Money Magic – Financial Independence - Laurence Kotlikoff
Retire Richly. Financial independence. Money Magic. Laurence Kotlikoff. Jar with savings money
"Money Magic - An Economist's Secrets To More Money Less Risk And A Better Life" by Laurence Kotlikoff offers a compelling and often counterintuitive guide to modern financial problems and tactics for those that to enhance their financial well-being, mitigate risk and strive for financial independence. Kotlikoff, a distinguished economist, argues that traditional financial advice is fundamentally flawed and can lead households into expensive and dangerous financial products rather than accumulate financially independent wealth. Kotlikoff expands on the foundational idea of "smooth living standard over time" by detailing how individuals can optimize their financial lives through strategic decisions regarding their careers, retirement, housing, marriage, divorce, education, and investment portfolios. Kotlikoff offers specific advice on longevity, retirement age and social security income.
RATINGS FOR MONEY MAGIC – ECONOMISTS SECRETS TO MORE MOMEY, LESS RISK AND A BETTER LIFE- BY LAURENCE KOTLIKOFF
Goodreads 3.6/5.0
Amazon 4.4/5.0
TOP THREE THEMES OF BOOK MONEY MAGIC FOCUS ON MAXIMIZING SOCIAL SECURITY INCOME AND DELAYING RETIREMENT AGE
Maximize Social Security Benefits. The book emphasizes that Social Security is often an individual's largest or second-largest financial asset, making its proper management crucial. It reveals that most people are unaware of the thirteen different benefits available, and that failing to formally claim them can result in "losing out on free money". A primary secret highlighted is the significant financial gain from delaying Social Security retirement benefits until age seventy, which can increase lifetime payouts by hundreds of thousands of dollars, far outweighing early collection. The book also warns against misleading advice from official sources and stresses the importance of proper sequencing for spousal and survivor benefits.
Delay Retirement for Financial Gain. "Money Magic" strongly argues that retiring early is often "financial suicide" for many, leading to a substantial reduction in living standards over the long term. The book challenges the conventional use of "life expectancy" in financial planning, insisting that individuals should plan for their "maximum life span" to avoid outliving their savings. Working just a few additional years can lead to a dramatic increase in sustainable lifetime spending, potentially boosting it by more than 17% for some households, a far more impactful strategy than aggressive saving alone.
Challenge Conventional Investment Beliefs. The book critically examines traditional investment advice, identifying it as often leading to significant financial mistakes. A core principle presented is that "stocks aren’t safer in the long run," directly contradicting the common belief that long-term stock holding guarantees returns; instead, stock prices often follow a "random walk". Counterintuitively, the book suggests that "the rich should invest in bonds and the poor in stocks," arguing that lower earners' Social Security benefits already act as a substantial safe asset, balancing their overall portfolio. It also introduces "upside investing," a strategy that sets a living-standard floor while allowing for gains from risky assets without downside risk.
“All of our financial decisions—whether about our education ... involve our living standard.”
“Don’t borrow for college — it’s far too risky.”
BOOK MONEY MAGIC PROVIDES DIVERSE INSIGHT TO BECOME FINANCIALLY INDEPENDENT
Career Management as the Foremost Money Trick: Kotlikoff emphasizes that managing careers well is "the most important money trick going" for maximizing lifetime earnings. He highlights surprising truths, such as the claim that plumbers can earn as much as general practitioners (GPs) over their lifetimes after factoring in education costs, training time, and automation risks. The author advocates for continuously researching career options using resources like the Bureau of Labor Statistics (BLS) and leveraging "compensating differentials"—extra pay for unpleasant or undesirable jobs—by finding work that aligns with one's unique preferences. He also champions entrepreneurship for offering "maximum job security" and "enormous rewards".
The Magic of Delayed Retirement: One of the book’s most impactful arguments is that delaying retirement can dramatically increase one's living standard. Kotlikoff strongly advises planning to one's "maximum life span" (e.g., age 100) rather than relying on average "life expectancy". He demonstrates how even a few extra years of work can translate into hundreds of thousands of dollars in increased lifetime spending, particularly for lower earners, and how it reduces the required savings rate during working years.
