A practical how-to blog for small businesses by Stephen L. Nelson. Stephen is a CPA working in the Seattle area who specializes in serving small businesses and their owners. He’s been a CPA for three decades, and his greatest expertise lies with tax issues related to S Corporations, foreign tax issues, small business consulting, financial planning, and individuals with complex personal finances.
Okay, I am not a direct real estate investment fanatic. Absolutely not.
Further, I get that direct real estate investment burdens investors with some problems. Illiquidity for one. A lack of diversification for another. And then the extra work of owning and managing properties.
But critics of real estate investment absolutely get it wrong when they say real estate investment doesn’t make sense for individuals. Often real estate investment does make sense for these folks. And for at least a dozen reasons…
Reason #1: Illiquidity Sometimes Helps
A first quick thing? The illiquidity of direct real estate investment helps some investors “stay the course.”
For example, in order to get a nice-sized balance in an IRA account or 401(k) account, you and I need to regularly save additional amounts. Maybe every paycheck. Year in and year out.
But it’s easy to become irregular in our savings. And that irregularity will cause the plan to fail.
In comparison, when someone invests in real estate, the investment process often locks in the investor.
One example of this: A landlord using a mortgage must continue to make mortgage payments (which means at the very least building wealth by reducing the mortgage.)
Another benefit of illiquidity? An investor with a big IRA or taxable account balance can be tempted to use that money to buy a bigger house or a more expensive car. An illiquid investment in real estate doesn’t offer the same easy access.
Illiquidity, then can improve the behavior of some investors. And so some investors save successfully with real estate when they can’t successfully save using options like retirement accounts.
Reason #2: No Limit on Investments of Pretax Money
A subtle, second thing people often don’t realize.
As compared to tax-deferred wealth building options like an Individual Retirement Account or a 401(k) plan, direct real estate investment may offer the ability to invest large amounts of pretax income without paying taxes.
To understand this, first remember that tax law limits the amount an investor can save pretax into an IRA or 401(k) account. In 2019, for example, tax law limits a typical individual to no more than $6,000 of tax-deductible contributions to an IRA and no more than $19,000 of tax deductible contributions to a 401(k).
Direct real estate investment vaporizes these limits.
I’ve talked about one example of how this works with vacation rentals. But to use an extreme example, a family that earns $500,000 a year may be able to use, say, $300,000 of this income to invest in real estate before paying income taxes on the $300,000.
A family, for example, might be able to use $300,000 of pre-tax income as a down payment on a $1,000,000 property and then on the first tax return put a $300,000 depreciation deduction.
Lots of complexity exists for people who want to generate giant real estate deductions. But the point is, you can do this with real estate.
Reason #3: No Limits on Sweat Equity
Direct real estate investments often do burden investors with extra work as compared to someone investing in a mutual fund or bond.
But that extra work can be viewed as a benefit. That extra work can increase the return the investor receives.
If you repaint a rental, for example, you do shoulder extra work. But you also probably increase the value of the property and its rental income.
In comparison, you don’t have anyway to increase the value or income of investments you hold inside an IRA or 401(k) account.
Practically, for example, you have no way to increase the value of a mutual fund you own inside an IRA or 401(k) account.
And tax law prohibits you from increasing through sweat equity the value of direct real estate investment you hold in an IRA or 401(k) account.
Reason #4: Inefficient Market Opportunities Exist
Something else to consider—though I want to be careful here…
With real estate, you sometimes get the opportunity to buy property at a price that’s fair to the seller but less than its value to you. That inefficiency, which doesn’t exist for mutual fund shares or bonds or company stocks, sometimes makes for great real estate investments.
One example of this? You might be able to buy your parents’ house at a 6% discount because mom or dad wants to sell but doesn’t need to pay a 6% real estate commission by selling to you.
Another example of this? You might be able to buy a beat-up property at a $100,000 discount because of repairs the property needs… but then do the repairs yourself for $20,000 because you have a small construction company.
You don’t get these sorts of opportunities with traditional stock and bond and mutual investment choices.
Reason #5: No Required Minimum Distributions
As compared to money held inside an Individual Retirement Account or 401(k), real estate investments offer the advantage of no required minimum distribution.
In other words, if you have 20 years of life left and you’re over age 70 and half, you’re required to withdraw 1/20th of your IRA or 401(k) balance. Regardless of what you need or want, required minimum distribution rules force you to liquidate investments and report the proceeds as income.
With real estate investment, you will need to report the rental income on your return. But you won’t be forced to “liquidate” your properties and pay capital-gains-like taxes on the appreciation and depreciation recapture.
