GTH Estate Planning Blog

Lars is putting about $30,000 a year into his retirement plan at the CPA firm. Actually it isn't just Lars's; it's earned income therefore his and Kyra's community property. His account has grown to about a million and a half. This would have seemed like a great amount when Lars started work. Now it's not even their largest asset; they have more than that in real estate, thanks mostly to the smarts and generosity of his childless Uncle Nils.

Some of the retirement plan is Roth, meaning Lars doesn't get to deduct that portion going into the plan, but it isn't taxable when it comes out. His account is invested in stocks, bonds, and REITs. The plan permits Lars and the other participants to direct their own allocations. Lars likes watching the numbers and has an especially good feeling about this holding generally. Why?

Another thing that strikes Lars as he prepares and reflects on his 2012 personal income tax return, is the amount of self-employment tax. He pays this because, as a partner in a CPA firm, he gets a share of the partnership's net income rather than a salary, so there is no Social Security tax deducted from his draws (paychecks). For him the SE tax is about $20,000 for the year, roughly half the amount of income tax he's paying.

At 55, Lars is ten years or so away from drawing Social Security, and has been paying SE tax for a long time. He has not factored Social Security income into his retirement planning, although as the time gets closer and the system remains in place he becomes a little more confident he'll actually receive some. But it doesn't seem like a great bargain, paying today's equivalent of a $20,000 a year for decades in hopes of his and Kyra's getting $30,000-plus for -- well, maybe decades, maybe it isn't so bad.

Seeing the reduced tax on his capital gains and dividends, Lars feels confirmed in favoring stocks over bonds. There is part of his portfolio that doesn't show up in his income tax return, though, at least not yet: his retirement plan.

Some of it actually never will: the Roth portion. Lars's firm has a 401(k) plan, and he has some of his account in Roth status, meaning he pays the tax on the income as it goes in, but neither the future income and gain on these contributions, nor the distributions when they come out, will be taxed. Lars likes this idea.

Even the non-Roth portion of the retirement plan that will be taxed when it comes out, gets tax-free growth in the meantime. This takes away one of Lars's reasons for not liking bonds, the taxation of interest income at ordinary rates.

Lars is a professional tax preparer. Actually at this advanced stage of his career as a CPA, he is much more reviewer than preparer; the less senior accountants in his office do the return assembly. He has a couple of peculiarities in the way he does his own return. First, he extends it so he can go over it with some deliberation. Tax season is a crush every year.

And Lars does his return by hand, at least initially. This is so he can see how the income and tax ingredients really go together. After he's done that, he does indeed run it through their software and, since the results are always at least a little different, he learns something from that too.

One thing he notices this year is the tax calculation on dividends and capital gains. These have a maximum rate of 15%, about half that on ordinary income like earned income and interest. The policy reasons for this benefit, Lars recalls, are to soften the double taxation of dividends (taxed both at the corporate and the shareholder level, theoretically at least), and to encourage people to invest. Invest in equities, at least. Not bonds.

Yes, Lars and Kyra had provided in their Living Trust for $100,000 to go to Lutheran World Relief after both of their lifetimes. This is quite a way out in the future (they hope), but Lars knows from doing income tax returns for and advising on the estate plans of clients, that it's a bigger chunk than most wealthy people contribute.

This is the first time their plan has benefited anyone other than their own kids. It feels like a good step. Is it enough? Is it too far off in time? Lars isn't big on dredging up things to feel guilty about, but the new element in their Living Trust has him thinking.

What are Lars's apologies? He's a solid citizen. Successful, supports his family, goes to church, helps other people (sort of). He realizes he's a little more concerned with his own finances, with funding his and Kyra's retirement, than he should be. Really that's pretty well taken care of, thanks in part to the success and generosity of rich and childless Uncle Nils.

Lars could do a little more for other people in his extended family. The recent good conversation with nephew Walter was encouraging, but also a little revealing. Lars had sort of written off his sister's son as an indulged career student, and hadn't done much to try to mentor him off that track. It was only when Lars had to talk with Walter about Nils's trust that he showed an interest in the kid. And Walter had come to a seemingly improved attitude on his own, without Lars's help. They had agreed, though, to meet periodically now - Lars felt better about that.

