- I've made my fair share of money mistakes over the years. But now, as a financial planner, I can help others avoid the same.
- There are two types of investments I see young people misuse: permanent life insurance and Roth retirement accounts.
- Paying into a permanent life insurance policy instead of maxing out tax-advantaged retirement accounts is a mistake. You will never earn the same investment return.
- Roth retirement accounts can be useful, but pre-tax accounts may be your best option when you're in your 20s and 30s.
- SmartAsset's free tool can find a financial planner to help you take control of your money »
Regret, unfortunately, is part of life. We all have decisions we wish we'd made differently, or actions we'd rather take back — especially when we look back on our finances and see mistakes we made in the past.
Even though I'm a nationally recognized financial expert now, I'm not exempt from having a few financial regrets of my own.
There are a handful of financial decisions I made when I was younger that I wish I could do over. While that's not possible, I can help generations coming up behind me avoid their share of mistakes.
In that vein, here are two very common investments I most frequently see younger folks misuse.
One of my biggest pet peeves is seeing a diligent saver in their 20s, 30s, or 40s bypass tax-favored savings vehicles to obtain a permanent life insurance policy that accumulates cash value. These products are often oversold by insurance salespeople — meaning, the people who purchased the policies bought far more than they truly needed.
Putting money into a cash-accumulating life insurance policy is not a replacement for investing into pre-tax investment vehicles. That's not to say these products can't be useful to the right people, but you should max out tax-deferred plans and accounts first.
Why? For one, the cost to invest dollars is much higher if you do so within a life insurance policy.
The main purpose of a life insurance policy is to provide a death benefit. There is a built-in cost associated with that benefit, whether you purchased the policy for that or not. Those costs come in the form of administration fees and mortality and expense risk charges, which can quickly eat into your desired return.
Second, unlike other pre-tax accounts, like 401(k) plans and traditional IRAs, you lose the ability to write off any contributions made to a life insurance policy when you file your tax return.
The cash accumulating within a life insurance policy does grow tax-deferred and can be withdrawn tax-free via policy loans — but you'd need to do a detailed tax projection to see if punting your tax benefit into the future provides a greater benefit than writing it off today. Most people simply eyeball this analysis, which may not always yield the best decision.
Third, putting money into a life insurance policy instead of a traditional investment portfolio means possibly losing out on full stock market participation.
This is where reading the details in the fine print of your life insurance policy is paramount. With most insurance policies, investors do not fully participate in the full returns of the stock market. Individuals are either capped at a specific return rate, or are subject to what insurance companies call participation rates. The insurance company's participation rates are typically set anywhere from 25% to more than 100%.
Unless you've already exhausted all pre-tax and low-cost, tax-deferred savings strategies, using permanent life insurance as an investment is usually a mistake. Even after using all other avenues, don't bypass the necessary steps of assessing how a permanent life policy can affect your tax situation and your assets' growth trajectory before purchasing this product.
Most people are told that they should contribute to Roth 401(k)s and Roth IRAs whenever they can. While Roth accounts can provide benefits to savers and investors, knowing whether or not you should take advantage of them just because they're available, or you're allowed to, is not an automatic decision.
I know the allure of receiving tax-free withdrawals, but don't think this means you don't pay taxes on the funds at all.
Whether you contribute to a Roth 401(k) or Roth IRA, the funds you put into the account are considered "after-tax," meaning they were taxed prior to your contribution. You should consider if your current income (and the rate at which you expect that income to be taxed) is more likely to increase or decrease in the future.
Traditional advice tends to assume that you will probably make more income the longer you work, so saving in a Roth while you're young (and withdrawing the money later, when you're older, earn more, and are therefore in a higher tax bracket) makes sense. But this doesn't consider a number of factors that could change the situation.
For one, tax laws can change any time Congress passes new legislation. In addition, It usually takes younger investors time to gain significant tax write-offs (like having a mortgage on a home and being able to deduct interest on the loan, changing your tax status to married filing jointly, having children and claiming associated tax credits for dependents, or starting a business and finding more deductions there).
Given that, pre-tax savings vehicles may be your largest tax shelter while in your 20s and 30s. This is not a benefit you would want to dismiss without considering all potential consequences.
As a young investor, it pays to be mindful of both excessive costs and paying unnecessary taxes. Working with a certified financial planner to create a sound plan or cash-flow projections can give you the roadmap needed to make choices like when to contribute to a cash-value life insurance policy or any type of Roth account a lot easier.
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