Maximizing Social Security Benefits: Social Security is presented as "one of the most important, if not the most important, financial factor in most people’s lives" and often their largest economic asset. The author reveals "ten secrets" to maximize these benefits, with the most significant being the enormous financial incentive to delay collecting retirement benefits until age 70. This delay can yield hundreds of thousands of dollars in increased lifetime benefits for individuals and can also bequeath higher survivor benefits to spouses. He cautions against relying on Social Security Administration (SSA) staff or website for advice, citing instances of misleading or incorrect information.
Strategic Use of Retirement Accounts: Kotlikoff simplifies the complex world of retirement accounts, categorizing them into "tax-deferred" (traditional IRAs/401(k)s) and "non-tax-deferred" (Roth IRAs/401(k)s). He highlights the importance of the employer match as "free money". The primary goal in using these accounts is "tax-bracket smoothing"—paying taxes when one's marginal tax rate is lowest, often through strategic contributions, withdrawals, and Roth conversions. He also stresses that "cashing out your retirement-account assets to pay off your mortgage can be a big winner" due to interest rate differentials.
Becoming "House Rich": The book aims to help readers optimize their housing decisions, arguing that mortgages are "financial and tax losers" due to higher interest rates compared to safe investments and the limited applicability of the mortgage interest deduction. Kotlikoff highlights that homeownership is a significant "tax shelter" because imputed rent (the benefit of living in one's own home) is not taxed. He promotes "economies of shared living" through cohabitation ("shack up with Mom!") and downsizing, demonstrating how these can dramatically increase one's living standard. He advises caution against "expensive and risky" reverse mortgages.
Marry for Money, Divorce Only If It Pays: Kotlikoff directly addresses the financial implications of marriage and divorce. He unapologetically states, "Marry for money. You’re worth it. And yes, money can buy you love". He quantifies the "economies of shared living" from marriage, showing that it can raise a couple’s living standard by "more than one-third". For divorce, he offers "grim advice": "Assume you’ll get divorced", advocating for a careful cost-benefit analysis before splitting, as divorce can be "one of the most destructive financial forces on the planet". He stresses the financial benefits of prenuptial agreements and warns against costly legal battles.
Don't Borrow for College: This chapter delivers a stark warning: "Don’t borrow for college. It’s far too risky". Kotlikoff points out the alarming statistic that 40% of college entrants never graduate within six years, often saddled with debt for an unfinished education. He highlights the dangers of student loan default, which can lead to wage garnishment and even interception of Social Security benefits. He encourages understanding the "net price" of college (after aid) rather than the "sticker price" and advocates for forming one's own rankings of academic quality based on research faculty, rather than relying on misleading national rankings. He suggests leveraging online courses from elite institutions for "signaling value" and pursuing the "transfer game" to obtain an expensive education cheaply.
Investing Like an Economist: This section systematically dismantles conventional investment advice, arguing it’s based on four major economic mistakes, including encouraging incorrect saving levels and fixed spending targets. Kotlikoff introduces the concept of the "living-standard (LS) cone" to visualize financial trajectories and challenges the common belief that "stocks aren’t safer in the long run". He argues that the rich should invest more in bonds, and the poor in stocks to balance their overall human and financial capital. He also introduces "upside investing" as a strategy to invest in risky assets while maintaining a "living-standard floor", akin to gambling with a fixed sum in a casino.
PERSPECTIVE OF LAURENCE KOTLIKOFF, AUTHOR MONEY MAGIC
Laurence Kotlikoff’s perspective is deeply rooted in his extensive academic background as a Professor of Economics at Boston University, a fellow of the American Academy of Arts and Sciences, and a research associate of the National Bureau of Economic Research. This scholarly foundation permeates the book, shaping its rigorous, analytical approach to personal finance. He openly embraces being a "two-handed economist", willing to present nuanced arguments and challenge prevailing norms.