Section 1014 says the cost basis of any asset (like real estate) that you own when you die gets “stepped up” to its fair market value at date of death. Your heirs can then sell the appreciated or the previously depreciated real estate without paying tax.
Or they can continue to rent the property but begin depreciating the property all over again.
This is a giant benefit.
If you die with a $1,000,000 IRA balance, in comparison, the IRA basis equals zero. And your heirs will pay income taxes on the $1,000,000.
Two notes to clarify. First, stocks held in a taxable account get stepped up too. The Section 1014 step-up tax benefit isn’t unique to real estate. But the thing is, if you leave heirs a $1,000,000 rental property, you have deducted tens or hundreds of thousands of dollars of depreciation over the years.
A second thing to note about the Section 1014 step-up: Married couples residing in community property states get a full step-up when either spouse passes away.
For example, if mom and dad reside in a community property state and they buy a rental property early in their marriage, they can probably fully depreciate it. (Maybe thereby taking a few hundred thousand dollars of depreciation deductions.)
If dad predeceases mom (the usual way of things), the basis will get fully stepped up. And then mom can either sell the property without paying tax. Or she can start over on the depreciation.
Reason #7: Section 1231 Supercharges Tax Loss Harvesting
A tax benefit real estate offers but which stocks and bonds and mutual funds don’t: Supercharged tax loss harvesting.
Here’s the deal: If you lose money on a stock or bond or mutual fund, you do get to deduct the loss eventually. Probably. But tax law delays or limits your deduction in many cases.
The usual rule on capital losses is that you can use them to reduce capital gains for the same year and then also another to shelter another $3,000 of ordinary income.
You carry forward any leftover “unused” capital losses to the subsequent year. In that subsequent year, you use the carry forward to shelter capital gains and then another $3,000 of ordinary income.
And then? Any still “unused” capital losses get carried forward again to the next subsequent year.
In comparison, real estate investment losses don’t get limited. If you purchase a $100,000 rental property and, heaven forbid, you lose $100,000 when you sell, that $100,000 gets deducted as something called a Section 1231 loss on your tax return in the year of the loss.
In other words, with a Section 1231 loss you probably immediately harvest the entire tax loss. And you can use the tax loss to shelter any other type of income.
Reason #8: Production of Income Deductions
Another real-estate-y tax benefit. The expenses related to direct real estate investment become tax deductions (either currently or eventually).
Real estate expenses are Section 212 deductions which, like business expenses, just need to be ordinary and necessary for the production of income activity in order to be tax-deductible.
Investment portfolio expenses, in comparison, aren’t deductible. At all.
Just to hammer home this point, if you consult an attorney or accountant about a rental property investment you own, that expense is deduction. Similarly, if you take a class to better manage your rentals? Deductible. If you buy a computer for your rentals? Deductible.
These sorts of expenses, however, don’t become deductions if they’re connected to your investment portfolio of stocks, bonds and mutual funds. Instead, the deductions are nondeductible investment expenses.
Reason #9: Avoidance of Section 1411 Net Investment Income Tax
A potential real estate tax benefit for many young investors…
At some point in the future, many investors will pay the Obamacare “net investment income tax” on investment income from taxable accounts: interest income, dividend income, capital gains and so forth.
Why? The $200,000 and $250,000 thresholds for subjecting investment income to the Obamacare tax aren’t indexed for inflation. Accordingly, younger workers who build investment wealth will eventually pay this tax on at least some of their portfolio income when inflation pushes incomes up.
Note: Retirement income flowing out of a IRA or 401(k) is not subject to net investment income tax.
Another benefit for direct real estate investment as compared to some taxable investments that produce ordinary income?
Under current tax laws, specifically, Internal Revenue Code Section 199A, real estate investors whose activity levels rise to the level of a trade or business don’t have to pay income taxes on all of their rental income. They only need to pay income taxes on 80% of that income.
Reason #12: Real Estate Investment Plays Well with Other Investments
A final theoretical benefit. Direct real estate investment appears to do good things to your overall investment portfolio.
Real estate, for example, appears to deliver investment returns similar to stocks though with lower volatility. (That lower volatility should bump returns and dial down your investment risk.)
Further, real estate investment returns poorly correlate with equity market returns. You and I therefore dial down our investment risks by combining things like stock index funds with rental properties.
We’ve talked about this subject before in another blog post: Lessons from the Rate of Return of Everything. If you’re interested in more details and the hard data, refer there. (You might also want to peek at this short blog post which displays graphs of stock, housing and bond returns over the last century for about a dozen countries.)
