How do rich Americans get away with paying so little in taxes? I’ve written before about the mechanics behind Buy-Hold for Decades-Sell, the perfectly legal pathway that lets rich Americans pay taxes on their investment gains at super low effective rates.
How unfair a tax reality — for average taxpayers — has Buy–Hold for Decades–Sell helped create? Let’s consider how our current federal tax system goes about treating two prototypical taxpayers we’ll call Bob Golfsalot and Morris Worksalot.
Bob and Morris have several things in common. Both have just turned 30. Both start with the same $75,000 nest-egg and have cut financial deals with their wives that commit both Bob and Morris to growing that nest-egg until they hit age 65.
In Bob’s case, his wife has agreed to fund the couple’s household expenses over the next 35 years. Morris, for his part, will use income from his full-time job to help with household living expenses. Bob and Morris each will pay any tax on the income their activity generates, but otherwise may accumulate all the income they generate for their respective nest-eggs.
The Worksalots will depend on the nest-egg Morris accumulates to fund their retirement. The inheritance Bob stands to receive, by contrast, will be more than enough to finance the Golfsalots’ retirement years.
And a most comfortable retirement those years promise to be. The professionals managing the investment of Bob’s inheritance will, in all likelihood, generate returns far in excess of what’s needed to cover the couple’s extravagant lifestyle. For Bob, that lifestyle will include an annual golf vacation at one of the world’s best courses.
Bob and Morris, at age 30, have set equivalent goals for their $75,000 nest-eggs. Each wants to accumulate by age 65 a sum grand enough, once invested in U.S. Treasury bonds yielding a 3 percent annual after-tax return, to underwrite annual spending equal to their original $75,000. Morris will use that after-tax return to fund his family’s retirement expenses. In Bob’s case, all that annual return will go for golfing outings.
Bob and Morris live quite different lives. Bob and his wife, a highly paid corporate executive, live in a posh neighborhood and belong to a country club boasting two 18-hole golf courses. Bob, the club’s best putter, spends several hours a day on a practice green the Golfsalots installed in their backyard. Bob’s initial $75,000 nest-egg came as a gift from his deep-pocketed parents.
Morris, a plumber, and his wife, a cop, live in a middle-class neighborhood. His $75,000 nest-egg at age 30 has come entirely from money the Worksalots had saved from their jobs and from a small egg farm they had maintained in their backyard.
Why did Morris and his spouse work so hard to amass that $75,000? They needed that sum, the couple felt, because the city where they lived had eliminated — the year before Morris’ wife had become an officer — pension benefits for new police hires. To make matters worse, the small plumbing firm where Morris worked had no retirement plan for its employees.
Bob and Morris take entirely different approaches to the task of building their respective nest-eggs. Bob, seeking to maximize the time available for golf, invests in a publicly traded corporation that recently held its initial public offering. One of his golf friends recommended the investment, telling Bob he should see a 10 percent annual rate of return on the investment.
Morris works nights and weekends to expand the family egg farm. Why not simply invest his $75,000 nest-egg in a retirement account? Morris has learned from his reading that the annual return on investment for smaller retirement accounts typically runs lower than 4 percent. That rate of return will not generate a retirement fund sufficient for a decent retirement.
Morris also knows that he and his wife don’t have access to the high-returning investments rich Americans make, like the one he overheard a customer bragging about to a friend when Morris was fixing a leaky faucet at the Golfsalot residence.
For Morris, these realities make expanding the egg farm his best financial option. The income from the Worksalot egg farm, he believes, will run about 10 percent of the amount he’ll have available to spend each year on operating expenses. So if Morris spends $75,000 on his farm its first year, the operation should bring in that amount plus 10 percent, a total of $82,500.
Morris commits himself to pumping his egg farm’s net initial proceeds back into expenses the following year. From the $82,500 in total proceeds, Morris will pay the income and self-employment tax on the $7,500 profit from the operation, a total of $1,800, and plow the remaining $80,700 back into the operation.
Things go precisely according to plan for both Bob and Morris. Bob’s investment pans out exactly as his golf friend predicted. The investment does better in some years than others, but, overall, the value of Bob’s investment increases at an average rate of 10 percent per year.