Doing his and Kyra's estate planning has somehow made Lars philosophical. One aspect of this is he is reflecting on the words of songs. One he has heard a few times lately is Nirvana's "All Apologies." Like a lot of Western Washingtonians, Lars takes a little pride in Kurt Cobain's being local. "Come As You Are" reads the sign on entering Aberdeen. Kinda funny; there have to be some there who still think he was a punk.

Lars also just plain likes some of Nirvana's music. It wasn't really his era, but it's good stuff he thinks. The unplugged version of "All Apologies" is especially pleasing, and a little sadder. From what little Lars has read, some of Kurt's behavior might have been obnoxious, but he seems vulnerable and empathetic. Such touching words in his suicide note: "...I love and feel sorry for people too much I guess." OK, there are theories it wasn't a suicide and it wasn't his note, but the sorrow rings true.

What were Kurt's apologies?

CPA Lars has ruminated in recent weeks on the reasons wealthy people aren't jumping on the opportunity to make large tax-saving gifts. Part of it, he thinks, is concern about having enough for the long haul.

Lars has a conversation with a banker friend that tweaks his view a little. He likes having his view tweaked. They're talking about the phenomenon and the benefit of working longer. It goes something like this: investment yields are low, and this makes dollars from working more significant. The banker puts it this way: if a person can make say $150,000 working, what's the equivalent of that in a bond portfolio? If bond yields are four percent, it would take about $4 million of them to produce the $150,000. So in a very limited sense working one more year is like having millions invested.

Lars realizes this is just one perspective; for instance at the end of the year the investor would still have the bonds and the worker wouldn't have them. But the idea causes him to calculate in another way. What does it buy to work another year? Is it a double benefit, a twofer?

To refine his study of the wealthy a bit, Lars finds a sub-group within his 32, of the 11 with net worth in excess of $20 million. This still falls short of the league of the Carnegies and Rockefellers, but in Lars's town it's a bunch. Eight of the 11 are in real estate, an even higher ratio than in the larger group. The eight are evenly divided between commercial and residential success, and the four residential are equally split between single-family and multi-family. So maybe real estate is the thing, but there are different ways to do it.

How does leverage enter in? There are six of the 11 who made it in real estate without inheritance (more on the heirship thing in a minute). Lars eyes these six. All of them have borrowed a lot of money. It looks like leverage is critical. This might be a bit self-evident to some, but Lars wants to numbers-test a little. He figures: let's go back to our example of Cervantes and Panza. Panza has $1 million in cash and stocks and Cervantes the same value of equity in real estate.

Cervantes' $1 million consists of a $2 million property with a 5% mortgage for $1 million. Let's also assume each has an investment return of 7.5% per year (a little optimistic during these hard times, but not unreasonable for good investors over decades). Panza will gain $75,000 a year. Cervantes will have $150,000 of gain less $50,000 of interest expense, for an advance of $100,000.

Lars has stumbled upon a shortcut method for studying how the rich get rich. With 2012 being such a good year for making tax-saving gifts, he has early in the year made a list of 32 clients he'll follow up with specially. They are candidates for making large gifts and therefore rich people. It might not be a perfect sample for his new study, but it's a sample. He is Lars-type excited to test his real estate hypothesis, and learn other things. His initial tally is supportive: 17 of the 32 have mostly real estate.

Of the 17, he finds four especially interesting: a lawyer, a physician, and a two CPAs each of whom started out in those fields, began buying real estate, and used their professional incomes to feed it and keep buying more. Three of the four actually kept their hourly jobs for decades. Lars wonders: how do people have the energy to do this? He feels pretty consumed by his CPA practice and family life.

He sees that another 11 of the 32 have made their money on what he calls "business": things like banking, wholesaling, insurance, and employee stock options. A few of the 32 are just plain hard to characterize.

Nils is a rich guy, with a net worth of something like $20 million. Our CPA friend and Nils's nephew Lars is considerably less wealthy, but he has much more than the average person. Lars has many very wealthy clients. He's happy himself being less wealthy but quite comfortable, but he does find it interesting to think about how rich people get and stay rich. It's sort of part of his job to help people do this.

So he's started looking at his list of clients for clues. This is not done out of envy but of (mostly professional) curiosity. He realizes he has at least one preconception upon taking on this unscientific study. OK, let's make it sound a little more scholarly and say Lars has a hypothesis.