His academic journey, which began with a pivot from medicine to economics due to a fascination with its "potential to help people", directly informs his work. Kotlikoff emphasizes the use of complex mathematical models and computer algorithms, such as "iterative dynamic programming" and his proprietary "MaxiFi Planner" software, to solve financial problems that are "unbelievably complex—far beyond the capacity of our brains to solve without some clear direction". This viewpoint explicitly rejects the premise of "behavioral finance" which, he argues, unfairly blames individuals for their financial missteps.
Kotlikoff is a "hard-nosed" economist who "pulls no punches", often delivering blunt and counterintuitive advice, such as planning for a "longevity catastrophe" or telling a ninety-year-old to buy stocks. He positions himself as a "conscientious fiduciary", aiming to provide "real financial cures" rather than "fake elixirs", distinguishing his economics-based approach from conventional financial planning, which he views as often misguided and driven by industry incentives. His self-awareness regarding his potential bias as a software creator is also noted, though he still strongly advocates for his method due to its theoretical grounding.
“making perfectly correct personal financial decisions literally requires rocket science.”
“economists can do more than study people’s financial mistakes.”
MONEY MAGIC PROVIDES RIGOROUS, THOUGHTFUL INSIGHT TO BECOME FINANCIALLY INDEPENDENT
Originality and Depth of Insight: The book truly shines in its ability to challenge deeply ingrained financial assumptions. It forces readers to re-evaluate common wisdom, such as the idea that stocks are safer in the long run or that early retirement is always desirable. The depth of economic theory, drawing on Nobel laureates like Merton and Samuelson, provides a robust framework for its advice.
Rigorous, Evidence-Based Approach: Unlike many personal finance books that rely on anecdotes or rules of thumb, "Money Magic" is firmly grounded in decades of academic research and computational analysis. The author's personal experience developing complex financial planning software (MaxiFi Planner) lends credibility to his assertions about the necessity of a scientific approach.
Focus on the "Living Standard": By defining the "living standard" (spending per household member over a lifetime) as the ultimate financial metric, Kotlikoff provides a holistic and intuitive way to assess financial decisions that goes beyond mere wealth accumulation or retirement savings targets. This re-framing helps readers understand the true "price" of lifestyle choices.
Practical and Actionable Advice: Despite its theoretical underpinnings, the book translates complex economic concepts into concrete, actionable "secrets". The numerous examples involving hypothetical and real households (e.g., the Smiths, Martha, Jerry) make the abstract concepts tangible and relatable, demonstrating the profound impact of applying these principles.
Unique Perspective on Risk: The introduction of the "LS cone" and the concept of "upside investing" provides a sophisticated yet understandable framework for managing financial risk. The argument that paying off debt is the "best investment" because it's safe and provides a guaranteed return, and that investing heavily in risky assets like stocks can be akin to "borrowing to gamble," is a crucial differentiator from conventional advice.
MONEY MAGIC ADDRESSES SOME CONCEPTS OF INVESTING PSYCHOLOGY AND INVESTMENT PORTFOLIOS THAT MAY BE COMPLEX
Complexity and Accessibility: Despite the author's intention to make the book accessible, some of the underlying economic concepts and technical details (e.g., "iterative dynamic programming," "LS cones," "random walk" in depth) can still be challenging for readers without a strong financial or economic background. The density of information, especially in chapters on Social Security rules or retirement accounts, might be overwhelming for a casual reader.
Repetitiveness: Some core messages, particularly about planning to maximum life span and delaying Social Security benefits, are reiterated frequently across multiple chapters. While this reinforces key points, it can also make the reading experience feel repetitive at times.
Authorial Voice and Tone: Kotlikoff's "hard-nosed" and direct tone, while refreshing for some, can come across as blunt or even condescending to others (e.g., "screwed the pooch", "nuts", "conehead"). The occasional self-congratulatory remarks and explicit promotion of his company's software, while acknowledged, might detract from the academic neutrality for some readers.