Over the course of the next 35 years, Bob wins his club age-bracket championship seven times. Best of all, he gets invited twice to play in the pro-am at Pebble Beach, America’s highest prestige invitational tournament for amateur golfers.
Morris’ egg farm, in the meantime, generates the income he had hoped for, a steady 10 percent over expenses each year. But over the next 15 years the combined income from the egg farm and the family’s plumbing and police jobs shoves the Workalots into a higher tax bracket. They find themselves paying taxes at a 34 percent top-bracket rate, some ten points higher than their previous 24 percent top rate — and that greater tax burden ends up slowing down the growth of the egg operation.
Eventually, Morris has enough wherewithal to retire from his work as a plumber and focus his full effort on the egg farm. Thanks to his years of hard work, things have gone according to his original plan. By the time Morris hits 65, the egg farm is returning $80,000 in income per year.
So how does retirement overall look for the Golfsalots and the Worksalots?
The Golfsalots face a tax bill when they sell their retirement fund investment shortly before Bob’s 65th birthday. After 35 years at an average annual growth rate of 10 percent, its value stands at over $2.1 million. The 23.8 percent one-time tax on Bob’s investment gain comes to about $468,000 and reduces his golf vacation nest-egg to a bit over $1.6 million.
That sum represents an after-tax annual return of just over 9.21 percent, only a modest reduction from the pre-tax annual return of 10 percent. If the Golfsalots invested their $1.6-million nest-egg in Treasury bonds with an after-tax annual return of 3 percent and proceeded to spend $75,000 on golf junkets per year, their retirement fund will last until Bob’s 101st birthday.
The Worksalots have been paying tax all along on the income from the egg farm. At the end of 35 years, they have $807,959 in their retirement fund. That represents an average annual after-tax return of 7.03 percent, about 30 percent less than their pre-tax return of 10 percent.
The Worksalot retirement fund, if invested in Treasuries returning 3 percent annually after tax, will last just past Morris’s 78th birthday if they spend $75,000 per year. Fearing that their retirement funds will run out if they spend as they had originally planned, the Worksalots cut their retirement budget to $55,000 per year, an outlay that should have their retirement fund lasting until just before Morris’ 85th birthday.
How realistic can we deem these two scenarios? The egg farm success story Morris enjoyed actually seldom happens in real American life. Precious few average Americans could employ their own labor to expand a modest sum of wealth, as Morris did through his egg farm, at the same rate rich Americans grow their wealth through investments.
But even this unrealistic egg farm success story doesn’t bring Morris anywhere close to Bob’s financial success — because our current tax law privileges investors like the Golfsalots.
Here’s how: The annual increase in the size of the Workalots nest-egg, as a percentage of the original nest-egg amount, runs lower for the Worksalots than for the Golfsalots because the Worksalots lose a portion of their nest egg each year to annual taxes.
The growth of the Golfsalots’ nest egg, on the other hand, compounds each year free of tax. The Golfsalots, when they finally do pay tax when they sell their investment, pay at a preferential rate of just 23.8 percent.
That one-time tax after 35 years of tax-free compounded growth leaves them with a nest-egg the same size as what they would have if they paid tax annually on their investment gains at the rate of 7.9 percent and sold a number of shares of stock sufficient to pay the tax.
How much better do the Golfsalots fare because of tax differences alone? Over 35 years, the Golfsalots grew their next egg nearly 22-fold after taxes. The after-tax growth of the Worksalot nest-egg? A bit less than 11-fold.
The end result: The Golfsalots annual budget for a week or so of golf turns out to run over twice the Worksalots entire retirement budget.
This sort of disparity at the individual household level, writ large, is fueling an oligarchic concentration of America’s wealth.
The Golfsalots and Worksalots make for an apt microcosm of our contemporary nation. At age 30, the Golfsalots hold just 50 percent of the total of the two families’ $75,000 nest-eggs. At age 65, the Golfsalots share of the families’ total wealth — over $1.6 million — has increased to 67 percent. At age 85, the modest Worksalot family wealth sits entirely depleted.
The bottom line: If federal income tax policy continues to privilege income from wealth over income from work, we’ll have baked a totally oligarchic concentration of wealth into America’s economic cake.
For the first four installments in this “Buy-Hold for Decades-Sell” series, check here first, then here, here, and here.