But the point is, real estate shows poor long-term correlation with stocks and bonds. And this is good.
For example, the worst case 30-year retirement scenario for U.S. investors starts in 1966. The three decades after 1966 subjected these folks to a sagging stock market and high inflation. Holding 25% of a portfolio in rental property investments, however, would have protected their retirement plans from failure.
Summing Up the Case for Direct Real Estate Investment
Full disclosure: I did not myself prepare financially for retirement using real estate investment. I used tax-deferred retirement accounts stuffed full of cheap index funds from Vanguard.
However, though that approach worked well for me and many in my generation, it seems pretty obvious direct real estate investment offers some attractive and unique benefits.
Not everyone will want to get on the real estate bandwagon. Not everyone should. But the critics who say direct real estate investment doesn’t make sense don’t know enough about real estate’s unique tax features and financial character.
If you think real estate investment might work for your financial plan, you ought to consider this option…
Let me share a handful of upfront comments to give you some background, however.
First, each line chart shows how 1000 local currency units–dollars, francs, marks and so on–invested in a particular country’s equities, stocks and bonds grow over time.
My line charts start in 1919, right after World World I, and end in 2015.
The line charts plot real values in the local currency. (I adjusted for local currency inflation, in other words.)
Unfortunately, I could not plot a meaningful line chart for Japan or Portugal. For Japan, return data for the years after World War II aren’t available. And for Portugal, housing return data don’t become available until after World War II.
Note: Portugal’s stock market essentially melted down in the 1970s due to civil unrest, dropping in value by roughly 50% annually five straight years in a row.
The line charts here reflect geometric averages. If some country’s stock market falls by 20% one year (from a 1000 dollars to 800 dollars, say)… and then it rises by 25% the next year (from 800 dollars back to 1,000 dollars), the line charts show that as an average 0% return over the two years.
I mention this because the the average returns shown in the study’s tables represent arithmetic averages. (An average return would look at a -20% return in year one and then a +25% return in year two and say the average equals 2.5% per year. The actual calculation goes like this: (-20%+25%/2) equals 2.5%.) They do this, by the way, for a good reason we don’t need to get into here…
And now let’s begin… (I’ll work through the charts in alphabetical order.)
Australia Rates of Return
The Australia chart, shown first, highlights two things. First, the “stocks” red line and the “housing” green line show the premium investors earn from these risky investments. Second, the line chart shows that housing often provides smoother returns than stocks. (The green line is smoother than the red line.)
Belgium Rates of Return
The next line chart shows stock, housing and bond returns for Belgium. And it spotlights something that appears again and again in the data. Real returns on housing investments often beat real returns on stocks. (The legibility of the legend isn’t great–sorry–but it shows Belgium equities earned roughly 4.1% over last century versus housing which earned roughly 6.4% over the same time frame.)
Denmark Rates of Return
Denmark’s rates of return line chart shows again the superior return delivered by housing as compared to stocks. And one interesting note… See how a small difference in the real return (6.27% for stocks versus 7.28% for housing) snowballs over time? Wow.
One thing to mention here, however: As noted in the original study, the researchers weren’t able to include the impact of property taxes in the return calculations. (They suggest that omission may reduce the real return by about 1% annually.) For Denmark, that sort of adjustment equalizes returns obviously.
Finland Rates of Return
The Finland line chart shows again a superior return delivered by housing: 6.7% roughly for stocks versus 8.6% roughly for housing. But you wonder about the interplay of Finland’s small size (roughly 5.5 million people) and then the giant global successes of Nokia.
France Rates of Return
The France line chart tells an important story. You can lose money in the stock market–even if you invest for a long, long time. The century long real return on French equities equals -.18%. That’s minus .18%. Roughly, a 2/10ths of a percent negative return, annually, for nearly a century.
Note: The purple “bonds” line in the chart below hides the red “stocks” line.
Germany Rates of Return
The Germany line chart tells two important if predictable stories. First, hyperinflation, like that experienced by the Weimar Republic after World War I, destroys bond returns. The average annual real geometric return on German bonds equals -21.08% (minus 21%) annually over roughly the last century. (Wikipedia has a good write-up here.)
Note: If this sounds impossible, note that if 1000 German marks in 1919 lose 99.999% of their value through inflation, thereby dropping in value to a penny, even a hundred years of solid bond interest doesn’t begin to rebuild the balance.
A second predictable story: War destroys returns. (This same story shows in Japan’s returns for the post-war years.)
Italy Rates of Return
Italian lessons… Stock market returns can fluctuate wildly. Inflation destroys bond returns. Housing, the other risky investment, offers no guarantees.
