Preserving Your Heritage Through Planned Giving
A Simple Shift That Made a BIG Difference
By Jeffrey Smith, CPA
The Raymond’s have been two of the most enjoyable clients I’ve had the pleasure of serving for two decades. Both had lifelong careers as schoolteachers and even in retirement stay involved in high school athletics wherever they go. Their wealth primarily came from inheritances on both sides. Except for their annual trip to wherever the America’s Cup sailing contest is held, you’d never guess they were modestly wealthy.
Like so many people of their generation, raised in the Great Depression, they are hard savers. It is in their DNA. I’ll never forget Pete telling me in a comical way that though they sought my advice, I was never to violate the one rule his dear departed Mama had taught him.
In a Red Skelton-esque way he stood up and in an affected voice said: “Petey, my dear boy, three things I ask of you: Work hard, save your money, and NEVER, NEVER, spend the principal.” While I had heard this moniker of never spending the principal about a thousand times before, I genuinely laughed at Pete’s performance.
“Oh boy,” thought I. “I’m going to have my work cut out for me with the Raymonds.”
Looking at their tax return I noticed that most of their substantial income was from dividends and taxable interest. The IRS was gobbling up 30 percent or better for their part of the partnership in the Raymond’s wealth. What a shame! Mama, say it isn’t so!
Let me unlock for you the secret of the tax code. Learn this simple truth and you’ll see the world clearer than ever before and tax strategy will begin to make sense. The code is organized around the common behaviors of the most number of people. Or, as John Baptiste Colbert put it in the 17th century: “The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.” Mr. Baptiste was the Minister of Finance for King Louis the XIV of France.
What the Raymonds and every other person needs is cash flow. They THINK they want income, and income is good, but what they spend is cash, not income. Income is what you are taxed on. Even though most dividends get preferable treatment today, they still pump up your income at the margins.
For our second meeting, I set my conference room up with a chalkboard and organized the seats in classroom fashion and a makeshift desk in the front of the room. Pete had been a high school math teacher so I decided to have some fun with him and his wife, Kay. They loved it.
I told the “class” that we were having a pop quiz today, but promised I would grade on the curve.
“Peter, let us suppose you have bought 10,000 shares of XYZ stock at $10 per share. How much is that worth?”
“Very good. Now, Kay, let’s say XYZ had gained 10 percent in value over the course of a year’s holding. How much would it be worth?”
Playfully, Kay said, “Let’s see, I’m going to say $110,000.”
“Excellent, Kay. Peter, let us suppose that someone is planning a special vacation, say, to an America’s Cup in New Zealand, costing $10,000. Together with your advisor, you decide to withdraw $10,000 from your XYZ stock portfolio. After taxes, how much money would you have? And please come to the board and demonstrate your math to support your answer.”
Pete smiled and came to the board while I took his seat next to Kay.
“Well, let’s see: $110,000 - $10,000 = $100,000, so I’m back to where I started. And since it’s stock, I’ll get long-term capital gains treatment. So, $10,000 x 15% = $1500 tax. So, Kay and I have $8,500 to head to New Zealand.”
“Very good, Pete. Now, for a bonus point, if you withdrew $10,000 from your IRA, what would you and Kay have to spend?”
“At my tax rate of 30 percent. I’d only have $7,000.”
“Gold Star! So the former is $1,500 better than the latter. But what if I told you that the first would actually leave you $9,864?” None of Pete’s math made any sense to him now.
“May I?” I asked as Pete handed me the chalk. I demonstrated that to produce $10,000, Pete would have to sell 909 shares at $11 per share. Since he paid $10 per share that would produce a $909 capital gain. After a 15 percent cap gains tax of only $136, he’d have $9,864.
“You see, Pete and Kay, it PAYS to spend principal down slowly and let gains accumulate on capital assets. Guess what, when you pass these assets to your children, the capital gain is forgiven and they inherit nothing but principal. The key is to grow your net worth, and the best way to do that is to quit giving the government so much.”
Over time, the Raymonds repositioned their portfolio in non-dividend paying stocks, exchange traded funds and tax-efficient mutual funds, and organized their cash flow under this manner. In three years, they cut their taxes by more than half and have grown their net worth.
A few years later, feeling sufficiently confident in their net worth growth, they established a Charitable Remainder Trust to benefit their beloved alma mater. I’m certain that Mama would be proud.
Bottom Line: Most people can apply this technique at some level to dramatically reduce taxable income. When you cut down taxes, net worth accelerates and frees money for meaningful purposes such as the mission of NIAF.
Caution: This is not to be construed as investment advice, simply a tax strategy. Consult your advisors before you attempt to apply this technique. Feel free to reach out to me at firstname.lastname@example.org. I’m more than happy to go over this with you and or your advisors at length.