I am about to share with you the exact strategies of the super rich and use them as a basis that may frame opportunities in your personal life. To better understand it, let’s look at a few articles from the recent press.
Edward McCaffery is a professor of law, economics, and political science at the University of Southern California. On September 25, 2012, he wrote an article for CNN called “Why Do the Romneys Pay So Little in Taxes?” He explained that the Romney’s pay an effective tax rate of 14.1 percent. He then states, “This is a low tax rate, lower than the typical middle-class American worker pays, especially when one considers payroll taxes. . . .”
He goes on to say, “The simple strategy of the super-rich is to buy and hold, and to borrow when needed to finance their lifestyles.”4 [emphasis added]
On April 9, 2013, McCaffery wrote another article for CNN about Mark Zuckerberg called “Zuk Never Has to Pay Taxes Again.” In it he says, “The truly rich do not have to pay any tax once they have their fortunes in hand. They can follow the simple tax- planning advice to buy/borrow/die. Buy assets that appreciate in value without
producing cash, borrow to finance lifestyle, and die to pass on a ‘stepped up’ basis to heirs wherein the tax gain miraculously disappears.”5
Whether your net worth is much smaller or even higher than the Romneys or the Zuckerbergs, you will be as shocked as I was when I learned these secrets. I hope to create a path for you to use them as well.
Chances are very small that your life looks exactly like the Websters. But even if your situation is very different, you can glean some idea of what might be possible in your case. If your net worth is higher or lower, we will see how we can keep your taxes around the same levels as this example.
If you are the type of person who wants to dive into details and throw elbows, I encourage you to read this whole book cover to cover—including the details in Appendix C where I discuss this chapter’s assumptions in detail. Ideally, I’d also love for you to read The
Value of Debt and engage me in a public or private debate; I like nothing more than a good conversation. To facilitate this debate and discussion, please go to
www.valueofdebtinretirement.com or www.vodr.com, where you are welcome to share your thoughts, ideas, and takeaways from these strategies.
I make some broad assumptions here, and it’s impossible to give an example without doing so. It’s most important that you understand the purpose of the exercise. I’m frankly trying to stir the pot and generate public debate and conversation on this important topic.
The goal is to empower you and your advisor and to encourage you to think more holistically.
OK, then, here is the Websters’ situation as found in Table 5.1. They are each 65 years old and retired—he was a business executive, and she was a schoolteacher—and they have done pretty well. They own their primary residence outright, and it is worth $1 million.
They also own a vacation home worth $1 million, and they have a $500,000 mortgage on it. And they have a total investment portfolio worth $4 million, half in an IRA and the other half in an after-tax (meaning taxable) account. Their investments are in a globally diversified portfolio of stocks and bonds, mostly using mutual funds and index funds.
Table 5.1 The Websters’ Balance Sheet
Assets Liabilities
Home 1 $ 1,000,000
Home 2 1,000,000 ($500,000)
Taxable Account 2,000,000 Retirement Account 2,000,000
Total $ 6,000,000 ($500,000)
Net Worth $5,500,000 8% debt ratio*
*Debt ratio = Liabilities/Assets ($500,000/6,000,000).
The Websters’ assets are $1 million home + $1 million vacation home + $2 million portfolio + $2 million IRA = $6 million. Their only debt is a $500,000 mortgage. $6 million – $500,000 = $5.5 million net worth.
After working through their budget with their financial advisor, the Websters determine that to maintain their lifestyle at the level they want, they will need about $20,000 per month, or $240,000 per year, after taxes to cover all of their expenses. This excludes the fees they pay their financial advisors.
Of course, the Websters also have some significant expenses. Some of these are tax- deductible and some are not. Tax-deductible expenses total up to $80,000 and include
$20,000 in charitable donations, $20,000 in property taxes between their two homes,
$10,000 in mortgage interest, and $30,000 in professional fees, which are mainly paid to their financial advisor who manages their portfolio on a fee-only basis. Their income need is $240,000 plus the $30,000 to their advisors, so $270,000 total. $270,000 minus
$80,000 of tax-deductible expenses means that they are paying about $190,000 in living expenses. It doesn’t really matter how this breaks down, but let’s say it’s about $12,500 per month for general living (taking care of the homes, food, medical, entertainment, etc.)
$30,000 per year in travel, and $10,000 per year helping out family.
For tax purposes, we really care about their tax-deductible expenses. Table 5.2 shows what their tax-deductible expenses look like.
Table 5.2 Tax-Deductible Expenses: The Websters Expenses
Charitable Donations ($20,000) Property Taxes (20,000) Mortgage Interest (10,000) Professional Fees (30,000)
Total ($80,000)
What about income? Let’s start with the easy parts. The Websters don’t have a pension (she didn’t teach long enough to qualify) or a deferred compensation program. They have only $20,000 of Social Security.
