Assume for a few moments that you are Mr. Bob Stern, a scholar who works for the IRS. One morning your manager, Mr. John Young, calls you into his office. He gives you an assignment: to enhance his understanding of the relationship between income and wealth.
Mr. Young: Bob, I keep reading reports about the growth of the millionaire population.
Mr. Stern: Yes. I have a pile of articles and clippings on the same topic in my desk.
Mr. Young: Well, here is the problem. The number of wealthy people keeps rapidly increasing. But our income tax revenue for a lot of these people is not keeping pace.
Mr. Stern: I read somewhere that the wealthiest 3.5 percent of the households in this country account for more than half of the personal wealth. But these same folks account for less than 30 percent of the income.
Mr. Young: I wish Congress would wake up. What this country needs is a tax on wealth. Even in biblical times the rich had to pay 10 percent of their wealth each year in taxes. Now that’s what I call the ultimate tax reform.
Mr. Stern: I know what you mean. But sooner or later we will get ‘em. Remember, it’s inevitable—death and taxes.
Mr. Young: The estate tax area is not your specialty, Bob. You are a little naive on this issue. You are thinking that we will eventually take a big bite out of all the millionaires in this country by taxing their estates.
Mr. Stern: The Grim Reaper is on our side.
Mr. Young: Not so fast, Bob. Just think of all the millionaires in
this country. Most of them own some kind of a business, and a whole bunch own stocks. What do these folks do with their money? They sit on it, or they plow it back into their business. They hold on to all those stocks that keep appreciating.
Mr. Stern: But what about the Grim Reaper?
Mr. Young: Look at it this way, Bob. We have often looked at estate returns in the $l-million-and-above level. Last year there were only about 25,000. But, Bob, at the same time there were 3.5 million millionaires alive and kicking. That means that 0.7 percent were picked up by the Reaper. This number should be twice as high. But you know what a lot of millionaires do? Before the Reaper shows up, they transform themselves. It’s like magic.
Mr. Stern: How do they do it? They can’t just vanish. Do they move offshore before the Reaper shows up?
Mr. Young: Offshore is not a significant factor. But I would not be surprised if we found that half of the millionaires transform themselves into nonmillionaires BR.
Mr. Stern: What do you mean by BR?
Mr. Young: It’s an insider term. BR means “Before the Reaper,” or prior to death, as opposed to AR, or “After the Reaper.” Look at this case study. Here’s a woman, Lucy L., who had $7 million just a year before she died. She lived on her pension money. Never in her life sold a share of stock out of her portfolio. Her wealth doubled in just the six years between her seventieth and seventy-sixth birthdays. But what did we get out of it? In terms of income tax, nearly zip. She essentially had no realized income from her portfolio. I hate unrealized income.
Mr. Stern: You’re right. It is a clever enemy. But the Reaper—he got her, right? Death and taxes.
Mr. Young: Wrong, Bob. She died last year. And do you know what her net worth was at the time the Reaper finally showed up? Less than $200,000. No estate taxes. Another former millionaire moves on without leaving a taxable estate. Some days I wish I were in another
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line of work. The enemy is winning. Mr. Stern: But where did all her money go?
Mr. Young: She gave it to her church, two colleges, and a dozen or more charitable organizations. She also gave $10,000 to every one of her children, grandchildren, and nieces and nephews. She’s real country—loaded with relatives, like a lot of mountain people.
Mr. Stern: And what did we finally end up with?
Mr. Young: You’re not listening, Bob. We, the government, got zippo! Can you believe it? Her own government. There’s just no justice in America. We need a wealth tax.
Mr. Stern: Well, she sounds like a pretty nice person to give so much money to a church, colleges, and charities.
Mr. Young: Bob, shame on you. She and her ilk are the enemy. America needs their wealth to keep our government operating. We need her money to pay off the federal debt. We need to fund all our social programs.
Mr. Stern: Perhaps she feels that her church, the colleges, and the charities also have needs.
Mr. Young: Bob, you are so naive. This woman is an amateur. What type of experience does she have doling out her wealth? We are her government. We’re experts in redistributing wealth. We should decide where and how wealth is distributed. We are the pros. We have to start taxing wealth before all the millionaires transform themselves into nonmillionaires.
Mr. Stern: What about all those famous people we read about in the newspaper? The ones who have very high incomes?
Mr. Young: God bless them, Bob. They are our best customers. I love people who are big earners. Realized income is our salvation. I want you to study these types. But I also want you to find out how these other types can exist without realizing a lot of income.
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Some of them must live like monks. What’s wrong with these people? Why don’t they sell a few million dollars’ worth of stock and buy a mansion?
Mr. Stern: Is that why you have all those pictures of America’s highest-paid celebrities on the walls of your den at home?
Mr. Young: You bet. I love those people. They’ve got a real bad case of the “spends.” And to spend they have to have realized income. Look at it this way. When a ball player buys a $2 million boat, we become his partner. He will need to realize $4 million to pay $2 million for his boat. We are his partner.