Netherlands Rates of Return
The Netherlands rate of returns map well to the study’s core conclusions: Housing investments often beat stock investments… and they deliver smoother returns.
Norway Rates of Return
Norway’s rates of return history counts as yet another example of housing beating stocks. But one wonders how to or whether to factor in the effect of the country’s vast oil wealth.
Spain Rates of Return
The Spain line chart again highlights the common case of higher returns to housing. And it maybe hints at something else interesting for U.S. investors. The Spanish stock market’s returns during the 1970s seem correlated with the US stock markets returns. (U.S. investors couldn’t diversify away their risk with Spanish stocks.)
Sweden Rates of Return
Sweden again showcases the higher returns delivered by housing–9.21% for housing versus 7.43% for stocks–and then the uneven returns of stocks.
Switzerland Rates of Return
For Switzerland, stocks slightly beat housing investments: 5.98% versus 5.92%. But the jagged red line in the chart really highlights the greater volatility of stocks.
United Kingdom Rates of Return
The United Kingdom’s line chart shows stocks handily beating housing over a century–and also substantial volatility in returns. (That’s the jaggedness of the red line…) The other thing to note if you’re a retiree or someday plan to be: The UK stock market also tanked in the early 1970s meaning that its stocks would not have helped you diversify away the worst case retirement scenario in living memory: The cohort who retired in 1966. (Ben Carlson did a good write-up here on this bit of financial history.)
United States Rates of Return
And the last line chart of returns: The United States’… For the US, stocks beat housing. But in line with the study’s observations, stocks give investors a roller-coaster ride of returns. Also, in relationship to the 1966 scenario in the US (which happens to be worst scenario for retired US investors over the last century or so), housing would have shored up an investor’s portfolio. Apparently.
Quick Closing Comments
I’m not going to going to spend more space here talking more about the study. As noted, we’ve got that earlier blog post that summarizes my sense of the actionable insights. But this obvious comment: Stocks (and real estate investments too) burden investors with additional risks. Also, investing in a single country has often been a very risky practice. Investors need to stay sober and alert.
And this final comment: The very best place to dig into the details of the study is the study itself!
In a few weeks, students will start or return to college and register for classes.
Given this, I thought it’d be a good time to follow-up on last month’s discussion of the lifetime earnings of high income folks with a discussion about how college choices impact lifetime earnings.
And no, your parents didn’t ask me to do this… Really.
The Right Data Source: A Longitudinal Study
Unfortunately, looking at the financial impact of college choices gets tricky.
You don’t want to look just at starting salaries for college graduates (though that’s interesting as shown here.) You don’t want to just average everybody together by comparing salaries of college graduates to folks who didn’t go to college. Finally, you want to somehow adjust for factors other than college that impact income.
And what that study shows? Well, some pretty fascinating and actionable stuff…
College Can Pay Big Dividends
For example, a bachelors degree can and should result in a substantial bump in lifetime earnings.
The present value lifetime earnings of a man who holds only a high school diploma averages about $680,000. In comparison, the present value lifetime earnings of the average, male bachelors degree holder averages about $930,000.
The same numbers for women run $339,000 for a high school diploma holder and $557,000 for a four-year college degree.
Note: A table of data from the aforementioned study appears here. Note that the table reports on the gross, or total, lifetime earnings for men and women… the net lifetime earnings which adjust for other factors that might affect the earnings (race/ethnicity, birth year, region of birth, high school type, years since the highest degree, college preparation courses, math/science AP courses, and year of the survey are controlled for)… and then the present value of the net lifetime earnings.
Clearly, college can make a difference.
And a fair conclusion here? You ought to get a bachelors degree if you can and want to do so.
And then if you can’t get a bachelors degree or simply don’t want to do that? Well, consider some other good way to bump your earning potential. A skilled trade (like an electrician). Or an in-demand technical field (like programming.) Or one of the other good vocational options that surely is available… if you look hard enough.
Earnings Vary Substantially Across Fields of Study
Another important point the lifetime earnings data by field of study shows? Lifetime earnings vary massively by field of study. You really must stay alert to this.
The present value lifetime earnings of man with a “STEM” bachelors degree in science, technology, engineering or math averages about $1.15 million dollars. And for a woman? About $800,000.
In comparison, the present lifetime earnings of a man with a bachelors degree in education runs about $650,000. And a woman with the same degree averages about $442,000.
You don’t have necessarily pick the highest earnings field of study. (I didn’t.) But you want to include those differences in earnings in your analysis.
