Disclaimer: I am now retired, and am therefore no longer an expert on anything. This blog post presents only my opinions, and anything in it should not be relied on.
No, it’s not from hiding the money overseas, or tax-saving tricks that skirt the outer edges of US legality. It’s from the peculiarities of the way the tax code handles capital gains taxes. And a recent change to the estate laws to allow a “step-up in basis” is a big part of it. Can you, the average reader, take full advantage of it? Only if (a) much of your net worth is in stocks (preferably low-expense index funds), and (b) 9% times your total stock value is much greater than your yearly expenses.
What follows is an explanation using a “typical case” approximating the real-world experience of someone I know.
What follows is an explanation using a “typical case” approximating the real-world experience of someone I know.
The Idle RichLet us suppose that you have net worth of $10 million, entirely invested in a Vanguard or Fidelity S & P 500 index fund (expense ratio 0.1 %), with little or no work income and expenses of about $250,000 per year. You reinvest dividends immediately back into the index fund. Studies suggest that over the long term such an investment increases by 10.85 % per year. If we subtract the expense ratio from that, you may expect actual income from this investment to increase by 10.75 % every year, or $1,075,000. Presto, you are a millionaire this year, without working a day for it.
Now you need to pay income taxes – and here’s where things get complicated. The money comes to you in two forms: (1) dividends, which you reinvest, and (2) “capital gains” (all the rest). My comparison of the S & P 500 total return index (which includes dividend reinvestment) to the S & P 500 index we all see on the financial pages suggests that in the long run, dividends increase your investment by 2.25 % per year ($225,000), leaving 8.5 % ($850,000) from capital gains. The tax code handles these two cases differently.
DividendsYour Federal tax bite from dividends is pretty straightforward: 15 % (let’s assume you live in a state without dividend and capital gains taxes of its own; note also that at about $25 million in investment wealth it kicks up to 20%). So on the order of 2.25 % of your income tax for this year is at this 15 % rate, or about 2.25 % of your actual income (about $27,000).
Capital GainsCapital gains are defined as the amount your stocks in that index fund have appreciated since you first bought them. To maximize the yearly gain in net worth (for reasons too complicated to explain here), you are going to pay your expenses of $250,000 by selling stocks from your index fund.
Let’s assume, for the sake of simplicity, that all your stocks are effectively just over 1 year old – as in the case where this is a new inheritance (explained later). You typically have three choices of what you’re going to tell your index manager to sell: “first in, first out [FIFO]”, “average cost [basis]”, or “modified last in, first out [LIFO]” (you won’t necessarily see FIFO and LIFO presented that way). FIFO, which really means “first bought, first sold”, is a no-brainer: that means the oldest stocks with the biggest capital gains get sold first, so you typically don’t want to do that. “Average cost” is, as it seems, halfway between worst and best in most cases. LIFO means “first bought, first sold”, and modified LIFO means that you actively go in when you sell from your portfolio of stocks or index fund and arrange to not sell stocks bought less than a year ago – because otherwise your capital gains tax just about doubles. In our simple case, all three selling approaches get the same result.
Your capital gain on your $250,000 of yearly expenses is about 9 % (0.1075/1.1075). A Federal tax rate of 15 % therefore leaves you taxed about an additional 0.14%, on top of the 2.25 % from dividend income.
Finally, index funds steadily buy and sell stocks throughout the years on their own hook, in order to reflect stocks entering and leaving the index. In the case of the S & P 500, a typical year might see 10 stocks “turn over” like this, usually the ones least capitalized, for a rough guesstimate of 1 % of the index’s total value. That’s a straightforward additional 0.15 %.
TotalYour total tax bite from your actual total income, therefore, is about 2.55 % of $1,075,000, or about $27,400. However, this now flows into gross income, which is then “adjusted” for various tax breaks and then converted to “taxable income” via the usual standard or itemized deductions. The typical rich household (married filing jointly) has at least $12,700 from these sources – so the net is at or below $14,700 (more like 1.45 of actual income %!). Over the long term, this will creep up as the average stock gets “older”, but I will anticipate that discussion below and state that it effectively stays below 5 % for quite a long time.
[Note: Here I don’t discuss the recently-added Net Investment Income Tax of 3.8 %, which appears to apply only to much richer individuals]
Thomas Piketty in his book Capitalism in the Twenty-First Century points out that the top 0.1 % of the US income distribution (which roughly corresponds, I believe, to $10 million and up in net worth) has the bulk of their net worth not in land or other assets, but in investments, mainly in stocks. I conclude that, therefore, we may expect the savvy rich person to pay perhaps 4 % of his or her actual income – not the income declared in tax returns, but with the additional income from untaxed capital gains added back in – in income taxes this year.
