July 2001
Vol 24 No 11
One of my early mentors, Cliff Weaver, used to say that “It's terribly embarrassing to be physically alive and financially dead.” But that happens to a lot of Floridians for one primary reason: Because of its climate, relatively low cost, and lack of State income taxes, Florida is a leading destination for retirees. Over the years I've had an opportunity to get a real close up look at how they live, and how they liquidate their assets to maintain their lifestyle. By and large, they've underestimated the income they would require to support themselves over their lengthening life-spans, and they failed to start early enough to aggressively begin to prepare for it.
I still have an image from the early 1970s of an ancient bespectacled, bloodied lady, who appeared to be near 90 years old, who was run down by some joy-riding teenagers in St. Petersburg. We all rushed over to help, and someone called an ambulance. She refused medical treatment because she couldn't afford it. Even though she would have been reimbursed in time, she couldn't spare the cash until then. That was what prompted me to begin to get serious about funding my retirement plan. Now might be a good time for you to do it too.
Today, a lot of people are nearing retirement with what could prove to be inadequate financial resources. Many simply didn't plan ahead, putting all of their faith into Social Security and fixed-income pensions that don't take inflation into consideration. Others rolled over company plans into a self-directed plan invested in mutual funds and stocks only to lose half their value in the past year or so. Some simply speculated and lost their savings. Today, expectations of a comfortable retirement are swiftly turning into the realization that millions of people are going to be forced to work into their late seventies. Although financial market news talks in terms of billions and hundreds of millions of dollars, when you confront the cold reality of having to strive for just what it takes to provide a reasonable degree of comfort without earned income, it can be a daunting task to see where the money is going to come from. It takes both planning and discipline.
Planning for retirement is a “Catch 22” proposition. If you expect to be able to live even modestly when you stop working, you have to start making sacrifices at an age when the demands of raising a family must compete with savings and investment. It's pretty hard for the average wage earner to be able to set aside as little as $100 per month when he or she is struggling just to make ends meet; especially when retirement seems so far away, and current financial needs seem so urgent. Unfortunately, the later you start, the more you'll have to sacrifice.
Let's say that you wanted to have a retirement income in constant dollars of $34,500 per year over and above any Social Security you might receive. That would boil down to $30,000 per year after taxes, if tax rates stayed constant. Let's suppose that, in order to be able to receive this much income, you'd have to have acquired $345,000 in free and clear assets that would earn 10% in net yield after all expenses. We'll also premise that you'd want to be able to start receiving this income at the age of 55. Now comes the hard part of the process:
From your targeted $345,000, deduct the net value of all of the above assets after adjusting them to pay for future costs of raising and educating your kids, and take a hard look at what's left. Divide this figure by the number of years until you reach the age of 55, and you'll see what you have to achieve within that time period. Assuming no current invested assets, for a 35 year old it will be necessary to set aside $454.33 per month for the next 240 months. In the 15% bracket, that boils down to $534.51 a month out of your family budget. In contrast, a 25 year old would only have to set aside $152.63. A 20 year old with 35 years until retirement would only have to save $90.88 each month. That's the joker in the deck. What youngster of 20 even thinks about retirement, let alone actually makes financial sacrifices for it?
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In order to see how far away you are from your goal, you've got to start by adding up all current assets. If you're like a lot of Americans, you've got a small fortune tied up in expensive home furnishings, SUVs, “collectibles”, tools and equipment, recreational vehicles, boats, sports equipment, etc. In the harsh world of economic reality, even though they may have cost a lot of money, and consumed years of effort to pay off, these have very little cash value if sold at public auction. The costs of education and medical insurance are growing at flank speed as they consume large portions of family earnings. So, you'd want to reduce net worth by the foreseeable financial drain of college for kids or the needs of your business. If you're an average citizen, there isn't much left to invest. If we were going to devise a perfect retirement plan, it would contain several features.
A. It would be funded with un-taxed dollars. If that couldn't be accomplished, contributions to it would be deductible from income.
B. It would be able to grow tax-free and be impervious to assaults from creditors and predators alike.
C. When withdrawals were made from it, they would be tax-free.
D. It would be hedged against inflation and deflation to maintain the purchasing power of the income it provided.
E. It would not be highly regulated, and there would be few limitations as to whom it could do business with.
F. It could be funded with earned income, unearned income, un-taxed profit, or debt-leveraged assets.
G. There would be no minimum age at which it could begin to pay out retirement income, nor would there be any minimum or maximum amount of payment.
