in their 50s and 60s, as they approach retirement, when they don’t have as many years to accrue interest to offset the taxes they’ll be paying now to convert to a Roth IRA.
Additionally, if there is a gap in your income, and it goes down for a few years, that might also be a good time since you’ll pay less in taxes to convert.
Conversely, a person in their prime earning years will probably want to lower their taxable income now, so it’s smarter to use a traditional IRA to reduce your taxes.
Ultimately, a dollar is always worth more now than in the future. And since we don’t know if taxes will go up or down tomorrow, it may not be such a good idea to pre-pay income taxes to the government.
3. Social Security is going bankrupt or becoming insolvent, and I don't expect to collect any benefits
Social Security is a pay-as-you-go system, which means that self-employment and FICA payroll taxes go directly to pay beneficiaries, with any surplus going to savings.
The discussion around Social Security being bankrupt or insolvent refers to the Old-Age and Survivors Insurance (OASI) Trust Fund. For decades, when Baby Boomers were working, a surplus went into this Social Security trust fund.
But now that the Boomer generation is retiring, and the birthrate is lower, there are a lot fewer workers, so we’re burning through the trust fund.
Current estimates indicate we’ll exhaust the trust fund in 2033. Does that mean retirees won’t be able to collect? The answer is no.
If the Social Security trust fund runs out and Congress doesn’t act, projections show that beneficiaries will still get about 80% of benefits, because there is expected to be enough coming in to pay the bulk of benefits.
Of course, the federal government can also fortify the trust fund by raising the wage base limit, increasing self-employment and FICA taxes or pushing the full retirement age forward.
4. Withdrawing 4% of your retirement savings ensures that you won't run out of money before you die
What many refer to as the 4% rule isn’t so much a rule as it is a rule of thumb. In 1994, financial adviser William Bengen coined the phrase “the 4% rule,” theorizing that if you have a 50%-50% stock-bond portfolio and take out 4% in the first year, you can increase the amount to match the rate of inflation and won’t likely run out of money before dying.
Does Bengen’s rule still hold true? It’s safe to say it’s outdated.
The 4% rule assumes that stock and bond returns will be similar to long-term averages, which may or may not hold true.
In fact, many hypothesize that the next decade will produce below-average U.S. stock market returns due to the past two years of substantial outperformance, with the S&P 500 returning 23.3% in 2024 and 24.3% in 2023.
Bond returns may also be less robust than during Bengen’s time, because the 50-year U.S. bond bull market, largely driven by a secular period of falling interest rates, has now ended.
Beyond market returns and volatility, the 4% rule assumed that people would live only 25 to 30 years in retirement. Today, people might have 40 to 45 years in retirement, and the 4% rule isn’t designed to cover that scenario.
Another limitation to the 4% rule is spending variability. During retirement, most retiree spending varies significantly from year to year, which can meaningfully reduce how long their savings will last.
If you want to make sure you have enough money to last in retirement, the best thing to do is to speak to a financial adviser who can help develop a plan based on your specific situation.
5. It's better to get a tax refund than owe taxes to the IRS
People like to get tax refunds. But getting a refund just means that you’ve given the government an interest-free loan.
Ideally, your payroll-tax withholdings should be close to what you’ll owe in taxes. No more, no less. Getting a tax refund may feel good, but it’s even better to earn 4% interest throughout the year.
While some basics stay in style forever, finances aren’t one of them. It’s a good idea to revisit the “golden rules” of money and finances to stay up to date for a modern generation. Otherwise, you could be making costly mistakes.
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