Note: I don’t have a good source to point you to, but my understanding is even within the “STEM” category, large differences in earnings appear between those graduates who major in technology and engineering and those who major in science and math.
Graduate Degree Return on Investment Tricky
An important point about graduate degrees: You need to be careful here about the economics.
In some fields, you enjoy a nice bump in the present value of the lifetime earnings. The average woman holding a business bachelors degree enjoys present value lifetime earnings of about $630,000 according to the aforementioned study while a woman with graduate business degree (so like an MBA) enjoys lifetime earnings of nearly $870,000.
That’s a big difference.
But graduate degrees in other fields return more meager profits or even no apparent profits. Both a bachelors degree and a graduate degree in science, technology, engineering or math produce average present value lifetime earnings of around $800,000 for women.
Men enjoy higher averages and wee bump for a graduate “STEM” degree: roughly $1.15 million for a bachelors degree and roughly $1.2 for a graduate degree. But that wee bump doesn’t seem that compelling…
Also, the traditional professional schools? Gosh, those choices seem complicated.
Law school? That seems tricky these days.
Medical school? In spite of the complaining you hear from some doctors (like my brother), yeah, that’s still an outstanding choice in terms of the present value of lifetime average earnings. But you would want to stay alert to the earnings of different specialties.
Final Caveats About the Lifetime Average Earnings Data
Let me throw out four final cautions about the economics.
The first caution goes like this: The study discussed in this blog post doesn’t include the cost of the education. But surely both a student and her or his family will want to carefully consider that issue too.
Someone who keeps college costs low by starting at community college, finishing at a public university and then choosing a field like engineering (or accounting!) may get an awfully good return.
In comparison, someone who ends up with a physician’s or attorney’s salary but only after seven or eight years of expensive private college and medical or law school may not…
And now a second caution: The research data and results described in this blog post aggregate the data. A lot. Accordingly, recognize that within each of the big groups of earners, tons of variability exists.
A field of study like, for example, business might include majors (accounting, finance, industrial engineering, human resources, marketing and operations research) with lifetime earnings both way above or way below the averages.
A graduate degree category might combine only vaguely similar degrees. (The business graduate degrees might include fifth-year masters programs in accounting, MBA degrees from elite schools, and then PhD degrees for people who intend to do research.)
And an occupational category like law might include lots of people earning way less than the average and lots making way more. (Check out this blog post about bimodal lawyer salaries if you or your parents are even considering law school.)
A third caution: Don’t make the mistake of thinking you can’t earn a great income unless you go to college. That’s simply not true. Further, don’t make the mistake of thinking that a college degree guarantees you a great income. That’s also not true. Lots of overlap appears when you look the income folks earn with and without a college degree.
Finally a fourth caution: You need to be careful about picking a field of study you can successfully complete and then which leads to a career that you can successfully pursue. No, no, you and I don’t want to set the bar too low. And we don’t want to accept any old career in life. But we do need to play to our strengths.
In fact, my opinion? In-N-Out delivers the very best fast food burger available.
This blog post isn’t a restaurant review however. Or least not really.
And here’s why… In-N-Out doesn’t just produce a masterpiece burger. I think they’ve built a masterpiece business that small businesses may want to copy.
Specifically, I spot half a dozen things they’ve done which are just super-clever. And which you and I want to consider adopting as tactics. See if you agree…
Clever Thing #1: A Great Product as the Firm Foundation
The first and fundamental thing In-N-Out showcases? The way a great product becomes just a superb blocking block for a small business.
Just so you understand (because lots of people don’t live in a part of the country where In-N-Out operates), here’s how good In-N-Out’s burger is. The burger is their only entree. Their burger, in other words, is enough to attract customers.
A quick clarification. You can get a side order of French fries. You can order a soft drink. The chain also serves up delicious chocolate, strawberry and vanilla milkshakes.
But the only entree option? A burger with a beef patty on a toasted bun with a slice of cheese, lettuce, tomato and then a thousand-island-y sauce.
For McDonald’s to resemble In-N-Out, they’d need to cut their entree offerings to a single item. Like their filet-o-fish sandwich.
For a CPA firm to resemble In-N-Out, they’d need to prepare only a single tax return. Like only S corporation tax returns.
In any case, this masterpiece product ripples through their business in all sorts of healthy ways.
Clever Thing #2: Extreme Product Discipline
For example, one of the first ways a single “great product” helps? Having a single great product helps In-N-Out show extreme discipline about their menu of offerings.
They offer you a burger.
Options for other entries (tacos, wraps and salads) simply don’t exist.
