Friday, January 1, 2010

New Year…New Equation…. Opportunity Costs= Unintended Consequences

As we have come into a new year most of us have made a list of resolutions. I am no different than many others. One of my professional resolutions is to teach as many people as possible about a term called “Opportunity Costs”, or as I like to say unintended consequences.

So what is an opportunity cost you ask? In simple terms it is an idea about money where if you put your money in one place you may be giving up something in return, many times without knowing it (i.e. unintended consequences). Many other people who give financial advice behave as if the only way to eliminate opportunity costs is to give up some part of your lifestyle (i.e. that cup of coffee in the morning at your favorite coffee shop). While this is true, I want others to know you can reduce or eliminate opportunity costs simply by where you put your hard earned assets. Knowing about opportunity costs and its unintended consequences can have long reaching effects in the future.

For most people it is still a difficult concept to get so I thought I would list some examples of where opportunity costs (or unintended consequences) of money might come into our everyday lives.

Money in a Savings Account/C.D./Money Market at a Bank…There are two opportunity costs most commonly found in these types of accounts:

1) Often we are earning little to no interest on these accounts.
2) Any interest that is earned is fully taxable as regular income.

As an example, using a 5% opportunity cost rate, a $100,000 saving account earning 4% will be worth $324,340 after 30 years. You would have paid $67,302 in income taxes, assuming a 30% tax rate (federal= 25% + State= 5%), along the way. However, the opportunity cost (or unintended consequence) is the money you could have earned on the taxes paid along the way. That total (Taxes + Opp. Cost) is equal to $129,425. Factoring all costs your left with a net balance of $324,340 - $129,425 = $194,914. So your account over those 30 Years compounds at a net rate of return of 2.25%, not 4%, when factoring in taxes plus opportunity costs

Putting Money In a 401(k)/IRA…The opportunity costs here is you lose the use of this money as a source of financing. So you are forced to pay someone else interest for the use of their money (most often a bank or finance company).

As an example say you are in the market for a new $20,000 car. Since you can not access your 401(k), due to your age and many other restrictions, you are forced to finance the car at a 6% interest rate. After 30 years the opportunity costs of financing just this one car is $86,823 in “After-Tax” dollars. In other word your 401(K) would have to be equal to $124,032 “Pre-Tax”, assuming a 30% tax rate (federal= 25% + State= 5%), just to equal the cost of financing one car after 30 years.

Buying Term Life Insurance…The opportunity cost here is the premiums you pay and the fact that less than 1% of all term life policies ever pay a claim. So in other words 99% of the people who have term life insurance are simply just giving away their money to an insurance company for nothing in return.

As an example say a young couple (husband and wife good health age 30) purchases (2) 30 year term policies worth $1,000,000. We will also assume they get the 2nd highest health rating, which lowers their cost. The annual premium is about $1,660/year. At the end of 30 years, they would have no life insurance and the term insurance would have costs them $129,577 net “After-Tax” using a 5% opportunity cost.

I hope these examples are helpful, and you are able to see places where opportunity cost may be affecting your life!

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