As Dilbert creator Scott Adams is fond of saying, everyone – even the most intelligent person – is stupid for brief periods of time. When one makes a mistake with finances it can cost a great deal of money. When that happens, one can be said to be paying “stupid tax.”
Paying stupid tax isn’t necessarily a bad thing if we learn from it. Some things sound great on paper. Even though we can be told that a certain investment strategy will not work we often need to actually lose money trying before we believe the experts. The important thing though is once we’ve paid the stupid tax not to repeat the same mistakes.
Listed below are five mistakes people make which can result in paying a lot of stupid tax.
1. Partnerships. Sure, it sounds great. You and a close friend from college decide to open up a store together. At first everything is going great. Then your friend has an affair and the business you two built is now tied up in an ugly divorce fight.
Avoid forming partnerships, even with people you firmly trust. Life circumstances can change from a failed relationship, a death, or other occurrences. Even if nothing bad happens, a partnership can often result in bad feelings that result in the loss of a friendship or even a legal battle.
Instead of forming a partnership, if you must go into business with someone else, have one person be the owner and the other person an employee with profit-sharing, a shareholder, or another arrangement.
2. Co-signing on a loan. You want to help your son out in getting that new car so you co-sign on the loan. After making payments for a few months your son decides he wants to take it easy for the summer and quit his job. You are now stuck with another car payment since a default or late payment will go on your credit report. Even worse, you co-sign with a roommate who departs with the vehicle and then decides to stop making payments.
Never co-sign on a loan. If the bank is not willing to issue credit to a person, why should you vouch for them? If you have a relative who needs a vehicle and you would like to help them out, consider buying an inexpensive vehicle and giving it as a gift. Otherwise, encourage them to save and pay cash.
3. Buying a house with a boy/girlfriend. You are in love and are thinking about marriage. Since you’re often sleeping over anyway, it makes sense to stop renting and buy a house together. After all, you’ll probably be married in a few years and you can be building equity instead of wasting all that money in rent. A few month after closing, however, you have a big fight and he moves out and refuses to pay his half of the mortgage or let you sell the house. You’re now stuck with a house payment you can’t afford and a property that reminds you of the failed relationship every time you walk in the door.
There is a difference between playing house and actually going through the committment of marriage. If nothing else separation in marriage has the benefit of a divorce where debts can be divided by a judge. Until vows have been said, don’t buy anything together. If you must buy a house, consider having one individual buy the house and the other pay rent like a roommate until marriage. That way if things don’t work out you two aren’t tied together through a mortgage.
4. Balloon Mortgages. In 2006 these were all the rage. Get a low payment on an interest only mortgage with a balloon payment due in five years. Sure the balloon payment was high, but one could always sell the house if needed.
Have a balloon sitting over your head and sure enough you will lose your job right when that balloon is ready to burst. If you can’t afford the payment on a 30-year loan, you can’t afford a balloon loan either.
5. Holding large positions in single company stock, particularly the one for which you work. You work for company XYZ. They have a great employee stock purchase plan so you put a portion of your paycheck into the plan. In a few years after the stock has gone through the roof you have a huge position and are thinking of retiring to an island. The business conditions turn and you see the value of you stock fall to 10% of its previous value the same day you get a pink slip.
Never invest more in a single stock than you can afford to lose. Likewise, if a position does well and grows too large, trim it back and diversify your holdings. Common stocks can and do fall very quickly in price. It is even worse if you work for the company since your employment and savings are then tied up in the same place.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing