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Success has two ‘C’s

Tie Dye Senior FI is a reasonably bright guy, maybe not a SPITR*, in a world with lots of smart people.  In undergraduate college I only got two ‘C’s.  Turns out these classes were ones that helped me earn my living.  Sometimes it is the hard stuff that helps the most.

The first ‘C’ was in Income Tax Accounting.  This was a class designed to teach how to prepare an income tax return.  I did reasonably well on the tests, ‘A’s as I recall.

The problem was the final.  This was a full income tax return.  This inch thick package was given to us as a take home assignment, due in one week, with permission to work with others in the class.  Unfortunately, I had not made friends with others in the class.

The package was complex.  I could not figure out where to begin.  I would pick and poke at it but never really got off the ground.  I turned in a poor excuse of a return.  Then we watched the teacher do the return.

That is when my schooling began.  He solved this like the elephant eating problem, one bite at a time, working from the outermost layer.  When all the outer forms were done, only then did he take up the 1040.  I learned a lot watching this approach.

I got a 19 on the final and a ‘C’ in the class.

My first side hustle (we called them part time jobs back then) after college was doing income tax returns!  I did this for a number of years.  Today I use Turbo Tax for my own return but my understanding of how this is supposed to work helps me to optimize.

Getting your taxes right and structuring your income streams to make effective use of the tax code is very helpful in accomplishing FI.

The second ‘C’ was in a computer class that dealt with peripherals – tape drives, disk drives, etc.  How they worked, uses, advantages and disadvantages, etc.

At this point I should note that I was a liberal arts major, not a tech major.  This was the late ’70s.  I had intended to go to law school.  I majored in Poly Sci (they called it Government) but I really tried for a well rounded education that involved a few computer courses.

I should also note that I am a night owl, not a worm eater.  If I recall this class was at 8 AM.  I overslept it a lot and probably slept through it while I was attending.

Years later I am working in the technology world.  On one assignment I am designing a unix workstation solution for my customer, receiving the solution at the dock, assembling the components, loading the OS and the applications, etc.

On another assignment many years after this, I was put in charge of a data center and the backup systems.  We had inherited some old tape backup systems that were slow and expensive.  I had to design a new solution.

The point is to file away all knowledge as you never know where it will come in handy for making money, and just because you got a ‘C’, doesn’t mean you didn’t learn anything and cannot use the information.

*SPITR – Smartest Person In The Room – I get very uncomfortable when I see people trying to outdo each other.  A lot of useless spittle is spent.

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What Diversification Really Means

“Don’t put all your eggs in one basket”

“If you put all your eggs in one basket, guard the basket”

Conversations around diversification often revolve around which groups of stocks or mutual funds to own in what proportions:

  • Domestic vs International
  • Large Cap vs Small Cap vs Mid Cap
  • Stock Funds vs Bond Funds
  • Individual stocks or bonds vs mutual funds or ETFs

Being a Senior FI guy, I give this conversation a cranky Harumph!

This is NOT what diversification is really about.

Think of your family unit as a business, YOU INC.

Diversification is about YOU INC. creating multiple independent sources of income.  The hope is that all sources will do well, but in case some do not, the goal is that at least some will in any given time period and YOU INC. will prosper as a result.

Examples:

  • W-2 income: This is income from your full time and/or any part time jobs
  • 1099 Interest income: this is generated when you are the lender, whether it is checking/savings or CDs at banks*, corporate bonds, municipal or US government bonds (or t-bills), or any other type of loan that generates interest for you.
  • 1099 Dividend income:  Dividends are paid by a corporation that is sharing profit on a per share basis.  If you own 100 shares of stock and it pays $2 per year per share, you will make $200 per year in dividends.
  • Schedule E Real Estate Rentals:  You are the landlord and report income (and expenses) on Schedule E of your tax return
  • Schedule E Royalties:  not discussed much on FI websites.  May devote a separate post on this.
  • Schedule C Income:  If you have a side hustle or a full time business that you run as a sole proprietorship, this is where you report this income (and related expenses)
  • Schedule D Capital Gains: The proceeds of selling stocks or other items of value are reported here.  Remember to buy low and sell high!  (How to make a small fortune in the stock market?  Start with a large one!)  Some people have a really good sense of when to buy and when to sell.  I don’t count myself amongst them.  Mutual fund and ETF gains are reported here as well.
  • Sch K-1 (LLC, Partnerships, Joint Ventures, P.A. etc – IRS considers them all the same) – these are all various businesses that file their own partnership return and distribute the income through a Schedule K-1 to each partner.  This is called pass-through income, as the K-1 will tell you which lines of your tax return to put the income on.