In the Long Run, The Rich Are Dead, But They Still Don’t Pay Much Income TaxThere are two caveats that do apply to my scenario, which indeed drive the income tax rate of the rich higher. However, on closer examination, they don’t really increase the tax rates of the rich that much. These two caveats are:
1. The rich don’t really behave like that; and
2. In the long run, capital gains should approach 100 % of the stock’s value.
The Rich Don’t Really Behave Like ThatThe first objection to my scenario under this heading is that the rich don’t invest the way I’ve described: they invest more in (corporate and state) bonds. One may also include property, but, again, Piketty notes that this is typically less than 10 % of the holdings of the rich and particularly the very rich.
The answer to this objection is that bonds simply don’t provide anywhere near the long-term return of stocks (more like 1-3 % percent after inflation), so that a 60-40 stock/bond split works out in practice to more like an 83-17 income split, and an 80-20 stock/bond split works out to more like a 92/8 income split, for a likely maximum of 1.6 % in additional taxes (on much less income!). Moreover, most investors tend to prefer “tax-free” bonds, which pay no Federal tax at all – if the investor does this exclusively, the overall tax rate actually decreases, so a better guess of the effect is more like a 0.5 % tax rate increase.
Next up is the idea that the rich typically don’t instruct their funds to do modified LIFO (“last bought, first sold”), for other reasons that may or may not be valid (e.g., complicating tax preparation, tax consequences when the market is going steadily down). In fact, the real-world case I draw on uses “average cost basis” for precisely those reasons.
When most stocks in the portfolio of the rich person are pretty new, say, in their first two years of ownership (the “short run”), the answer to this objection is that the tax effect of average costing is pretty minimal: about 1.6 average years of total increase works out to about a 17 % average increase in stock value and a 15/85 gains/no gains split. With adjustments for the fact that some of these stocks would be sold anyway by the index fund, it works out to about a 40 % increase in capital gains taxes, from about a 0.30 % tax bite to a 0.42 % one – significant, but still leaving us well below 3 %. Over the long run, this case involves capital gains approaching 100 % of the stock’s value, so I’ll discuss that part of the answer to this particular objection below.
The third objection to my scenario is that most rich people spend more per year on expenses than $250,000. This is true; and yet the key figure here is actually the ratio of expenses to income. As long as the ratio of expenses to income (about 0.2) in my scenario is the same as that of the average rich person, our analysis doesn’t alter in the slightest.
And the evidence appears to be, if anything, that as you consider richer and richer people, the ratio of expenses to income goes down. By the time you reach $100 million, it would take buying a $10-million-dollar house every five years to approximate an 80/20 split. By the time you reach $1 billion, nothing short of a $50-million political investment every two years would do. And as that ratio dips, the percentage of income that must be paid in capital gains taxes goes downwards. Assuming, for example, a $100 million fortune and $1.25 million per year in expenses, we are talking about capital gains taxes cut in half compared to our scenario. Of course, at that point the deductions have much less effect, but the net effect is still to cut our “real-world” tax bite so far to well below 2 %.
In the Long Run, Capital Gains Should Approach the Stock’s ValueIt would seem reasonable, given my scenario, that as the average stock in the rich person’s portfolio far surpasses its original value, the average ratio of original value to value now would approach zero. Certainly, I have heard of cases in estates where “generation pass-through trust” stocks when sold had a cost basis of 1 or 2 % of the total, and therefore 98 or 99 % of the value of the stock was taxable as capital gains.
Let’s be more concrete. To a first approximation, the person newly coming into a $10 million fortune in investment stocks is in his or her mid-40s, and has maybe 30 years to live. What does the capital gains situation look like in the tax returns for his or her 75th and last year, and what therefore is the tax rate?
Under average costing, if we assumed no stocks have been sold in the meantime, the average stock has been in the portfolio for 30 years, with an average gain of about 1327 % (1.09 to the 30th power). So 93 % of the portfolio would seem now to be capital gains.
But, in fact, we know that stocks have been sold in the meantime, for expenses and (by the index fund manager) to keep up with the underlying index – about 21-22 % of income, meaning about 3.5 % of total stocks, year after year. So, after 30 years, every stock in the portfolio has been sold an average of 1.17 times, and the actual age is more like 12.8 years, with an average gain of 300 %, so the actual percentage of the portfolio which is capital gains is now 75 %. In turn, that means that the tax bite for capital gains is about 11% of total income and therefore the overall total tax rate has now climbed to 13.25 %.