Simplistic Assumptions for Illustrations: While necessary for clarity, the constant assumption of a "1.5 percent nominal return" and "zero real return" might lead some readers to overlook the real-world variability of interest rates and inflation, even if the author addresses it elsewhere.
“Don’t overpay for housing.”
“Homeownership is a tax shelter.”
WHO SHOULD READ THE BOOK MONEY MAGIC BY LAURENCE KOTLIKOFF?
"Money Magic" is ideal for financially conscious individuals seeking a deeper, more robust understanding of personal finance than what traditional advice offers. It particularly benefits those facing significant life decisions—such as career changes, retirement planning, home buying, or family formation—who are willing to engage with economic theory to make optimal choices. Readers open to unconventional wisdom and a direct, analytical writing style will find it highly rewarding. While the book aims for accessibility, it demands a certain level of engagement and comfort with quantitative thinking, making it more suitable for motivated general readers and potentially valuable for financial advisors looking to evolve their methodologies to a more evidence-based approach. It is less suited for those looking for quick fixes or simplified rules of thumb.
WHAT SIMILAR BOOKS ON FINANCIAL INDEPENDENCE AND PERSONAL FINANCE SHOULD YOU READ?
Other books by Laurence Kotlikoff: Notably, "Get What’s Yours", coauthored with Paul Solman and Phil Moeller, specifically delves into maximizing Social Security benefits, a key theme also elaborated in "Money Magic."
Books by academic economists on personal finance: It shares a lineage with works like Burton Malkiel’s "A Random Walk Down Wall Street", which emphasizes market efficiency, and Moshe Milevsky’s "Are You a Stock or a Bond?", which explores how human capital affects asset allocation. Kotlikoff also references Zvi Bodie’s "Risk Less and Prosper", another work from an economics perspective that challenges traditional risk management.
Books on college finance: Ron Lieber's "The Price You Pay for College" and Phillip B. Levine's "Mismatch: The New Economics of Financial Aid and College Access" offer complementary perspectives on navigating college costs, a topic Kotlikoff tackles with strong warnings against student debt.
HOW IS MONEY MAGIC DIFFERENT FROM OTHER BOOKS ON FINANCIAL INDEPENDENCE?
Rigorous Economic Foundation: Its most prominent differentiator is its unwavering commitment to economic theory and Nobel Prize-winning insights. Unlike books that offer anecdotal or common-sense advice, Kotlikoff’s recommendations are derived from complex models, emphasizing a scientific approach to personal finance.
"Living Standard" as the Central Metric: While many books focus on accumulating wealth or maximizing returns, Kotlikoff's singular focus on optimizing one's "sustainable living standard" provides a fundamentally different and arguably more human-centric goal. This allows for a more comprehensive assessment of life decisions beyond purely financial metrics.
Computational Necessity: Kotlikoff explicitly states that the human brain alone cannot solve the complexity of modern financial problems. This leads to his advocacy for sophisticated software tools (like MaxiFi Planner), a stance rarely seen in personal finance books that typically empower readers to do it themselves with simple calculations.
Counterintuitive, "Hard-Nosed" Advice: The book's willingness to contradict conventional wisdom on numerous fronts—from the riskiness of long-term stock holdings to the benefits of delaying Social Security, or the optimal investment strategy for the rich versus the poor—sets it apart. This directness, while potentially off-putting, aims to provide genuine, unvarnished financial truths.
MAGIC MONEY – LAURENCE KOTLIKOFF – FINANCIAL INDEPENDENCE - CONCLUSION
"Money Magic" by Laurence Kotlikoff is a powerful and provocative read that challenges the very foundations of conventional personal finance advice. It’s a call to arms for individuals to abandon simplistic heuristics and embrace a rigorous, economics-based approach to managing their money. While its dense theoretical explanations and occasional self-promotion may require patient engagement, the insights offered are profound and potentially life-changing. By reframing financial goals around a sustainable "living standard" and providing a blueprint for making informed decisions across all major life stages, Kotlikoff delivers on his promise of "money magic". For those willing to transcend common misconceptions and adopt a "hard-nosed" yet ultimately empowering perspective, this book serves as an invaluable guide to achieving a more secure, prosperous, and happier financial life. The invitation to conduct regular "financial checkups" and the promise of making financial planning "immensely fun and rewarding" underscore the author's commitment to empowering readers to take control of their financial destiny.