Further, while you’d totally understand a firm letting its sandwich options expand (chicken, fish, vegetarian), In-N-Out hasn’t done that.
They built a better mousetrap. And then they focused on building a business based just on that better mousetrap.
By the way? In-N-Out operates more than 300 locations. People estimate they generate roughly a billion dollars of revenue.
Clever Things #3 and #4: Easier Inventory Management and Easier Employee Training
The single excellent product and associated menu discipline deliver other follow-on benefits, too.
For example, think about how much more easily and more successfully In-N-Out manages its inventory.
The firm basically needs five ingredients to make its burgers: beef patty, bun, cheese slice, lettuce, tomato and the “sauce.”
And then consider, too, an operation that only needs to train someone how to make a short, short list of items: a burger, fries, and milkshake.
I don’t want to brag. But I am pretty sure I could learn to make fries in an afternoon. Or at least the standard fries.
I encountered some pretty interesting data recently. The lifetime earnings of the top one percent, top five percent and top ten percent.
A surprise appears here. And then, more relevant to the purpose of this blog, the lifetime earnings data provides actionable insights to small business owners.
But let’s look at the data. And then we can discuss a handful of issues and the insights.
What Lifetime Earnings Top One Percent Data Shows
The table below reports average annual earnings between ages 25 and 55 by percentile for people who started work in 1983. These income measures don’t include investment income. The numbers do adjust for inflation through 2013. But on the whole, for reasons explained in the actual paper the numbers come from, they provide a good estimate of what lifetime average incomes look like.
Note: The table data comes from a National Bureau of Economic Research working paper, “Lifetime Incomes in the United States Over Six Decades,“ written by Fatih Guvenen, Greg Kaplan, Jae Song and Justin Weidner. (The 2013 data appears in the last row of Table A.1 on page 50.)
Skip This If You’re Comfortable with the Statistics
Just to make sure we’re all on the same page, the data says that on average someone who worked between 1983 and 2013 earned about $38,000 a year. Half the people who worked averaged less than this amount. Half averaged more.
Note: Remember the income numbers all get adjusted for inflation through 2013. So, we’re talking the same sized dollars.
And then to make sense of the high-income earners, to hit the 90th percentile, someone needed to average about $95,000 a year over the years they worked.
To hit the 95th percentile? Someone needed to make roughly $129,000.
Combining the 90th percentile and 95th percentile data, if someone earned on average between $95,000 and $129,000 over thirty years, they earned more than 90 to 95 percent of workers.
That 99th percentile value needs to be interpreted a bit more carefully. If someone averaged $290,000 a year over thirty years of work, that person earned more than 99 percent of workers.
But the top one percent didn’t all average $290,000 a year. Rather, the top one percent averaged $290,000… or more.
That last bit makes sense, right? The top one percent, ironically, includes not just billionaires like Bill Gates, Warren Buffet and Jeff Bezos. It also includes successful politicians and college professors.
Can These “Lifetime Earnings Top One Percent” Numbers Be Right?
In any event, the big income numbers above seem wrong, don’t they? I mean, really wrong? Not in line with what you read in the news? Yeah, I agree.
The table that follows compares the National Bureau of Economic Research data for the 95th percentile to three other popular and often-reported values:
95th Percentile Income Amount
National Bureau Economic Research
Federal Reserve Survey of Consumer Finances
Piketty/Saez (as reported by Economic Policy Institute)
Sommeiller/Price (as reported by Economic Policy Institute)
Note: You can grab a summary of the Federal Reserve Survey of Consumer Finances 2013 data here and an Excel spreadsheet with Economic Policy Institute 2013 numbers here.
So the question becomes, is something wrong with the low-ball number(s) from the National Bureau of Economic Research?
No, I don’t think so.
The problem appears with those bigger income numbers. That problem? Those bigger numbers hide the variability in year-to-year earnings that occurs—and especially the variability that occurs at the extremes.
In any given year, a few people see their income spike up for the year. They maybe win a lottery, receive an inheritance or earn a big one-time bonus.
Other people enjoy a spike up that lasts a few years. This case might occur for a professional athlete. Or an entrepreneur or executive.
But then, usually, incomes move back toward the average.
That variability mostly explains the differences between, say, the National Bureau of Economic Research’s “average” numbers and the “point-in-time” numbers that come from the Federal Reserve’s Survey of Consumer Finances or that get reported by the Economic Policy Institute.
Quick Qualification about Apples and Oranges
Let me also add one other note about these numbers here. The numbers do report on slightly different things.
The National Bureau of Economic Research, for example, reports on the earnings of individuals.
