December 1, 2013

Lawyers’ Personal Investment Plans and Tax-Subsidized Opportunities

By Paul L. B. McKenney

On July 31, 2009, the Senior Lawyers Division and Section of Taxation cosponsored a program at the ABA Annual Meeting, co-chaired by Bruce Alan Mann, chair of the SLD Investment Strategies Committee, and Paul L. B. McKenney, vice-chair of the Sales,  Exchanges,  and Basis Committee of the Section of Taxation. The following article is based on the presentation by Mr. McKenney at that program

This article will offer a nontechnical guide to lawyers’ own investments gleaned from thirty-five years of practicing tax law. Lawyers have been a disproportionately high percentage of my client base, and we keep observing the same fact patterns. Only 18 percent of Americans have properly invested to provide a secure retirement with no diminishment to their standard of living. Unfortunately, lawyers appar- ently fit in with the national statistics.

There are some common myths about retirement. First, “I will spend less” has been disproven by numerous empirical studies. Eighty-eight percent think they will cut expenditures, but there will likely be little, if any, change in your burn rate of cash. Second, health care does indeed become expensive and is unlikely to continue to be employer provided. Third, retirement typically lasts a long time. If you retire at age sixty-five, your actuarial lifespan is another 17.5 years. Have you accumulated sufficient income-producing capital to last that long?

Rule #1: Have a Plan

It is that simple. Adequate investment does not sporadically happen “if there is any money left.” A lawyer has to have a systematic plan for investing. This means a specific amount of money is automatically taken from every paycheck or distribution. For lawyers age sixty, it is not too late to invest—better late than never. It is always sad to see a lawyer who had a successful practice for many years who retires, voluntarily or otherwise, and has no meaningful savings. The resultant great decline in lifestyle is always painful.

If you are with a large law firm or employer, start with what elective monies can be automatically contributed to a 401(k) plan and other qualified retirement plans. Talk to your Human Resources Department to learn what is available. If you are with a small firm or if you are a solo practitioner, consult a tax advisor to learn about myriad tax-deferred vehicles. You will likely be surprised by the magnitude of available options.

Virtually every investment advisor, brokerage house Web site, and investment fund offers online an interesting and valuable software program that calculates how much retirement funding is needed to retire at a given age to maintain a specific level of income through your actuarial life expectancy. Every attorney, even those far too young to join the Senior Lawyers Division, should go through this ten-minute exercise. This target is a funding goal for a secure retirement. For example, to retire at age sixty-five with a spouse the same age and a portfolio then invested in 60 percent bonds and 40 percent equities at today’s lower yields requires $5.1 million of core capital for $200,000 of desired after-tax income, per AllianceBernstein. This sobering result employs current actuarial tables and bond returns as well as historic stock performance. Such core capital excludes residences and other non-income-producing assets.

Investing for Retirement

You have to recognize that due to advances in health care and lifestyle, people simply live far longer today. Recently released actuarial tables verify this. Today, the additional life expectancy of a sixty-five year old is over 17 years for males and 20 years for females. Corresponding numbers in 1950 were 12.8 and 15 years. The additional life expectancy of a seventy-five-year-old male today is 10.8 years and 12.8 years for females. The money needs to outlast you, and if you are married, your spouse. If you and your spouse are both sixty today, the actuarial tables show the age of the second spouse to die will be after age eighty. If both members of a couple are sixty-five, there is a 50 percent chance one of them will survive to age ninety-two.

There is always the public Social Security system. However, for almost all people reading this article, that will not provide them the level of support to which they have been accustomed or one in which they would be comfortable. It is up to you to do it for yourself. You simply have to be proactive.

The Tax System Is Your Friend—Really

The above title is not a typographical error. A huge failure of lawyers over many years is not recognizing that they effectively have two baskets into which they can place investments. One basket is tax free in terms of 100 cents on each dollar pretax that goes in, and that dollar earns tax-free returns and grows compoundedly in the tax-free environment over time. Examples of tax-free baskets include 401(k) plan interests, other employer-qualified plans interests, and individual retirement accounts (IRAs), including rollovers. Conversely, we also have a “taxable” basket in which after-tax proceeds are invested and the income and capital gains from those are also currently taxed. Examples would be securities or rental properties that are titled in your name.

Asset Allocation—Do  Not  Let  This  Opportunity  Pass  The allocation of assets should generally place income- spawning items in the tax-free basket. For example, a long-term bond portfolio generating significant income every year can, in tax-free baskets, accumulate income on a tax-deferred basis. Assets that are ineligible for tax- free baskets, together with long-term capital apprecia- tion assets, are usually invested in your own name or a taxable basket. The main benefit of a tax-free basket is that you have a dollar to invest at the beginning. Investing a dollar is far better than investing a dollar less the sum of current:

  • Federal income tax,
  • State income tax,
  • Any local income tax, and
  • Employment taxes.

A simple example at a relatively low compounded growth rate far below historic public market averages, 6 percent, illustrates this. You take a dollar of pretax income and contribute it to a 401(k) plan or other tax-free basket, and it has compounded growth for ten years. At the end of ten years, it is worth $1.79. At an 8 percent growth rate, the corresponding number is $2.16. By comparison, assume the same individual takes another dollar, and the combined effective federal, state, local income, and employment taxes aggregate 35 percent. The remaining $0.65 is invested for ten years. At a 6 percent growth rate, he or she only has $0.97 left after a decade, and it would be $1.11 at 8 percent per annum. Because of compounding, the disparity between tax-free and taxable baskets grows if one goes out further in time.