What about their portfolio? In 2015, it’s tough to get income. Almost half of government bonds around the world pay under 2 percent6 and the S&P 500 dividend yield is just under 2 percent.7 The Websters’ taxable portfolio could be $1 million in the S&P 500, generating $20,000 of dividends. Their $1 million in bonds at 2 percent is paying them
$20,000 in interest. Their portfolio manager triggered $20,000 of gains while rebalancing their portfolio. Fortunately, all of these were long-term gains.
What about their IRA? That account, of course, is tax-deferred so the Websters don’t pay tax on the interest, dividend, or capital gains. They pay taxes on only the money that they take out. Let’s say that they take $80,000 from their IRA. This is a 4 percent distribution on a $2 million IRA. ($80,000/$2 million = 4%). See Table 5.3.
Table 5.3 Taxable Income: The Websters Income
IRA Distribution $ 80,000
Interest 20,000
Dividends 20,000
Social Security 20,000
Long-Term Capital Gains 20,000 Total Taxable Income* $157,000
*Only a portion of a taxpayer’s Social Security benefits may be taxable. Here, the Webster’s received $20,000 in Social
Security benefits but only $17,000 is considered taxable income. Please see IRS Publication 915 for details.
The multimillion-dollar question, then, is whether the Websters will ultimately have enough cash flowing, because they are afraid they might get socked with a significant income tax on the incoming money that they need to live on each year.
A quick recap: The Websters, who have a net worth of $5.5 million, have $160,000 of income. With memories of what it was like to be in the highest tax bracket while they were in their peak earning years, the Websters are afraid that they might owe tens of thousands in taxes. So, take a guess: How much do you think the Websters will pay in income tax given this scenario? Will it indeed be in the tens of thousands of dollars range? If so, will they need to sell off more of their IRA each year?8
Perhaps the Websters’ tax rate will be as little as 20 percent, that is, in the $32,000 range or even less . . . maybe it will be 10 percent, or only $16,000 a year? Or could it, might it, possibly be even less than that because they are now retired, and some of their incoming money sources, like their IRA distribution, might receive favorable tax treatment?
To answer this question, let’s turn to Intuit’s TurboTax TaxCaster tool, generously provided for free online. I suggest that you do this online exercise for yourself, but I’ll also provide you with a series of screenshots so that you can follow along as you see exactly what I did here, step-by-step. To start, go to www.TurboTax.com/tax-tools. There, you can access the TaxCaster tool by clicking on “Get Started” on the left hand side of the page. (They update this webpage frequently, so you may have to dig around a little to find the TaxCaster tool. A TaxCaster app is also available on iTunes and Android through
Google Play.)
Once in TaxCaster, we can input the various facts and figures for the Websters (see Figure 5.2). We start by inputting their basic personal information, that is, married, filing jointly, and age on December 31, 2013 (65).
Figure 5.2 The Websters’ Basic Personal Information
Reprinted with permission © Intuit, Inc. All rights reserved.
Because neither of the Websters are working any more, we can click on the box that says
“Other Income” and fill in the figures from above, so that it looks like Figure 5.3.9
Figure 5.3 Other Income: The Websters
Reprinted with permission © Intuit, Inc. All rights reserved.
Now it’s time to input the Websters’ tax deductions as outlined earlier. After clicking
“Continue,” find “Deductions, Credits, and Payments” and click on “House.” For mortgage interest payments, type in $10,000, and for real estate tax payments, insert $20,000.
Click “continue,” then click on “Other Deductions,” and under “Employee Business
Expenses,” type in the $30,000 professional fee the Websters pay their financial advisor.
Finally, click on “Donations” and plug in the $20,000 that the Websters gave to charity (which, given their net worth, is really not all that much). See Figures 5.4, 5.5, 5.6, and 5.7.
Figure 5.4 Total Taxable Income before Deductions: The Websters
Reprinted with permission © Intuit, Inc. All rights reserved.
Figure 5.5 House Deductions: The Websters
Reprinted with permission © Intuit, Inc. All rights reserved.
Figure 5.6 Donations: The Websters
Reprinted with permission © Intuit, Inc. All rights reserved.
Figure 5.7 Other Deductions: The Websters
Reprinted with permission © Intuit, Inc. All rights reserved.
Once we’ve input all relevant information, we come up with the Websters’ 2013 income tax estimate of just $3,956! Less than $4,000! Think about it: These folks, worth $5.5 million with $160,000 of reported income, will pay less than $4,000 of income tax a year!
(If you ask me how that is even possible, my response is that the tax code is basically nuts. That’s just the way it is.)
By paying less than $4,000 in taxes (Figure 5.8), the Websters end up having about
$156,000 of income each year (the $160,000 they put together, minus the $3,956 that they have to pay in tax).
Figure 5.8 Final Estimated Taxes Due: The Websters
Reprinted with permission © Intuit, Inc. All rights reserved.
But wait. The Websters need $240,000 of income, so $156,000 after taxes isn’t enough.
They need $84,000 more: $7,000 more per month!