The Federal Reserve’s survey reports on the incomes of families–which may include one earner or multiple earners and will include unearned income.
The Economic Policy Institute numbers summarize tax returns which usually report on the income of individuals (63% of time) but which also report on the income of married couples (37%) which in turn may combine two earners’ incomes.
In any case, the big irrefutable point is people’s incomes show variability.
Further, this variability matters a lot for small business owners.
I think I spot at least three actionable insights in this reality. See if you agree…
Actionable Insight #1: Recognize the Variability
First of all, this simple insight. Successful small business ownership probably means not just a higher income but surely also higher income variability.
But the bottom line? Recognize that the higher incomes produced by small business ownership often zig and zag.
We all need to plan for that reality.
Actionable Insight #2: Slow and Steady May Win the Race
A second possible actionable insight: Consider the counter-intuitive possibility that a venture producing a steady 80th or 90th percentile income for decades may beat the flash-in-the-pan 99th percentile opportunity.
You earning, for example, $95,000 a year for decades doing something that balances well with the rest of your life?
You might be forgiven for thinking those “other guys” down the street—you know who I’m talking about—will end up in much better shape. At least financially.
But you know what? In the end, you may not only earn more than some big risk-taker. You may live a better life.
Can I share one other actionable insight hinted at in the lifetime average earnings data?
See if you agree, but the data suggest to me people and pundits often overestimate what we can can save for retirement. The data may even help explain why most people don’t accumulate much retirement savings.
The third and final table (see below) builds on the lifetime earnings data presented in the first table. It estimates the maximum annual retirement savings each percentile might accumulate by investing in a balanced stocks and bonds portfolio that averages a 5% real return annually.
30-year Nest Egg
I assume the lowest percentile groups lack the ability to save. Further, I assume the folks saving 6% or 8% get half that money from an employer matching contribution. Only for the 99th percentile earner do I assume the person maximizes the “employee” part of something like a 401(k) plan and then also receives a 4% match.
We could get into a wrestling match about the assumptions in the table calculations.
Is the 5% real rate of return I used reasonable?
Can someone save for 30 years at the levels shown?
But here’s my hunch looking at the future values. Most folks should not plan on accumulating a giant nest egg for retirement.
All the talk about people needing or being able to save $1,000,000 for retirement for example? That sort of thinking, it seems to me, reflects unrealistic optimism about average earnings over a lifetime of work.
And getting to a $2 million retirement account balance? Oh my gosh. That surely counts as a low-probability outcome. You may need to (1) average top one percent earnings over three decades, (2) possess the discipline to save from the very start and then (3) be smart about your investing.
An average household with a couple of earners and $60,000 in annual income, for example, might logically hope to accumulate around a quarter million if they save for 30 years. (If they can save for 35 years, that amount grows to around $325,000.)
So, the actionable insight here? And framed for small business owners? Well, we should all do a way better job saving probably. We probably want to try to work longer. And then we also maybe want to plan for the reality that for almost everybody accumulating a gigantic nest egg is out of reach.
Two Final Comments in Closing
A couple of comments to close…
First, another similar “conflict” in the data appears when you look at wealth. On the one hand, for example, you have sources like the Federal Reserve’s Survey of Consumer Finances and publications from the Economic Policy Institute talking about very large net worth numbers for the top ten percent, top five percent and top one percent.
On the other hand, as we’ve discussed in other blog posts here, the IRS personal wealth statistics calculate much, much smaller numbers.
And then a second comment: The lifetime earnings data, just to clarify, don’t undermine the idea that income inequality is increasing.
I discussed only the lifetime earnings of people who started work in 1983 above. But those studies referenced earlier look at a bunch of workers: people starting work in 1957, in 1958, in 1959 and so on. And the distribution of lifetime earnings, the income inequality in other words, has increased over time.
But this inequality stuff gets complicated once you dig into to the details. If you’re interested in the income inequality subject, the Our World in Data website article, Income Inequality, merits a close read.
Other Articles You Might Like
Because they relate to the stuff discussed above, you might find the following blog posts interesting:
Potentially, a vacation rental tax shelter generates extremely large tax deductions for an investor.
Even better, almost anybody can use a vacation rental tax shelter.
Accordingly, this long-ish blog post explains how this tactic works.
To start, though, a quick review of how real estate tax shelters work.
How Rental Properties Reduce Taxes
Let’s say you own a beautiful log cabin in Montana. Say you can rent the property for $2,000 a month, an amount that covers your operating expenses, taxes and an interest-only mortgage.