Mr. Stern: Ball players? Are they good role models for our youth?
Mr. Young: Absolutely. They are high-income spenders. They tell our youth to earn and spend. It’s realized income that our youth need to learn about. These spender types are true patriots. That’s why I keep Webster’s definition of patriot on my wall. Why don’t you read it to me, Bob?
Mr. Stern: Patriot: one who loves his country and zealously supports its authority and interests.
Mr. Young: Yes, Bob—zealously supports its authority and interests. You know, Bob, the real patriots out there are people who earn big incomes—$100,000, $200,000, and $1 million or more a year —and spend it all. Congress should mint a new medal for this type of patriotism, Bob. It would be called the Congressional Medal of Taxation and Consumption. And as long as these patriots keep training their kids to be medal winners, we are in good shape. Bob, do you think we should start sending out holiday greeting cards to all those companies that promote luxury cars, yachts, million-dollar homes, and expensive clothes and accessories? These people are really patriots in their own way. They encourage spending. They are keeping us in business. Well, Bob, it’s getting late. You have your assignment. I want to know more about the medal winners. But I also want you to study the ways of those who don’t spend their money.
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What evidence is there that the government knows the formula for becoming financially independent in America? Just read some of the articles its employees have written recently. Many well-trained economists and other scholars who work for our government frequently conduct studies about the rich (or, as they refer to them, the “top wealth holders”). We are particularly interested in the articles published in the Internal Revenue Service’s Statistics of Income, a quarterly report. It’s a research scholar’s paradise, providing mountains of Statistics on income. But income is not the government’s only focus. It also studies top wealth holders. We are envious. We have to do our own surveys of the affluent. That’s our main source for understanding the “How to Get Rich” formula.
C. Eugene Steuerle is assistant director of the Office of Tax Analysis in the U.S. Department of the Treasury. He is also a scholar and talented researcher. He asks the same question we do: What is “the relationship between realized income and wealth”? (SOI Bulletin, Department of the Treasury, Internal Revenue Service, vol. 2, no. 4, Spring 1985) What does he find? That people accumulate significant wealth by minimizing their realized/taxable income and maximizing their unrealized/nontaxable income.
In the study that Mr. Steuerle conducted, he compared the income tax returns that top wealth holders filed while they were alive with the estate returns their executors filed after the subjects passed away. He studied a national sample of estate tax returns. Then he matched each of these with their respective income tax returns from previous years. Why all this contrasting? Mr. Steuerle wanted to study the correlation between realized income as documented in income tax returns and the actual net worth of each subject in the sample. Of special interest was the relationship between realized income generated from investments and their actual market value.
Why would a scholar who works for our treasury department spend so much time conducting a study like this? We consider the staff of the IRS a clever bunch. They study their target market. And they lust for its wealth. They want to know how many affluent people generate so few dollars of realized income. Since owners of closely held businesses are especially adept at this strategy, Mr. Steuerle selected for study those estates in which the value of the closely held business(es) exceeded 65 percent of the estates.
Here are some of the findings of Mr. Steuerle’s study:
◆ The income realized from the assets of closely held businesses was only 1.15 percent of the appraised value of the assets. Note that even this small percentage is likely to be biased in the upward direction, since there are estate tax advantages for heirs and executors who provide conservative appraisals.
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◆ The total income realized from all assets and all salary, wages, and income combined was only 3.66 percent of the value of all assets.
What do these results tell you about the affluent? They suggest that a business owner who is worth, say, $2 million on average has an annual realized income of only $73,200, or 3.66 percent of $2 million. Could you live on $73,200 today and still invest a minimum of 15 percent each year? No, it’s not easy. But it’s not easy being financially dependent, either.
FINANCIAL INDEPENDENCE
We once asked a high-income/low-net worth corporate manager (we will refer to him as Mr. Rodney) a simple question:
Why is it that you never participated in your corporation’s tax-advantaged stock purchase plan?
This manager’s employer offered him a matching stock purchase plan. Each year the manager could purchase the equivalent of 6 percent of his income in shares of the corporation, which would reduce his realized taxable income. Also, the corporation would match his purchase of company stock up to a certain percentage of his income.
Mr. Rodney reported that, unfortunately, he could not afford to participate. It seemed that all his income went toward his $4,200 monthly mortgage payment, two leased vehicles, tuition bills, club dues, a vacation home that needed to be fixed up, and taxes.
Ironically, Mr. Rodney wants “eventually to become financially independent.” But like most UAWs, Mr. Rodney is not realistic in this regard. He has sold his financial independence. What if he had taken full advantage of the tax- advantaged benefit from the time he was first employed? Today he would be a millionaire. Instead, he is on the perpetual earn-and-consume treadmill.
We have interviewed countless high-income/low-—net worth people. Sometimes it can be depressing, especially when the respondents are seniors.