H. Any un-distributed funds remaining in it could be left in it tax-free for heirs, or passed on to anyone tax-free to be liquidated, or not, as desired as a part of an estate plan.
There aren't many retirement plans out there that will fill this prescription, but a few come close. The magic is in getting retirement plan assets to compound swiftly so that profits compound tax-free, and that the person who knows most about discounted mortgages, foreclosure and tax sales, Options, and creative finance be in control of plan investments. Thus, the most critical ingredient in any retirement plan would be that it only includes one person who controls what it invests in. For that reason, I am not considering insurance annuities, Simple IRAs, K-401s and other plans administered by banks, stock brokers, financial advisers and insurance companies. Who knows, one of these plans might be just the ticket for you.
SELF-DIRECTED QUALIFIED CORPORATE DEFINED BENEFIT PENSION PLANS:
Corporations are taxed at low rates initially, but their rate rises swiftly as their income grows. Similarly, as a corporation becomes more profitable, its employees' salaries rise. At some point, the corporation can get maximum benefit from current expense deductions, and the employee can get maximum benefit from un-taxed compensation. A qualified corporate retirement plan fits this situation admirably. Contributions are tax-free to the employee and deductible to the corporation.
There are two principal types of corporate retirement plans, Defined Contribution Plans and Defined Benefit Plans. Defined Contribution Plans come in a couple of flavors which include Money Purchase Plans and Profit Sharing Plans which permit up to $30,000 per year to be contributed and deducted from annual earnings. Defined Benefit Plans are ideal for the middle aged person who has reached his peak earning years without much in the way of retirement funding. The actual amount set aside is determined “actuarially” based upon the number of years to retirement, the three highest years of earned income, and the expected investment yield realized by the portfolio. Currently, a corporation can contribute, and deduct, enough money to permit this person to retire at up to $160,000 per year.
Plan contributions by the corporation aren't taxed to the wage-earner until he begins to withdraw it. At the point of withdrawal, at least one revenue ruling permits the plan recipient to contribute funds to a charitable trust and to defer withdrawals indefinitely. So, a self-directed qualified corporate defined benefit pension plan provides tax-free compensation on significant sums of money that would otherwise be taxed at top rates, deductions to the corporate employer which reduce its taxes, deferred taxation –and perhaps zero tax — on withdrawals, the ability of the plan beneficiary to borrow funds from it, and a degree of asset protection unsurpassed with other types of retirement plans. Because corporate retirement plans must be available to all employees of a firm, they're best suited to a corporation comprised solely of family members. Plans typically can accumulate tax-free earnings, usually in the form of capital gains that are taxed as ordinary income when withdrawn.
With some exceptions, retirement plan withdrawals made before age 50.5 are subject to a 10% penalty tax. At age 70.5 mandatory withdrawals must be made in accordance with federal regulations. If not made as prescribed, a 50% penalty tax is levied to the extent of distributions that weren't made each year. When piled on top of other taxable income that a fruitful career might provide, this can cause retirement pay to be taxed in the highest tax brackets. What's worse, when undistributed plan funds are added to a large estate, both income and estate taxes are levied against them. This can deprive an estate of up to 85% of plan assets.
SELF-DIRECTED INDIVIDUAL RETIREMENT ACCOUNTS (IM): These plans are subject to most of the same regulations as qualified corporate pension plans with less flexibility and a few more limitations. IRAs work well for the younger wage earner, and the family with limited resources not covered by an employer plan. They enable wage earners to deduct up to $2000 per year of earned income from taxable wages and to put them into a special retirement account for investment. A spouse with no earned income can still contribute $2000 that is deductible from his or her spouse's taxable earnings. The account is administered by a qualified plan custodian who invests plan funds according to the instructions of the plan beneficiary. IRAs may seem puny compared to corporate plans, but, if started early enough, they can compound tax-free into significant sums. For example, if a couple were to contribute $4,000 for 25 years, and invest the account to earn 10%, the tax-free yield would grow to $393,388. Starting an IRA early is certainly worth doing.
SELF-DIRECTED ROTH IRAs : The Roth IRA can be a real powerhouse if started early and invested aggressively. It differs from the other types of retirement plans in that contributions must be made out of non-deductible after-tax dollars. That's the bad news. There are limitations: Marrieds with incomes over $100,000 can't “roll over” an existing IRA into a Roth IRA, nor can those with adjusted gross incomes in excess of $160,000 contribute to a Roth IRA. The good news is that, after the later of 5 years or age 59.5 there are no minimum or maximum distributions required. Better yet, distributions are tax free for the life of the original beneficiary, and can be rolled over in an estate plan so as to be income-tax free to heirs. They'll still have to pay estate taxes to the extent the amounts in the IRA exceed the (in 2007)$1,000,000 per spouse that can be gifted or devised estate tax-free.