“making you more money, reducing your risk, and enhancing happiness.”
“mortgage payments are not part of the cost of owning a home.”
FREQUENTLY ASKED QUESTIONS ABOUT MONEY MAGIC BY LAURENCE KOTLIKOFF
What exactly is "Money Magic," and how does economics-based financial planning differ from conventional advice?
"Money Magic" refers to the powerful and often surprising ways economics can help individuals find more money, lower their risk, and enhance their quality of life, often without gambling or resorting to complex schemes. It's about optimizing your financial decisions through the application of economic principles, rather than relying on outdated rules of thumb or self-interested industry heuristics. The core difference between economics-based financial planning and conventional advice lies in their fundamental approach and goals.
Goal Focus: Conventional advice often focuses on maximizing wealth accumulation or achieving arbitrary "replacement rates" for retirement income, which may not align with an individual's actual needs or optimal spending patterns. Economics-based planning, conversely, focuses on your living standard (LS)—the spending per household member you can afford over your lifetime—and aims to keep it as smooth and stable as possible, even in the face of uncertain future events. This involves ensuring you don't starve when young or splurge when old, a principle called "life-cycle consumption smoothing".
Complexity Recognition: Kotlikoff argues that financial problems are "unbelievably complex"—far beyond the capacity of our brains to solve without clear direction. Conventional advice, however, often simplifies these complexities into crude rules of thumb. Economists, like Kotlikoff, use sophisticated computer algorithms (like his "iterative dynamic programming" which garnered a patent) to handle the myriad interdependent factors, tax rules, and benefit provisions, which literally requires "rocket science".
Holistic View: Economics-based planning considers all aspects of your financial life—education, career, job, lifestyle, marriage, retirement age, taxes, Social Security, and investments—and their interdependent impacts on your living standard. Conventional advice often treats these as separate silos.
Critique of Conventional Simulation: Conventional financial planning often uses Monte Carlo simulations but assumes you continue to save the wrong amount, put pre-retirement savings on autopilot, set unrealistic retirement spending targets, and keep that spending target on autopilot. This approach leads to recommendations for overly risky and expensive investments to meet often unrealistic goals. Kotlikoff contends that this is fundamentally flawed, likening it to "using a map of Los Angeles to drive in New York City".
Why is delaying retirement and Social Security benefits so important, and how does it help?
Delaying retirement and, consequently, the start of Social Security benefits, is one of the "simplest and most powerful ways to get more money" without gambling your savings. The sources highlight several critical reasons why this is a highly beneficial "money magic" trick:
Addressing Longevity Risk: Most people underestimate how long they will live, planning for their "life expectancy" (an average) rather than their "maximum life span" (the oldest age they could possibly live). Planning to your maximum age (e.g., 100 years old) dramatically increases your planning horizon and reveals the true need for savings. If you retire early and live longer than expected, you face a significant risk of running out of money.
Increased Social Security Benefits: Waiting to collect Social Security benefits, particularly until age 70, results in significantly higher lifetime benefits. This is due to "delayed retirement credits (DRCs)," which increase your annual benefit by 8% for each year you wait past your full retirement age, up to age 70. For example, waiting until age 70 instead of 62 can make your retirement benefit roughly 76% higher. For a hypothetical Sandy earning $50,000 annually, this translated to a $267,520 increase in lifetime benefits. These actuarial adjustments were designed decades ago when interest rates were higher and lifespans shorter, meaning the Social Security Administration currently "overpays us at an astounding rate for being patient".
