3 wealth destroyers to fight ferociously: taxes, inflation and overspending by Bruce Fraser

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When financial planner J. Landon Loveall was a teenager growing up, he says,  “I guarded my Lego creations with life and limb from the destructive nature of  my little sister.” Loveall is founder and president of Cumberland Wealth  Planners in greater Nashville, Tenn.

Creating wealth is not unlike building something solid with Legos, as  discussed in the article “Steps  to building wealth.” In the same way, you must protect your wealth from  destructive forces, such as taxes and inflation, which can erode wealth. Add to  these another wealth destroyer: overspending.

Tax strategies

Tax planning can help you save hard-earned dollars. But to be effective, tax  planning must be proactive.

While there are ways to minimize taxes, you can’t avoid them completely. “On  every gross dollar you earn, pay your taxes first,” says Rick Kahler, president  of the Kahler Financial Group in Rapid City, S.D. “Estimate your total tax  liability and be sure your employer withholds enough to cover it. If you are  self-employed, set up a savings account, deposit a percentage of every check,  and use that money to pay your quarterly estimated taxes. Never raid these  funds.”

Planners generally recommend that high-income earners place assets that  produce ordinary income (interest and short-term capital gains) into  tax-deferred accounts. Assets that produce long-term capital gains and dividends  can go into taxable accounts.

Be careful about placing real estate into such tax-deferred accounts as a  self-directed IRA. You will lose the long-term capital gains advantage and  instead turn the gains into ordinary income tax.

Congress increased income tax and capital gains tax rates for the 2013 tax  year for those pushed into higher income brackets. Kahler says investors who  sell appreciated assets will need to pay close attention to tax  consequences.

“The 3.8 percent Obamacare surtax and the 20 percent capital gains tax  bracket will catch many ‘small’ investors by surprise,” he says. Many investors  with large gains may benefit by splitting sales of appreciated assets, selling a  portion one year and another portion in the following year, for example.  “Splitting sales into several years could mean a savings of up to 8.8 percent.  That’s huge,” he says.

Building wealth is like building a solid structure with Legos — you must  protect it from destructive forces.

There are three wealth destroyers that you should fight with all your  might: taxes, inflation and overspending.

Effective tax planning can minimize the amount of taxes you pay on your  wealth. This includes estimating your tax liability and making sure your  employer withholds enough money from your paycheck to cover it. For the  self-employed, depositing a percentage of your pay into a separate savings  account and using those funds to pay your quarterly estimated taxes should do  the trick.

Combat inflation by maintaining exposure to asset classes that can  outpace inflation.

Overspending is the most harmful wealth destroyer, but the one you have  the most control over. Avoid lifestyle creep; just because your income grows  doesn’t mean your spending has to.

Combating inflation

Inflation is another insidious wealth destroyer. While small increases in the  cost of goods and services may seem benign, over time, inflation deals a deadly  blow to wealth. For example, assuming a 3 percent annual inflation rate for 25  years, the value of a dollar shrinks to less than half, to about 48 cents. A  nest egg of $1 million shrinks to $478,000 in 25 years. That’s huge.

Planners say it’s important to maintain exposure to asset classes that can  outpace inflation in the long term when interest rates rise — including  equities. Consider also Treasury Inflation-Protected Securities, or TIPS,  commodities, international bonds and real estate investment trusts, or REITs,  which can help you squeeze more yield out of the current interest-rate  wilderness, says Kahler.

One should also consider alternative investment strategies such as merger  arbitrage, long-short funds and managed futures as inflation busters, he says.  You should also keep the duration of your high-quality bonds under five years,  he advises.

Spending: The worst wealth destroyer

Of the three wealth destroyers — taxes, inflation and overspending — the  last one can have the most destructive effect on your wealth if not kept in  check. It’s the force over which you have the most control.

“A bigger threat to wealth-building is lifestyle creep,” says Loveall. “Most  people allow their lifestyle to grow as fast as their income. Doing this  destroys their ability to take advantage of their income to building  wealth.”

Notably, the people who built wealth and rose to become millionaires in “The  Millionaire Next Door” by Thomas J. Stanley, Ph.D. and William D. Danko, Ph.D.,  didn’t wear designer clothes, drive luxury cars or live in extravagant houses.  They more typically wore jeans bought on sale, drove low-cost cars, lived in  middle-class neighborhoods and shopped at Wal-Mart or Target.

And just as they take advantage of sales at these discounters, the wealthy  invest consistently through all market cycles. Warren Buffett, perhaps the most  famous investor of all time, became a particularly vocal advocate of investing  in stocks during the 2008 financial crisis, when the stock market fell  precipitously, offering true bargain prices in stocks.

Though many investors tend to get nervous and sell their stock positions when  the market is freefalling, taking that step can be a very expensive mistake.  Maintaining an investment plan over the decades is one of the most important  steps to building wealth and thwarting its destruction.

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