Building Wealth in the Pandemic | 2020 Reflections

Building Wealth in the Pandemic | 2020 Reflections

October 1, 2020

The American Dream in 2020

I was born in Vietnam and raised in Texas. I graduated with a degree in Engineering and I have just started working as an engineer in the Oil and Gas industry two years ago. I thought I was living my American dream with my engineering salary, until one day, I received a huge wake-up call from work. Half of my team was laid off due to the Coronavirus pandemic, some of them were loyal employees with more than 10 years’ experience. I was lucky enough to be kept with my company, however I did not feel happy. It wasn’t me this time but it could have been me or it would be me being laid off when the next recession comes.

As I began to watch and reflect on things that happened during the historic event, there are two things I had learned:

1. I needed to create financial security for myself that no one could take away from me, that includes a second source of income that could help me survive the rainy days.
2. The government could raise tax significantly not only due to the stimulus money for the economic down turn, but also because of the growing cost of health care, education and welfare programs.

Question 1: How can you create financial security?

“If your salary is your only source of income, you are one step away from poverty.”

- Warren Buffett

Let me give you some of my investment ideas:

      1. Investment in Retirement Plans

To ensure you have a financially secure retirement, it is wise to contribute a portion of your paycheck into a tax-advantaged retirement savings plan, and let it grow exponentially. Retirement benefits are important but not everyone understands the benefits offered and which retirement plans are better for them.

Pros:

Traditional 401K/IRA contributions are made with pre-tax dollars, which reduces your taxable income and your tax bracket. Roth 401K, Roth IRAs, in contrast, are funded with after-tax dollars but both principal and growth are tax-free, therefore withdrawals after 59 ½, are also tax-free. Some retirement savings plans also include additional features such as matching contributions from your employer, and Roth 401k conversion.

Cons:

Retirement plans don’t provide leverage, it is your earned money, and is not liquid money. The stock investments may go down with a market crash. If you want to access retirement money prior to 59 ½, you will have to pay 10% penalty in most cases. (We will cover exceptions to this penalty in another blog).

      2. Investment in Real Estate

Have you ever thought about building wealth using "OPM" (other people’s money)? Real estate is one of the most common ways that use “leverage” to invest. Let’s look at some benefits that real estate can bring you.

Pros:

       1. Leverage - You cannot go to the banks and ask them to lend you money to invest in S&P 500. The U.S. government considers home loans, real estate loans as good loans. Nowadays, many people can easily get a mortgage with as little as 3.5% down. How fascinating!

       2. Building Equity - After paying off the mortgage, the value of property is added to your net worth.

       3. Cash generating system - Receive rental income

       4. Hedge against economic volatility - In an economic downturn, you can lower the rents to keep your properties occupied. When the market turns back around, you can raise rents or sell your properties for profits.

Cons:

       1. Managing properties take a lot of time and work.

       2. Usually require a large sum of money for down payment.

       3. Cannot quickly liquidate for cash in case of emergency.

       4. If properties are vacant, vacant time is lost profit

There are some common ways people invest in real estate:

       1. Rental Properties - This is a great way to create an additional income. It could easily add thousands of dollars to your annual income.

       2. House Flipping - Flipping a house means you purchase a house under market value, make improvements, and then sell it within a short amount of time. Buy low, sell high.

       3. Commercial Real Estate:

       4. Apartment building

       5. Warehouse & Offices

       6. Retail Center

       7. Hotels & Resorts

       8. Real Estate Crowdfunding

       9. Private Lending

      3. Investment in Life Insurance

If you think investing in stock market is too risky and being a landlord is too stressful, investing Indexed Universal Life Insurance (IUL) is another alternative. Besides a payout of death benefits and long-term care benefits, there is a small "bank" inside each insurance policy called “cash value”.  You can store your money inside your policy and let it grow with minimum risk. You have a choice to tie up to 100% of the policy's cash value to a stock market index, such as the S&P 500 or Nasdaq 100. If your indexed account shows gains, a percentage of the interest income is added to the cash value of the policy. If the index falls in value due to market downturn, your account will not lose much value compared to the market.

Pros:

                  1. Little to no risk. When the market goes south, the money inside your insurance policy doesn’t lose its value.

                   2. Money in cash value can be accessed anytime.

                   3. There is no contribution limit. The bigger the policy coverage, the more you can invest or you can buy multiple policies.

Cons:

       1. Because some portions of your invested money will be contributed to the cost of insurance, rate of return will be lower than an average market return.

       2. If you don't structure well, cost of insurance can be very costly when you reach 70-90 years old

       3. Life insurance illustrations can be complicated, you need to consult with professional.

      4. Investment in Business

Have you heard about the famous “Cash- flow Quadrant” by Robert Kiyosaki? His cash-flow quadrant divides all people into one of four categories based on their financial situation. The four types are (E)employee, (S)self-employed, (B)business owner and (I)investor.

The first 2 quadrants (E) and (S) are people who are dependent on their jobs and trade time for money. Because there’re only 24 hours a day, the amount of money you can make have a limit.

The (I) quadrants are investors - those who earn money through investing in real estate, stocks, bonds, etc., discussed above.

The (B) quadrant, are business owners (entrepreneurs), who design systems comprised of people and processes to generate a profit.  If you belong to this quadrant, your money can easily be doubled or tripled if you do it right. There is no limit to the income you could make.

Question 2: How can you strategize taxes?

“A fine is a tax for doing wrong. A tax is a fine for doing well.”

- Mark Twain

It scared me when I first looked at the history of income tax rates

Taxes could take away a large portion of your hard-earned money. The good news is you can use a CPA's help to perform tax planning and save taxes.

I would like to help you by providing some ideas of what I am currently doing and will be doing in the future. My plan is not only to find different ways to build up wealth, but also to have a strategic tax savings plan.

      1. Investment in Retirement Plans

Would you like to save taxes and keep more money for yourself right now? You can take advantage of contributing to Traditional 401k and Traditional IRA, and reducing your taxable income. Here are some of its tax features:

• Pay taxes later, reduce your taxable income now
• Principal and growth will be taxed at a later date

If you can afford paying taxes now and save taxes for the future (when your income is higher), you can take advantage of Roth 401K and Roth IRA contributions. Here are some of its tax advantages:

• Pay taxes now, all your retirement can be accessed tax-free.
• Money grows without any taxes.

The chart below helps you visualize how much money a Roth account can save you.

Scenario #1: Low Tax Bracket Now, High Tax Bracket later

Scenario #2: High Tax Bracket Now, Low Tax Bracket Later

      2. Investment in Real Estate 

       1. Real Estate Depreciation is a great expense deduction based on property value.

       2. If you sell your property to purchase another property equal or greater value, IRS Section 1031 Exchange allows you to defer taxes on capital gains. If used correctly, there is no limit on how many times or how frequently you can do 1031 exchanges.

       3. $250,000/$500,000 Home Sale Exemption - If you live in a property for at least two of the last five years, and your property appreciates up to 250,000 in value (500,000 if you’re married and filed jointly), your capital gain is tax exempt when you sell the house. That means you could live in a house for 2 years and rent it out for 3 years, still get tax exemption benefit.                              

      3. Investment in Life Insurance

The maximum contribution for Roth IRA is only $6,000 in 2020. People with higher income cannot contribute to a Roth IRA, unless they do Backdoor IRA (We will cover IRA details in a later blog).

You may be asking yourself: “Is there a similar way to invest your money tax-free?”. As mentioned above, there is another way to invest your after-tax money and pay no tax on the money you receive in the future through Life Insurance. There are different types of life insurance out there, the one that I want to focus on is Indexed Universal Life Insurance, also known as IUL. Here is the list of how IUL can help you save taxes:

                  1. Invest with after-tax money. Distributions from a life insurance policy are tax-free if planned right.

                  2. Money can be accessed any time, any age, for any reason - no tax and penalty if planned right

                  3. Death benefit and cash value inside the insurance policy can be passed to your heirs tax-free.

P.S.: Even though money inside insurance policy can be access anytime and for any reason, I wouldn’t recommend you access it too early, it will reduce the death benefit. Consider it as a retirement account. Wealthy people like Warren Buffet use life insurance as a place to park their money, diversify portfolio, then wait until next market crash to withdraw that money and buy cheap assets.

      4. Open your own business

Last but not least, the number #1 way to save on your taxes is to convert your personal expenditures into tax deductions. Turn your hobby into a business and maximize your eligible deductions to save taxes. If you don’t have a business, what are you passionate about? Start a business, either part time or full time.

Do you know that business owners pay less taxes than employees? This is because there are many business expenses that can be deducted from income to reduce profits. There are a few popular categories such as:

       1. Rents

       2. Meals and Entertainment

       3. Business Equipment such as Computers, Cellphones

       4. Mileage deduction for Business Cars

       5. Business Travel

       6. Sep IRA can also be funded to reduce taxes and save for retirement

***Tax rules might change per year and some of the tax benefits no longer apply at certain income levels. Before you assume you qualify for any tax benefits, please consult with a tax professional.

By Leah Nguyen

Sources and Links to Reference:

      1. Sabatier, Grant, et al. “Roth 401k Might Make You Richer.” Millennial Money, 7 Aug. 2020, millennialmoney.com/roth-401k-vs-traditional-401k/?fbclid=IwAR1PiurcHX7wxSsBI-vxZFfHej7R_dsXZqwgUnKxL52yIa19SHyFNAJ-qU4.

      2. Lyons, Ruth, et al. “Pros and Cons of Real Estate Investing: What You Should Consider.” Investor Junkie, 8 June 2020, investorjunkie.com/real-estate/pros-and-cons/.

      3. Powers, Stephanie. “Indexed Universal Life (IUL) Insurance.” Investopedia, Investopedia, 28 Aug. 2020, www.investopedia.com/articles/insurance/09/indexed-universal-life-insurance.asp.

      4. Kiyosaki, Robert T., and Sharon L. Lechter. The Cashflow Quadrant: Rich Dad's Guide to Financial Freedom. TechPress, 1998.

      5. “What Is a 1031 Exchange? The Basics for Real Estate Investors.” CWS Capital, www.cwscapital.com/what-is-a-1031-exchange/.

      6. Saving Your Future: Basic Principles of Building a Financial Foundation. X Press WSB, Inc., 2015.

      7. Quann, Mark J., and Josh Shapiro. Top 10 Ways to Avoid Taxes: a Guide to Wealth Accumulation. Publisher Not Identified, 2019.