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How would you like to be a sixty-seven-year-old cardiologist who has:
No pension plan ... never had a pension plan
in spite of earning millions during his lifetime? His total net worth is less than $300,000. No wonder he started asking us questions such as:
Will I ever be able to retire?
Even more revealing are the interviews we hold with the widows of UAWSs. In many cases, the widow has been a housewife throughout her long marriage. Often her mate, a high-income/low-net worth type, was underinsured or had no life insurance at all.
My husband always said not to worry about money.... “I’Il always be here,” he said. Can you help me? What should I do?
This is not a fun situation. How can well-educated, high-income people be so naive about money? Because being a well-educated, high-income earner does not automatically translate into financial independence. It takes planning and sacrificing.
What if your goal is to become financially independent? Your plan should be to sacrifice high consumption today for financial independence tomorrow. Every dollar you earn to spend is first discounted by the tax man. Earning $100,000 may be required to purchase a $68,000 boat, for example. Millionaires tend to think this way. That’s why only a minority own boats. Do you plan to live on a boat after you retire? Or would you prefer to live on a $3 million pension plan? Can you do both?
HIGH-STATUS NEIGHBORHOODS
If you read the last section about the IRS’s study of the affluent carefully, a question may have come to your mind.
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Are the results of the surveys we conducted different than those generated from income tax and estate tax returns? You will recall that, on average, the millionaires in our latest survey had a total realized income that was about 6.7 percent of their total net worth. The results from the income tax and estate tax data, however, indicated that top wealth holders realized only 3.66 percent of their wealth. How can this difference be explained? And what does it mean?
We employed a different sampling method than that used by the IRSin its study of income tax and estate tax returns. Our survey was based on sampling households that resided in high-status neighborhoods, whereas the IRS sampled from all income tax and estate tax returns. Since about half of the millionaires in America today do not live in so-called high-status neighborhoods, we also surveyed affluent farmers, auctioneers, and other wealthy people who live in nonstatus neighborhoods. Why do millionaires from high-status areas realize significantly more of their wealth (6.7 percent) than those top wealth holders selected from a national sample of all affluent decedents (3.66 percent)? Because the millionaires from high-status neighborhoods have to realize more income to live in these areas. What are the implications of our findings? It’s easier to accumulate wealth if you don’t live in a high-status neighborhood. But even those millionaires who do live in high-status areas realize only 6.7 percent of their wealth each year. Think of their non-affluent neighbors who, on average, must constantly realize more than 40 percent of their wealth just for the joy of living in a high-status gulch.
Perhaps you aren’t as wealthy as you should be because you traded much of your current and future income just for the privilege of living in a home in a high-status neighborhood. So even if you’re earning $100,000 a year, you’re not becoming wealthy. What you probably don’t know is that your neighbor in the $300,000 house next to yours bought his house only after he became wealthy. You bought yours in anticipation of becoming wealthy. That day may never come.
Each year you are forced to maximize realized income just to make ends meet. You can’t afford to invest any money. Essentially, you’re at a stalemate. Your high domestic overhead requires full commitment of all your income. You will never become financially independent without purchasing investments that appreciate without income realization. So what’s it going to be? Will you choose a lifetime of high taxes and high-status living, or will you change your address? Allow us to help you in your decision making. Here is another one of our rules.
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If you’re not yet wealthy but want to be someday, never purchase a home that requires a mortgage that is more than twice your household’s total annual realized income.
Living in less costly areas can enable you to spend less and to invest more of your income. You will pay less for your home and correspondingly less for your property taxes. Your neighbors will be less likely to drive expensive motor vehicles. You will find it easier to keep up, even ahead, of the Joneses and still accumulate wealth.
It’s your choice. Perhaps you will make a better one than a young stock broker, Bob, we recently advised. We gave him the same advice about the ideal ratio of home price to income. This thirty-seven-year-old broker had a total realized income of $84,000. He wanted our advice about buying a $310,000 home. He planned to make a down payment of $60,000. He also planned to become wealthy. Carrying a $250,000 mortgage, we felt, would be an impediment to his goal.
We suggested that he buy something less expensive, such as a $200,000 home with a $140,000 mortgage. This would be within the parameters of the rule. Bob rejected this advice. He did not want to live in a neighborhood full of “truckers and construction workers.” After all, he is a financial consultant and a college graduate.
But what Bob does not realize is that many construction workers and their spouses have combined incomes of more than $84,000. Of course, his mortgage broker told him he was qualified for a $250,000 mortgage. But that’s like asking a fox to estimate the number of chickens in your coop.
~ The value of private wealth in America is more than $22 trillion. Millionaires own approximately half of this amount, or $11 trillion. The total personal income for the same period is estimated to be about $2.6 trillion. Millionaires account for only about 30 percent of the total income, or $.78 trillion. This means that millionaires as a group realize the equivalent of only 7.1 percent of their total wealth each year ($.78 trillion income #x00F7; $11 trillion in wealth=7.1 percent).
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