A larger house won't often protect your money

Q. I believe inflation is getting out of hand and the dollar will continue to decline. So I am worried about my future. I am almost 63, have our house paid for, and have about six times my income in retirement savings and investments (not highly productive).

I think a good way to protect my life savings against inflation would be to buy a larger and more expensive home for us (worth about half our savings) in a nicer subdivision (ours is going down), pay cash, have no mortgage, and keep our current house as a rental.

If inflation runs crazy and the dollar continues to decline, real estate will be the only thing that could protect our life savings. In five or six years, when the price of the new home goes up at the rate of inflation and devaluation, we could sell it and (if needed) return to our rental home. What is worth $400,000 today will be worth $800,000 by then. Do you think this is a good idea? -- M.R., San Antonio

A. Concern about inflation and the decline of the dollar is now virtually universal. Unfortunately, buying a larger house isn't a good way to find a safe haven. Here are some of the reasons this path won't work.

Houses are consuming assets. That means it costs money to own and operate a house, even if you have no mortgage. When you buy a larger house, you are committing to greater expenses. Higher energy prices, for instance, will be reflected in higher utility bills. Similarly, real estate taxes are likely to grow faster than wages, putting you in a squeeze.

Worse, the same inflation will limit the number of buyers for your house when you want to sell it. Remember, the real pain from inflation comes when prices rise faster than earned incomes. That's when people are forced to make hard choices, like buy gasoline or have meals out, heating or cooling part of the house rather than all of it, etc.

Another thing you're not considering is liquidity -- houses seem reassuringly real, unlike financial assets, but you can't sell an extra bedroom or an empty closet when you need some cash. And you can't put in a sell order and have cash in a few days.

The most reliable measure of security and safety we have is a very simple one. How long will your liquid resources (cash in the bank, short-term CDs, short-term Treasury obligations, etc.) support you if you have no other sources of income? If your regular monthly expenses are, say, $4,000 and your liquid resources are $6,000, then you are secure for about six weeks. Surveys regularly show that most Americans will be in trouble very quickly -- a matter of a few weeks.

My suggestion: Look for ways to reduce your committed spending and increase your liquid resources.

Q. My husband and I are both nearly 60, retired and without a pension plan. We live entirely off our investment income. Our marginal tax rate is 25 percent. We have significant stock funds in our personal account. Our traditional IRA contains REITs, bonds and oil stocks. My husband thinks that as taxes are sure to rise we should draw down the IRA first. I think that since capital gains rates are lower than ordinary income rates, we should draw down our personal account first. Who is right? -- T.D., by e-mail

A. It's a guess, but most advisers will tell you to draw down the personal account first. There are two reasons for this. First, the 15 percent tax rate on qualified dividends and capital gains is likely to expire in 2010, so it's not a bad idea to realize capital gains now, while you can. Second, a portion of any sale is your cost basis. So it is not subject to taxation. This can be a big help for managing your taxes.

You can understand with a simple comparison. Suppose you need about $10,000 to meet expenses. If you are in the 25 percent tax bracket and take the money from an IRA account, you'll need to withdraw $13,333 from your account to net $10,000 after taxes.

Now suppose you have an investment that has doubled in your taxable account. If you sell about $10,800 of it, you'll realize a $5,400 capital gain and have a tax bill of $810 (15 percent of $5,400). The after-tax net proceeds will still be $10,000.

Finally, there is a very large spread between the 15 percent income tax rate and the 25 percent tax rate, so I doubt that we'll see a dramatic increase in income taxes at the 25 percent level.

© 2008, Universal Press Syndicate