There Is No Free Lunch in Investments or  Elsewhere  When the money comes out of the tax-free basket, such as an IRA rollover, then it will be subject to current taxation. Having looked at spreadsheets run under countless different scenarios going out a number of years, the response is always invariably the same—“so what?” Today’s present value of a dollar of tax to be paid in ten or twenty years is a very small fraction of that dollar. Also, the starting base will be so much higher that it really becomes almost immaterial if the marginal income tax rates go up between now and then. As a practical matter, most retired lawyers will be in a far lower marginal income tax bracket when they ultimately have to pay tax upon withdrawing the money.

The economic substance of this is strongly subsidized by the Internal Revenue Code for those who invest money into the tax-free baskets. Why has Congress consistently done this over the years? The answer is simple—the actuarial frailty of the Social Security system. Congress recognizes that when Social Security was established, very few people lived to age sixty-five to ever begin to draw money, and if they lived that long, they were not drawing money for very long. That was then, this is now. Both political parties have long recognized that they need to give tax incentives to those who take responsibility for themselves with their own retirement investing. This is why numerous “what-if” scenarios computed over the years with various assumptions essentially yield the same results. An individual is farther ahead to start investing a dollar in a tax- free investment that defers tax on it into the future than to start with a far smaller, after-tax amount. Even if marginal income tax rates go up 5 or 10 percent over the years—if you are 50 percent or more ahead then—so what?

Extracting Monies at Retirement

A related topic is how you extract specified monies from qualified plans and IRAs. This is a topic well beyond the limited scope of this article. It is also a complex area on which much has been written. This author’s opinion is that it would be well worth your money to obtain assistance from a knowledgeable tax practitioner when it comes to taking money out of qualified plans. This is because there are drastically different after-tax results depending on options under a given retirement plan. Qualified retirement plans are the polar opposite of a “one-size-fits-all” species.

That said, there are a few general rules. First, only take out the required minimum distributions after age 70½, unless you need additional money to live on. Second, never ever raid retirement funds before retirement. They were put into retirement accounts for a reason, and temporarily “borrowing” them is something you will long regret.

The Estate Tax Never Dies

Will there be a federal estate tax for those dying in 2010? Under the 2001 legislation that put the current estate tax rules in place, in 2010, there will be no estate tax only for that year. The stepped-up income tax basis at death will also be repealed. However, beginning in 2011, the estate tax will revert to a $1 million exemption equivalent (versus $3.5 million in 2009), and a 50 percent maximum rate versus 2009’s 45 percent maximum bracket. Congress and the new administration have to fix this. It is exceedingly unlikely that they will let the estate tax one-year repeal in 2010 occur, particularly in light of the historic deficits.

Gifting—The Proverbial Perfect Storm

There are a few primary rules to remember in gifting. First, do not give away assets that you think you may need in the future. Do not let the tax tail wag the dog on this. If you have estate tax concerns, or if you want to help children or other objects of your bounty at particular points in their lives, such as buying a house, educating grandchildren, and so forth, now is a wonderful time to do it. Second, values are at historic lows. Values for gift tax purposes reflect the markets. Third, grantor retained annuity trusts (GRATs) and other techniques can work wonderfully to accomplish both tax and non-tax goals. Interest rates are an integral part of GRAT determination of the value of gifted interests and other proven gifting methods. The interest rate impacts the amount of the gift as well as the economics of when a given approach is beneficial. With interest rates at equally historic lows, there are many opportunities for sophisticated and thoughtful giving. Also, gifting may be used as an effective means to separate ownership from control. For example, you can donate substantial value in property, be it real estate, investment funds, and so forth, with a small number of voting units or shares and a much larger number of nonvoting units. You give away asset value, yet retain control. Currently, the lack of marketability and lack of control discounts are recognized for gift tax purposes and are essential. There are legislative proposals to prospectively repeal these valuation discounts. There is something to be said for doing it now.

Properly documenting the value of gifted interest and discounts is vital. For large gifts of real estate as well as closely held business and LLC interests, a competent valuation is not optional. This is true if a nonpublicly traded family investment LLC owning marketable securities is gifted. Also, case law over the last decade repeatedly reminds taxpayers to respect the terms of the documents they create. For example, if a taxpayer creates a family LLC and gives 30 percent of the nonvoting interests to his two children (or trusts for grandchildren), then the LLC cannot be the donor’s personal bank account. Also, remember that “pigs get fat, and hogs go to slaughter.” Be reasonable.

What If I Don’t Use Up All of My Tax-Free Baskets When I Die?

If you have a spouse, you want to make sure that you protect them. However, qualified plans and IRA interest left to individuals after death are subject to the “income in respect to a decedent,” or IRD rules of IRC §691, et. seq. IRD items are generally included in gross income when received, unless subject to both state and income tax. For this reason, they are often used in an estate plan to fund charitable devices.

Stick to the basics, get some help where it is needed, and design and execute your plan. Whatever the costs of doing it, they are far less than the costs in the long term of not doing it at all. 

Paul L. B. McKenney specializes in federal tax mat- ters and has thirty-five years of such experience. He can be reached at