There Is Little Freedom In Free Money
"Millions of young Americans are struggling today because too many politicians have convinced them they need more government support to truly experience all the freedom America has to offer."
There’s an old saying: “Nothing is more obnoxious than a former smoker,” referring to someone whose life has improved so drastically that they develop an almost evangelical zeal to share their transformative knowledge with anyone willing to listen. That certainly described me when I entered the financial services industry over three decades ago.
When I became a financial advisor, I was determined to equip people with the skills they needed to achieve the American Dream within a single lifetime. Not long after I hung out my shingle, a low-income housing director approached me to teach a personal finance class to a group of single mothers in a subsidized housing complex. I jumped at the opportunity. I prepared a class titled: “How to Send your Kid to College by Saving One Dollar a Day.” The class was well received, and the attendees were engaged and eager to learn. However, one young mother in the audience asked me, “What happens when we save $1,500 for college?” In my naiveté, I told her that $1,500 was a wonderful first milestone toward ensuring her child could afford college in 18 years. The executive director of the program came to my rescue, quietly explaining that once the mothers in this program accumulated more than $1,500, they would quickly begin losing their government benefits—including subsidized rent, free diapers, food stamps, Medicaid, and a host of other entitlements. As a result of this financial barrier, the women who attended my seminar that day were extremely wary of earning too much at a job or saving too much for college, knowing it would have to be reported to their benefits office. Even when presented with rock-solid opportunities to improve their financial situations, the sheer terror of losing benefits prevented many from pursuing promising paths that could lead to genuine freedom.
Over the years, I witnessed many individuals limit their earning potential or avoid saving adequately out of fear that making choices to secure their future financial freedom would cost them their current benefits. Because of the time value of money, limiting one’s earning potential or failing to save as early as possible can have serious negative financial impacts over a lifetime. While it is self-evident that this may be a challenge for those in the lowest income and net worth quintiles, I have noticed over the years that middle-income Americans also face many of the same psychological obstacles that have historically led the poor to avoid earning or saving more. While there are many financial-based programs Americans can qualify for, I will focus on just three: 1) college savings and FAFSA, 2) Affordable Care Act subsidies, and 3) student loan forgiveness programs.
College Savings and FAFSA. In all my years giving financial advice, I don’t remember ever having a client angrier with me than the one who was incensed that his son actually had to pay his own college tuition. The client came into the office, obviously upset, and I couldn’t figure out why, as his account values had grown handsomely over the years. As a toddler, his now 19-year-old son had been in an automobile accident in which the driver was held liable for damages. The son was awarded a small but not insignificant amount of money that was put into a conservatorship. The money was invested in the stock market, and it grew nicely. It grew so nicely the money not only paid for the son’s tuition at a private college, but there were also funds available to pay for one of his siblings to go to college as well. The father was incensed because his son’s roommate’s father, a high-earning professional, had allegedly used fancy financial planning to qualify his son for need-based financial aid. Meanwhile, because my client’s son had assets, he was expected to use those funds for his education rather than spending them on other things. This is because the FAFSA (Free Application for Federal Student Aid) can be quite generous, particularly toward elite colleges and universities. However, when a student has assets—like my client’s son—the FAFSA process expects those assets to be used for college. In essence, when applying for student financial aid, it pays to appear poor.
The FAFSA process treats student-owned assets less favorably for financial aid purposes than when college expenses are paid for by parents or grandparents. As a result, young people are often encouraged to avoid getting part-time jobs while in high school because they might earn too much income or have too many assets to qualify for government financial aid. This can have huge negative implications on a young person’s future earnings and net worth potential, which I will illustrate later.
Affordable Care Act (ACA) Health Insurance Subsidies. The old Economics 101 adage is true: “you get more of what you subsidize, and you get less of what you penalize.” One needs to look no further than the ACA (Obamacare) to find evidence of this. The way ACA health insurance subsidies work is that a person estimates their expected income for the next year when applying for the subsidy. However, if they end up earning more than projected or if their employer begins offering affordable health insurance coverage, they may have to repay some or all of the subsidies when they file their income taxes.
I have seen more than a few individuals who had to borrow money to pay back their subsidies at tax time because they didn’t save the difference from their income windfalls. Someone only needs to be stung once to be conditioned like a Pavlovian canine to avoid earning too much money in the following year. Unfortunately, this leads many workers to turn down promotions or extra work hours out of fear that they will have to repay health insurance subsidies at tax time. In essence, workers capable of achieving the freedom they desire are psychologically prevented from doing so.
Student Loan Forgiveness Strategies. For a generation, the federal government has been teasing young people with promises of student loan forgiveness, and I am convinced this wishful thinking of a future jubilee has had an impact on our current labor shortage. One of the culprits for preventing young people from earning as much as they can is the Income Driven Repayment Plan (IDR).