Offsetting Taxes and Legacy: While higher benefits might seem to incur more taxes, delaying collection can lead to lower overall lifetime taxes by smoothing out taxable income across years. Furthermore, higher-earning spouses who delay benefits also provide higher survivor benefits for their spouses (or qualifying ex-spouses) should they pass away first.
Reduced Savings Burden: Working longer significantly reduces the amount you need to save annually during your working years to maintain a stable living standard in retirement. For someone earning $100,000 per year, working five extra years could add $500,000 in earnings and reduce the necessary pre-retirement saving rate by 40% (from 20 cents to 12 cents per dollar earned). For lower earners or those with limited savings, retiring later can be "financial salvation".
Suspending Benefits: If you took benefits too early, you can suspend them between your full retirement age and 70 to accrue DRCs and restart at a higher value.
Why should I avoid borrowing for college, especially if it's a "top" school?
The sources present a stark warning: "Don't borrow for college—It's Far Too Risky". This advice stems from several critical factors:
High Dropout Rates: A shocking 40% of college entrants never graduate within six years, yet most have borrowed for the privilege. This means a significant portion of student debt is incurred without ever receiving the expected degree or the associated earning potential.
Misleading "Awards" and Hidden Costs: College financial aid "award" letters often mislead students by lumping actual grants and scholarships with loans, failing to disclose crucial details like interest rates or repayment terms. Parents, too, often incur "Parent PLUS" loans at high interest rates, sometimes unaware their children may be implicitly expected to repay them, effectively hiding the true debt burden from the student.
Non-Dischargeability: Unlike most other debts, student loans are rarely dischargeable via bankruptcy. This means defaulting on student loans leads to severe, long-lasting consequences, including wage garnishment, interception of tax refunds, withholding of Social Security benefits, damage to credit history, and ineligibility for future aid.
Exorbitant Costs and Questionable Value of "Prestige": Many universities charge "astronomical" sticker prices, with some exceeding $74,000 per year, leading to potential six-figure debt for a four-year degree. While elite schools gather successful people, they don't necessarily make them successful; studies suggest that, after controlling for a student's ability and work ethic, future earnings don't depend on whether they attended an elite school. The idea that paying "big bucks to attend an elite school is likely a huge waste of money" unless significant financial aid is received.
Alternatives for Quality Education and Signaling: Students can pursue an excellent education at far lower costs by:
Comparison shopping: The "net price" (sticker price minus grants/scholarships) can be dramatically lower for low- and middle-income families, even at prestigious schools.
Strategic asset/income management: Parents can manage their finances (e.g., contributing to retirement accounts, paying down mortgages) to reduce their "expected family contribution" and lower the child's net cost of college.
Forming your own rankings: Focus on the research quality of specific departments, not unreliable overall college rankings, to find institutions with excellent teaching at affordable prices.
Leveraging online learning and transfers: Access elite education via free or low-cost online courses for certificates and grades, or attend an inexpensive school for a couple of years before transferring to a more prestigious one. This allows you to get the "signaling value" of elite schools on the cheap.
“Shacking up is a very powerful way to safely raise your living standard.”
“Assume you’ll get divorced.”
How can my housing decisions significantly impact my financial well-being?
Don't Overpay / Keep Tabs on the Market: Continuously monitoring housing costs in all potential living areas, whether for buying or renting, is crucial to avoid "overpaying". The cost of housing can vary dramatically by location, offering "compensating differentials" (e.g., cheaper housing in a less preferred city offsetting perceived downsides).
Mortgages Are Financial and Tax Losers: A mortgage is fundamentally a loan, and its payments are not a basic cost of housing. The financial loss comes from the "mortgage interest rate differential"—the difference between the high interest rate you pay on a mortgage and the lower safe interest rate you can earn on savings. Mortgages also offer little to no tax benefit for most households due to changes in standard deductions. Therefore, "avoid mortgages to the extent possible" and pay them off as fast as you can.
Cashing Out Retirement Accounts to Pay Off Mortgages: Using funds from tax-deferred or Roth IRAs to eliminate your mortgage can be a "big winner". This move frees up significant cash flow that would otherwise go to mortgage interest, providing a safe, guaranteed return that often outweighs investing in risky assets like stocks.
Homeownership as a Tax Shelter and Longevity Insurance: Owning a home provides a "subtle" tax advantage because the "imputed rent" (the value you effectively pay yourself for living in your own home) is not taxed. Additionally, homeownership can reduce longevity risk by providing inflation-proof housing services that don't end, unlike a rental agreement with potential rent hikes. Your home's equity can also serve as a "security blanket" or "entrance fee" into a decent long-term care facility, offering a crucial financial safety net in old age.
Maximizing Housing Value:
Cohabitation: "Shacking up" with others, including family members (e.g., with Mom), can dramatically raise living standards by sharing costs, potentially making two people live as cheaply as 1.6 individuals.
Renting Out: Subletting or renting out your home on a part-time basis (e.g., via Airbnb) can significantly lower your housing costs.
Downsizing: For empty nesters, downsizing to a smaller, less expensive home can free up trapped equity and lead to a significant increase in lifetime discretionary spending.
Reverse Mortgages (RMs) - Use with Caution: While RMs are designed to free "trapped equity," the sources advise extreme caution. They come with high interest rates and fees, give less spending power for a large chunk of equity, and can be very disadvantageous if you have to move or die "too soon". Selling your home and renting, or arranging a "leaseback" with family, are generally superior ways to access home equity.
What are the counter-intuitive rules for investing like an economist?
Economics-based investment advice focuses not on accumulating maximum wealth, but on managing your "living-standard cone"—the range of all your possible future living-standard paths. This involves strategies that often contradict conventional wisdom:
Stocks Are Not Safer in the Long Run: Contrary to popular belief, "stocks aren't safer in the long run". The more you invest in them, the more your LS cone will spread out over time, increasing both potential upside and downside risk, because asset prices largely follow a "random walk". This means a loss this year is as likely to be followed by another loss as it is by a gain.
Adjust Spending to Returns: If you're investing at risk, you should adjust your spending annually based on your investment returns. When you do well, spend somewhat more; when you do poorly, spend somewhat less. This helps manage your LS cone spread.
Rich in Bonds, Poor in Stocks: A surprising shocker is that "the rich should invest in bonds and the poor should invest in stocks". This is because lower-income individuals often have a large "bond-like" asset in their Social Security benefits, so investing their limited fungible assets in stocks helps balance their overall portfolio of resources closer to an optimal mix. Conversely, wealthy individuals, whose living standards are largely dependent on their market assets, should invest more cautiously to prevent dramatic declines.
Young Bond, Young Stock: If your future labor earnings are like a "bond" (stable, not correlated with the stock market), then as a young person, you should invest heavily in stocks to balance your total resources. However, if your earnings are like a "stock" (highly dependent on the market, like working for a yacht company), you should allocate your assets to bonds. If your earnings are very volatile (like a "Bitcoin"), "don't double down on risk"—invest less in the market.
Retirees and Stocks: Another counter-intuitive rule: "Retirees should invest more heavily in stocks the older they get". As the elderly spend down their financial assets, their bond-like Social Security benefits remain fixed. To maintain a constant ratio of risky to safe assets, they should hold an ever-larger share of their shrinking assets in stocks.
Upside Investing: For those who cannot tolerate a decline in their living standard, "upside investing" is recommended. This strategy involves setting a "living-standard floor" using safe, real investments like I-Bonds and TIPS (Treasury inflation-protected securities). Any additional funds are invested in risky assets like stocks. If the risky investments perform well, you gradually convert those "winnings" into safe assets, allowing you to permanently and safely raise your living standard above the floor, thus facing "only upside living-standard risk".
How can I use retirement accounts to cut my lifetime taxes?
Retirement accounts like 401(k)s and IRAs are powerful tools for cutting lifetime taxes and increasing your spending power, primarily through two mechanisms: tax-bracket smoothing and tax-free inside buildup.