If you are going to truly diversify your sources of income, consider generating income from many of these buckets.

The Tie Dye family have used all of the methods above.  Mrs. Tie Dye has her own business (Sch C).  We participate in some partnerships that generate Real Estate and Royalty income.  We have our own rental real estate.  We get 1099s for credit union interest (they call it dividends just to confuse everyone) and for dividend income from stocks we own.  Mr. Tie Dye is still generating W-2 income from a job.

As our mutual funds re-balance their portfolios (sell some stocks and buy others) they generate capital gains which they kindly report to us on a 1099.

I did leave out farm income which reports on other forms.  I don’t see many farmers yet in the FI community.

Some of these sources of income have interesting tax advantages over others.  Sounds like a future post is needed!

The point here is that YOU INC. can diversify by generating as many forms and sources of income as you want.  Do not think of diversification only as a question of which stocks or mutual funds to invest in.  The picture is much larger.

* I doubt most people think of their checking/savings/CD accounts as loans to banks or credit unions.  That is exactly what they are.  Banks pay you wholesale (lower) rates for this money and lend it out to borrowers at retail (higher) rates, making the difference on the arbitrage as one source of profit.  If you want to borrow money at lower rates and lend it at higher rates, become a bank!  This would be yet another source of diversification.

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Life Insurance: Whole Life vs Term

There’s No One with Endurance Like the Man Who Sells Insurance

In the ChooseFI facebook group, https://www.facebook.com/group/ChooseFI/ , the discussion about life insurance comes up from time to time.  Some important items to consider:

  • Why get life insurance
  • How much insurance do I need
  • How long do I need it for
  • Whole Life vs Term

Groundhog Day Insurance Salesman

Why get life insurance?

Like any other product, get it when you need it.  In the case of life insurance, get it when someone else is dependent on your income.  This could be a spouse or partner, and of course, minor children.  These are the beneficiaries of your policy.  Should you die, the beneficiaries will get the insured amount.  If you are single and no one depends on you, you do not need this product.

How much insurance do I need?

You need enough insurance to allow your beneficiaries to replace your take home income, taking into account taxes.

How long do I need it for?

Once your kids have graduated college and your debts are paid off, assuming you have accumulated taxable and pre-tax savings in sufficient amount for your surviving spouse/partner to live off of, you no longer need life insurance.  Figuring this out determines the Term of your policy.

Whole Life vs Term

Whole Life is sold as an investment vehicle wherein a portion of your premium pays for the insurance, a portion is commission to the sales team and a portion is invested in some investment of the insurance company’s preference.

The value of the investment is called ‘cash value.’  Each year the cash value builds.  At some point the cash value may grow to and exceed the face value of the policy.  The annual increase in cash value at some point may be more than the premium and can be used to pay the premium.

You can take the cash value out at any time, as it is your money, but you must either surrender the policy or reduce your death benefit, depending on the details.

Term Life is pure insurance.  Is there any other insurance product you purchase (home, car, medical) that comes with an investment?  Why should life insurance be any different?

Term Life policies are dramatically cheaper than Whole Life policies because there is no investment sold as part of the package.  The field is highly competitive so commissions are low.

Term Life contracts are typically either level or declining for a certain number of years.  So a 20 year level term policy gives you the same death benefit for 20 years, whereas a 20 year declining benefit policy reduces the benefit as you get older.  Level term is the more common product sold these days.

As I see it:  a Whole Life policy is really an expensive declining Term Life policy in disguise.  Why?  Because the insurance company is only at risk for the Face Value – Cash Value of the policy.

Once the Cash Value equals the Face Value, the insurance company is at risk for nothing and you have a not so great investment getting not so great returns.

Since you can do better as a smart person pursuing FI, why would you give the insurance company this large sum of money?

Buy term and invest the difference – that was the slogan of A.L. Williams, an insurance company started in 1977.  While that company (now called Primerica) has had its own issues (it uses MLM techniques to build its sales force), the general concept has caught on with the public and all life insurance companies now offer term plans.

So get as much insurance as you need to protect your loved ones, keep it as long as the need exists (until you are financially independent perhaps) and then discontinue paying for it.

Note that for individuals with very, very large estates, especially illiquid estates like a large family business, a whole life policy can be part of a strategy to keep the business intact after a death of one of the owners.  This probably does not apply to anyone reading this article.