But wait, there’s more. Our rich person is paying this rate in year 30. Remember, his or her underlying goal is not to minimize tax rates at one period in time, but overall taxes throughout the 30-year time period. And that means that we should consider the fact that in the 30th year, he is paying taxes on his capital gains an average of 15 years late. To put it in terms of purchasing power, if we assume inflation of 1.5 % per year over that time period (typical of the last 10 years), he or she may be paying 11% of capital gains in tomorrow’s dollars, but that’s the same thing as paying less than 9 % in today’s dollars. If we assume a more historical 3 % rate of inflation, it’s more like 6.5 % (although, for the rich person, the higher inflation is, the less the “real” income both before and after taxes). And thus, the “real” overall tax rate is back down to about 8.75 %!
What About When You Die?Now, it would seem that when the rich person in my scenario died, the chickens come home to roost, or, to put it another way, most of the capital gains of the rich person are finally paid out in taxes, one way or another. After 30 years, the final estate has grown to around $133 million (1.09 to the 30th power). 40 % of $122 million of that ($48.8 million), where a husband and wife are involved, would need to be sold to pay those taxes, plus enough to cover the 11 % capital gains tax rate on the sold stocks (about $5 million) and miscellaneous fees ($0.5 to 1 million). So we have net taxes of about $54.5 million, or 41 % of the estate. Add to this the previous 30 years of average 6% tax rates for stock income averaging about $6 million (0.3 times 30 times 6, or $5.4 million), and the total tax on capital gains would seem to be more like 45%.
Except for two things: Factor 1, the “step-up in basis”, and Factor 2, the effects of inflation.
Factor 1: Because of the recent law allowing stocks to be reset to show zero capital gains at the point of our rich person’s death, their heir(s) no longer need to pay that extra $5 million in taxes to cover capital gains taxes from selling stocks. So now we’re back down to about 41 %.
Factor 2: We are paying that $55 million in tomorrow’s dollars – dollars 30 years on, to be precise. Assuming a historical inflation of 3 % per year, those dollars are worth 41 cents in today’s terms. And that, in turn, means that we are really down to an annual capital gains rate on actual income of 16.9 %.
In other words, after these two considerations, the rich person has really paid the government only 12 % more than the Federal capital gains tax rate. And the clock is now reset to our original scenario, as the heirs pay less than 3 % of actual income on their next income tax bill on the remaining stocks.
Contrast this, by the way, to the schmoes who earn between the median wage of about $60,000 and $200,000 per year. Yes, they don’t have estate taxes, but indications are that they pay more than 20 % of real total income in income taxes – and then, if they save a fair amount for their old age, get taxed another few percentage points on their savings from any stock investments they have, which typically yield much less than 9 % per year anyway!
Advice and HorrorTo close out, let’s return to the question of whether the average reader can approximate this. As I see it, to pull this off a reader should do three things:
1. Start off with sufficient net worth in investments in diversified and low-expense-ratio stocks (at a guesstimate, a minimum of $3-5 million) so that your yearly expenses can be about 2.5 % of that net worth.
2. If you want to milk the last drop of profit from this scheme, arrange it, if possible, so that modified LIFO is your strategy for all stocks sold.
3. Make sure that between 1 % and 4 % of your stocks are “churned” – sold and bought – each year while preserving diversification and a low expense ratio. An index fund like a good S & P 500 one plus paying most of your expenses out of stocks are excellent ways to accomplish this.At this point, I should remind the reader that the most important thing for him or her is not minimizing taxes, but maximizing net worth after taxes. Things like low-cost index funds and reinvesting dividends are valuable because they help maximize net worth before taxes, and hence (because they have few or no tax effects per se) net worth after taxes. As I said in my unpublished book on personal finance, the strategy that aims to maximize income is almost always better than the alternative strategy that tries to minimize taxes.
And finally, I just want to express my personal feeling of horror at the implications of this analysis. It should take no reminding for readers to contrast this situation with income from wage work, which can be taxed at a typical rate of 5 to 10 times the rate for investments when your wage is between the median of $60,000 a year and, say, $200,000 a year. And for what? The rich don’t work harder on average, they spend much less of their income to contribute to an economy, thereby lowering the income of the rest of us, and if they’re top-level managers they also excessively squeeze wage income for the rest of us, as Piketty documents extensively. And in the long run, as Piketty also notes, by using some of their spare money to change politically the rules of the economic game in their favor, they raise the likelihood of serious recessions and depressions that harm all of us.
And there’s another apparent effect that really bothers me. In my scenario, the government sees most capital gains income for the first time, not when the income is gained, but in the reporting for the estate, 30 years from now. That means that, on average, in real terms, we see the real investment income of the rich 15 years after it occurs, when it has perhaps two-thirds of its actual value. If this is so, we are seriously, seriously underestimating today’s income of the rich, the degree of income and wealth inequality in this society, and the degree to which this tax code is causing that inequality.
Caveat homo medianus! Let the average person beware!