It’s Time to Make Smart Money Investments
Library of Investments: The Three File Cabinets
Check this out,” I said to Betty. I motioned to a picture on my desk of three file cabinets. In the drawing, each file cabinet has the same three drawers, labeled stocks, bonds, and real estate.
“This drawing represents the choices of classic investments that you can make to ﬁll your Money Machine. It’s a tool that allows you to visualize the organization of your financial life.”
Betty quickly scanned the sketch, which is a reference for the choices she’ll have as she decides what works best for her. The drawers of each file cabinet contain common types of investments—stocks, bonds, and real estate—from which you can choose, while the three file cabinets show the three different ways you can be taxed.
Look for a future article on this website where I will be talking about other investments, that are not the common investment vehicles — and include businesses, product sales on Amazon and other ways to generate reoccurring revenue.
The file cabinet sketch has two distinctive features. First, notice that the drawers in the file cabinets are the same: stocks, bonds, real estate.
These represent the viable alternatives you have for investing your cash in order to build your Money Machine: stocks, bonds, real estate. They don’t include investment oddities, like commodities, futures, precious metals, or “collectible items,” like antiques, rare coins, or art.
I’ve omitted the investment oddities for good reason. Commodities and futures are highly complex investment vehicles with their own specialized markets and a wealth of arcane theories about how to invest in them. Unless you intend to become an expert in these investments—which is a full-time job in itself—you’ll be steering clear of them. Similarly, you won’t invest long-term money in collectible items, like art, coin collections, rare books, or antique automobiles, unless you have a deep personal interest in them. Paintings, for example, are wonderful to look at, but they aren’t dependable investments for your Money Machine; the value of paintings rises and falls unpredictably as fads sweep the art world, and the hot artist whose work skyrockets in price this year is likely to plummet in reputation next year. You won’t want to hang your dignity money on fads!
Keep it simple. Here we’ll cover stocks, bonds, and real estate—all of which are bought and sold publicly in markets that regularly determine their value. That’s why they are key choices for your Money Machine.
How Do You Want to be Taxed?
The three file cabinets in the sketch illustrate your choices for how you’ll want the federal government to tax your income and your investments. Uncle Sam drops in to collect his tax at three different times:
- When you earn income from salary or business profits;
- When your investments pay you dividends or interest; and
- When you sell your investments and receive the profits.
When to pay Uncle Sam and how much you’ll have to give him are big factors in determining the income that your Money Machine will produce for your future. When you ease out of working and begin receiving cash from your Money Machine, will it come to you as taxable income, tax-free income, or a combination of both? If you have to pay tax on some of those moneys, what will the tax rate be at that time in your life? And based on your understanding of the current economic and political climate, do you believe that taxes are going to rise or fall? These are important questions to consider, because the answers will help determine how much cash you’ll be able to spend from your Money Machine later in your life.
File Cabinet #1
If you have investments in File Cabinet No. 1 (taxable investments), Uncle Sam taps on your door three times looking for tax dollars: when you earn money, when your investments pay you dividends or interest, and when you sell your investments and make a proﬁt.
For example, let’s say you’re planning to buy a piece of rental property with no special tax advantages—perhaps a small college-town apartment house, which you plan to rent out as student housing. This investment fits in the real estate drawer of File Cabinet No. 1. You’ll purchase the property with after-tax dollars (money that has already been taxed at the time you earned it). As you proﬁt from the rents the students pay you, the government will take a piece of the action. And if you sell the property and make a proﬁt, Uncle Sam will be back for more tax. That last proﬁt is a “capital gain”—the difference between the purchase price of your investment and the price when you sell it. So the money you invest in the rental property and the money you make from owning it will be taxed three separate times by the government.
In File Cabinet No. 1, the same is also true for a share of stock: You buy it with after-tax dollars, pay tax on dividends that you may receive while you own the stock, and pay tax on your capital gain when you sell the stock for more money than you paid for it. In other words, you’re taxed across the board.
File Cabinet #2
In File Cabinet No. 2 (tax-deferred investments), Uncle Sam takes a different approach—a kinder, gentler one. He visits only once for tax collection.
This file cabinet represents any type of investment that is known as a “qualified plan”: traditional individual retirement accounts (IRAs), simplified employee pensions (SEP-IRAs), simple IRAs (employer-sponsored IRAs), Keogh plans, 401(k) plans, 403(b) plans, and company pension plans. Don’t be thrown by the alphabet soup. The important thing to know is that you are taxed the same way on all of these investments.
Let’s use a traditional IRA as an example. When you contribute, say, $2,000 to an IRA, you don’t have to pay income tax on that money—you get a deduction from your taxable income on your income-tax return for that year. As the investments in your IRA grow, you don’t pay any tax on their earnings. But when you withdraw money from your IRA—or any other qualified plan—Uncle Sam will be waiting for you. You will be taxed at the ordinary income-tax rate as you withdraw money.
File Cabinet #3
In File Cabinet No. 3 (tax-free investments), Uncle Sam takes yet another approach. Again, he shows up only once. You do pay tax on money you are investing—but it grows tax free. More significant, you’re able to withdraw cash tax free down the road.
File Cabinet No. 3 we’ve called the private pension plan — because Uncle Sam is not your partner when you take money out. This is true for a flexible premium variable life insurance plan. But don’t be put off by its name—you’ll want to know about this type of investment. By including variable term insurance with your mutual funds, you obtain certain benefits that, under the insurance law, include no tax on the growth or use of your money. This way Uncle Sam is not your partner when you’re seventy something, as he is with traditional IRAs and 401(k) plans.
The 1997 tax law revisions made provision for a new form of IRA: the so-called Roth IRA (also known as the American Dream IRA and the Plus IRA), which took effect in 1998. It allows you to contribute up to $2,000 a year in your IRA. Under the new legislation, you won’t have a tax deduction for your contributions but you will be able to withdraw your funds tax free. If you earn over $95,000 a year or if you and your spouse jointly earn over $150,000, you can’t use this IRA and, in any event, you’re restricted to a $2,000 contribution per year. Although this new IRA is useful, it’s not sufficient for most people to build a thriving Money Machine.
The new legislation also provided for an Education IRA whereby you can contribute $500 a year for a child until age eighteen. When the child reaches age thirty, the Education IRA converts to a Plus IRA.
Finally, under the new tax-law provisions, you can withdraw money from your traditional IRA before age fifty-nine and a half for only two purposes without incurring a penalty—for education and for first-time home buying.
The file cabinet picture is a simple and accessible way for you to see where the investments in your Money Machine ﬁt into your financial picture. If you have cash in a bank or money market account, think of it as being in a “To Be Filed” basket alongside the three file cabinets. That’s because a money market account is a glorified savings account with low interest rates and it is not an investment to serve you as a productive wealth builder. It’s money that’s waiting for a place to go. If your company or employer provides an IRA or a 401(k) plan or if you have an IRA on your own, it’s in File Cabinet No. 2. And I know you’re wondering about File Cabinet No. 3, because the private pension plan is a newly talked about, but important, strategy for growing money these days.
Time and energy are the real premiums of our lives. Once your investments are neatly arranged in the drawers, you can see what investments will produce taxable or tax-free income, and you can apply the Rule of 72 to see how those investments will prosper. Finally, you’ll be able to estimate your cash ﬂow from your Money Machine.
Now that you have an overview, we’ll examine each file cabinet more fully. In my own Money Machine, I’ve used all of the file cabinets and many of the drawers, depending upon my goals. You’ll see how this works, too.