The IDR is designed to make student loan debt more manageable by reducing the monthly payment amount to ensure the payments aren’t bone crushing. In other words, the less you earn, the less you are required to pay. If a person continues to make reduced payments for 20-25 years, it is possible the federal student loans will be forgiven. Unfortunately, too many young people are under-earning as a strategy to have their student loans forgiven. One of the traps of this program is that the monthly payment can be smaller than the interest accrued each month, causing the student loan balance to grow even if the borrower makes consistent payments!
Additionally, there is also the phenomenon known as the “Tax Bomb.” When student loans are forgiven, the forgiveness is generally reported to the IRS as income earned in that year. Let’s say someone takes out $100,000 in student loans and voluntarily inhibits their earning potential to qualify for the IDR. Under the IDR, the student only re-pays $200 a month; however, the payment on the loan is actually $745 a month. As a result, by the time loan forgiveness day arrives 20 years later, the balance has ballooned to $200,000. All this loan forgiveness is added to the student’s income for tax purposes in the year of loan forgiveness. The tax liability on $200,000 could easily be $50,000 or more, and few people who kept their incomes low enough to qualify for the IDR have the wherewithal to come up with $50,000 to pay their taxes the year they are due. The student would have been much better off in the long run to earn as much money as possible and make accelerated loan payments with the additional money earned. This strategy of pursuing student loan forgiveness, which too many Americans follow, is not the path to freedom.
I call it artificial impoverishment when a person deliberately earns or saves less than their full potential in order to qualify for needs-based entitlement benefits. In most cases, it is a bad strategy for a number of reasons. First of all, avoiding employment as a young person robs the individual of accumulating work experience. Logically, a person who starts working at age 15 will have more work experience than someone who waits until age 22 to find a job. All things being equal, the 22-year-old who has seven years of work experience is more attractive to future employers for two reasons: signaling value and human capital value. Signaling value is proof the young person has a demonstrated work ethic, they can hold a job for more than a few days or weeks, and they can do unpleasant tasks even when they are difficult or distasteful. A person who worked part-time in high school and college “signals” to the labor market they show up even if they have schoolwork or other activities on their schedules. Human capital value is the expertise a worker accumulates over time. A person who has worked for seven years has already learned how to more effectively organize their workday, get along better with co-workers, work faster, and make fewer mistakes than someone who has no work experience.
A second pitfall of artificial impoverishment is it prevents young people from experiencing the amazing power of compound interest. The Rule of 72 does a good job of illustrating this. If you take the anticipated growth rate of your income and divide it into 72, that is the number of years it takes for you to double your income.
For example, let’s say you make $15.00 per hour today ($30,000 per year). If you grow your income by 7.2% per year for the next 10 years, your income will be $60,000; however, if it continues to grow by 7.2% over the next 10 years, in 20 years your income will be $120,000! The young person who starts working later––or works fewer hours or avoids pay raises to capture entitlement benefits––will never catch up with the person who pushes through and earns and saves as much as they can, even if it means losing out on subsidies, loan forgiveness, or other programs.
A third pitfall of artificial impoverishment is it changes our polarity. Instead of being attracted to financial opportunities, we become repelled by them. The person worried about losing benefits and subsidies will avoid pay raises, job promotions, extra hours, or better employer benefits. However, once a worker signals they aren’t interested in higher wages, employers quickly pick up on this disinterest—and in some cases, may even exploit it. Opportunities lost are gone forever, and employers aren’t going to beg an employee to earn more.
Arguably, the most damaging pitfall of artificial impoverishment is it creates a mindset of dependence, and dependence rarely leads to freedom. Rather than rely on local opportunities to solve problems, young people grow to expect programs executed from thousands of miles away to take care of them. In the politically charged climate we live in today, expecting an entitlement program to grow at the rate of inflation––or even be around ten years from now––is a particularly risky proposition. It is much safer to increase one’s signaling value and human capital value if economic freedom is the long-term goal.
Whether someone is a dental school graduate making decisions about student loan forgiveness programs, or a salesperson selling radio ads on commission trying to qualify for ACA health insurance benefits, earning as much as you can is usually the best if attaining true freedom is the goal. The costs in signaling value, human capital value, and the missed opportunities for compound interest to work its magic on future incomes, are usually too high for artificial impoverishment to be a workable option.
Millions of young Americans are struggling today because too many politicians have convinced them they need more government support to truly experience all the freedom America has to offer. Unfortunately, these charlatans have crippled with their handouts significantly more young workers than they have assisted.
Sometimes the freebies we are offered have a price tag that is much more expensive than what is immediately apparent. In the case of artificial impoverishment for the sake of qualifying for government financial assistance, the costs inevitably will be paid for with future freedom. Americans will usually enjoy the greatest amount of freedom in their lifetimes by following the 18th Century English theologian John Wesley’s timeless wisdom: “Earn all you can, give all you can, save all you can.”
This column is part of an ongoing series called Reclaiming Independence by our Board Chairman Joe Coco. In this series, Joe explores ways that Montanans can assert their own independence and free themselves from reliance on government through self reliance, resourcefulness, and building communities.