Tax-Deferred vs. Roth:
Tax-Deferred (Traditional): Contributions are often tax-deductible, meaning you don't pay income taxes on that money now. Investments grow tax-free ("inside buildup"). You pay taxes when you withdraw funds in retirement. Employer contributions are particularly beneficial as they are not subject to FICA (payroll) taxes.
Roth: Contributions are not tax-deductible (you pay taxes on the money now). However, investments grow tax-free, and qualified withdrawals in retirement are also tax-free. Roth accounts are not subject to Required Minimum Distributions (RMDs) during the owner's lifetime.
Tax-Bracket Smoothing: This is the "biggest 401(k)/IRA/Roth tax benefit". The goal is to pay taxes when your tax bracket is lowest.
If you expect a lower tax bracket in retirement, contributing to a traditional (tax-deferred) account is generally better, as you defer paying taxes on contributions until later.
If you expect a temporarily low tax bracket now (e.g., due to unemployment) or a higher tax bracket in retirement, contributing to a Roth account or performing a Roth conversion makes sense, as you pay taxes now at your low rate.
Roth Conversions: These allow you to withdraw money from a tax-deferred account, pay the taxes, and immediately contribute it to a Roth account, bypassing normal contribution limits. They are most valuable when you are in a low tax bracket (e.g., between retirement and starting Social Security/RMDs) and have considerable regular (non-retirement) assets to cover the immediate tax bill without disrupting your consumption.
Employer Match: This is arguably the "simplest money magic trick" and a "no-brainer". Many employers match employee contributions to 401(k)s (e.g., 4% of pay), which is essentially "free money". For some, this can translate to hundreds of thousands in extra lifetime spending.
Prioritize Retirement Account Withdrawals over Social Security: A "money magic eye-catcher" is the benefit of taking retirement-account withdrawals early (e.g., from traditional IRAs) to delay taking Social Security benefits. The "risk-adjusted" return on delaying Social Security (by accruing DRCs) is generally far higher than typical stock market returns, making it a very lucrative "investment".
Merit-Goods Accounts (HSAs, FSAs, 529s): These accounts, earmarked for specific types of spending like healthcare (HSAs, FSAs) or education (529s), offer significant tax breaks. HSAs are particularly powerful, offering tax-free contributions, tax-free growth, and tax-free withdrawals for qualified healthcare expenses, effectively expanding your IRA contribution limits.
“The rich should invest in bonds and the poor in stocks.”
“Stocks aren’t safer in the long run.”
ABOUT LAURENCE KOTLIKOFF, AUTHOR MONEY MAGIC – AN ECONOMISTS SECRETS TO MORE MONEY, LESS RISK AND A BETTER LIFE
Laurence J. Kotlikoff is a New York Times Best Selling author; a William Fairfield Warren Professor at Boston University; Professor of Economics at Boston University; Fellow of the American Academy of Arts and Sciences; Fellow of the Econometric Society; Research Associate of the National Bureau of Economic Research; and President of Economic Security Planning Inc, a company specializing in financial planning software. Professor Kotlikoff received his B.A. in Economics from the University of Pennsylvania in 1973 and his Ph.D. in Economics from Harvard University in 1977. The Economist Magazine ranked Kotlikoff among the world's 25 most influential economists. Professor Kotlikoff is author or co-author of 21 books and hundreds of professional journal articles. Professor Kotlikoff publishes extensively in newspapers, and magazines on issues of personal finance, taxes, Social Security, healthcare, deficits, taxes, generational policy, pensions, saving, and insurance. Professor Kotlikoff has served as a consultant to numerous international organizations including International Monetary Fund; World Bank, Harvard Institute for International Development; and he Organization for Economic Cooperation and Development. Professor Kotlikoff has provided expert testimony on numerous occasions to committees of Congress including the Senate Finance Committee, the House Ways and Means Committee, and the Joint Economic Committee.
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