CHARITABLE REMINDER UNITRUSTS : Although often thought of as a vehicle for funding charitable enterprises, in the special form of NIMCRUT (Net Income with Make-up provisions Charitable Remainder Unit Trust) offers an attractive alternative to the above types of plans for some people. It is ideally suited to high-bracket entrepreneurs and investors who either have no heirs, or who have provided for their heirs and who want to provide for charitable bequests out of their estates.
For all intents and purposes, NIMCRUTs are subject to the same restrictions as corporate pension plans and IRAs when it comes to self-dealing, high risk investment, unrelated business income, and the use of leveraged assets, but they differ in significant ways: First of all, NIMCRUTs can be funded with free and clear real estate that has been completely written off. A deduction from current income is based upon fair market value, not the adjusted cost basis. Entrepreneurs can contribute shares of their corporations and take a monster deduction. The NIMCRUT can then sell contributed property tax-free and continue to compound the sale proceeds over the lifetime of the donor, and heirs, without being required to make any distribution at any age to the donor, or to a charity.
That last statement might need some clarification: When the NIMCRUT is formed, a specific percentage of the net value of the NIMCRUT between 5% and 50% must be distributed to the donor each year; however, this can never be more than the actual income earned during that year. Thus the donor, who controls NIMCRUT investments, can decide to invest in non-income-producing assets such as appreciating land, zero coupon bonds, or stock in growth companies such as Viacom, Microsoft, or Berkshire-Hathaway that don't declare dividends and not take any distributions until he's ready. Nor is there any minimum or maximum age limit as to when “pension” payments may begin or must begin. Best of all, when the donor elects to take a distribution, it is taxed according to how the NIMCRUT realized a profit. Distributions based upon capital gains is taxed as capital gains. There are some fairly complicated rules, but tax-free income can be tax-free when distributed.
Think about this for a moment: An entrepreneur who has the capacity to acquire real estate at wholesale prices can leverage his deduction either by holding it as rentals and fully depreciating it prior to contributing it to his own NIMCRUT, then deduct the appreciated value of the contributed assets from current income. The actual deduction is calculated according to a variety of factors, and according to the type of property contributed. When non-capital assets such as “paper” or “inventory” is contributed, the deduction is limited to the actual cost basis of the donor, but the “pension” payments can still be made based upon the NIMCRUT assets that continue to compound tax free. So, a land developer or entrepreneur who buys low and sells high can contribute bargain-priced assets to a NIMCRUT which can then sell them at full retail, carrying back “paper” if need be, to quickly fund his retirement income faster than with any other kind of retirement plan.
SINGLE FAMILY HOUSES : Any and all of the above approaches to retirement income are self-directed, and they can all elect to invest in single family houses, but, that would “waste” all the tax benefits that leveraged houses can provide. Let's consider a single family house portfolio as if it were a retirement plan in itself. First of all, since it 'can be assembled with a high degree of leverage, even younger workers can begin buying houses long before they'd have enough earned income to be able to fund any of the other retirement plans. To the extent that a person can negotiate a discount from market value, use creative seller financing to buy a house, and manage it to produce income, he can wind up with a very comfortable retirement at a much earlier age than other plans can provide.
There would be no minimum, nor maximum age for distributions, nor would there be any minimum nor maximum required distributions. Moreover, retirement would be funded by tenants rather than by the person who would receive the “retirement“ income, and these payments would largely be tax-free, sheltered by real estate write-offs. Even when all depreciation were exhausted, properties could be sold to provide income, and this would be taxed at long term capital gains rates, or contributed to a NIMCRUT. When the retiree went to the big escrow in the sky, his heirs would be able to inherit this portfolio and get a step up in basis to enable them to “retire” in the same way, generation after generation.
Go back and take a look at the “ideal” retirement plan posited on the first page of this letter. Isn't it amazing how well a portfolio of single family houses incorporates almost all of these? Whether starting early or late to fund a retirement plan, a well-bought and well-managed single family house can provide financial security and benefits virtually unmatched by other retirement schemes; and all of these plans can include single family houses in their own investment strategies. If you haven't begun yet to fund your retirement, there's no better time than now to get started. Starting at 40, it sure worked for me . . .
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Quotation not permitted. Material may not be reproduced in whole or part in any form whatsoever.