Specifically, assume that “cash out” equals “cash in” as shown in the table below:
Cash flows from Vacation Rental
Less: Property taxes
Net Cash Flow
You might logically guess that this investment has zero tax effect. But tax laws let you depreciate the non-land part of the property. And that might mean you also get to deduct $10,000 a year of depreciation expense for the wear and tear on the property. (Yes, even though the property might actually be appreciating.)
That tax accounting, in fact, might show you losing $10,000 on the real estate investment for the year as calculated below:
Taxable Loss from Vacation Rental
Less: Property taxes
Taxable loss reported on return
Potentially, that $10,000 real estate loss shelters from taxes $10,000 of other income from W-2 wages or investments.
And that’s the real estate tax shelter. You’re not necessarily losing money. You may even be making money because the property appreciates.
But the tax accounting, mostly from depreciation, puts a ” loss deduction” on your tax return that shelters other income.
Once you understand the basic tax accounting, you want to know about a couple of other wrinkles, too…
When Real Estate Gets Really Interesting to Tax Accountants
Typically, real estate gets depreciated over roughly three or four decades. You depreciate residential property over 27.5 years, for example. And you usually depreciate nonresidential property over 39 years.
Say, for example, that you purchase a cabin for $350,000. Further say that $275,000 of the price represents the building while $75,000 represents the land. In this situation, you deduct $10,000 in annual depreciation.
Why? The $275,000 building component divided by 27.5 years equals $10,000 a year.
However, you can also often break apart the building into the “building” stuff that gets depreciated over decades. And then the “non-building” stuff which gets depreciated more quickly and maybe even immediately.
A $275,000 building, for example, might also be looked at as a $220,000 building with $55,000 of personal property (cabinetry, appliances and furniture).
In this case, the $220,000 building still gets depreciated over 27.5 years. And that produces $8,000 a year of depreciation.
But then the other $55,000 of personal stuff maybe gets immediately written off because it counts as personal property with a short life.
With $220,000 of building and $55,000 of personal property, the first-year depreciation deduction could equal $63,000 (the $8,000 of deprecation on the building plus the entire $55,000 of personal property.)
That might shelter $63,000 in income the first year.
Done right, then, you might buy a cabin or condo, rent it, and then drop a $63,000 tax deduction onto your tax return.
Note: After the first year, note that the annual depreciation deduction drops to $8,000. That $8,000 will probably just shelter the rental income and not any of the taxpayer’s other income from a job or investments.
How Passive Loss Limitations Work
Sounds pretty good, right? Almost too good? Yeah, Congress agrees.
Accordingly, Congress created the Section 469 “passive loss limitation” rule. It says most people don’t get to deduct these sorts of passive losses unless they have offsetting passive income—such as from another rental property. Or until they sell the property generating the passive losses.
In effect, then, folks can’t necessarily use giant “paper” rental property losses to shelter the income they earn in their regular job or from other investments.
Every Rule Has Exceptions
Exceptions exist to this passive loss limitation rule, however.
I want to briefly describe and identify these exceptions. You want to know what they are.
And then we’re going to focus most of the rest of the discussion on the vacation rental tax shelter.
Exception #1: The Active Real Estate Investment Participant
Okay, a first thing to know. One exception creates a decent-sized loophole for middle-class and many upper-class rental investors.
The Section 469 passive loss limitation rules allow these folks t0 write off up to $25,000 of real estate investment losses as long as they own at least 10 percent of the property and actively participate in the management of the property.
But note the taxpayer’s income needs to fall under $100,000 to get the full $25,000 deduction. If someone’s income falls between $100,000 and $150,000, the $25,000 write off amount gets phased out on a sliding scale.
Also, we’re talking about a limited real estate loss deduction here. Not about giant deductions to shelter great gobs of income.
Exception #2: Real Estate Professional
The most well-known exception for real estate investors? Real estate professionals don’t get limited.
In other words, if you’re “in” the real estate business—as an agent, broker, property manager, developer or some other real estate job—and you spend more than half your time and at least 750 hours on real estate? Hey, the Section 469 passive loss limitation rules don’t apply to you.
You can probably deduct your losses. All of them.
Example: You make $100,000 a year as a real estate broker. You lose “on paper” $100,000 on your real estate investing. Your taxable income equals zero. You owe no income taxes.
Interestingly, a married couple gets to deduct losses even if only one person qualifies as a real estate professional.
Example: Your spouse earns a boatload of money annually. Say $500,000 a year. You’re a real estate professional due to your management of the family’s rental properties and “lose” $200,000 a year. The total income reported on your tax return, however, equals $300,000. That’s the number that plugs into the tax calculations.
Which is why a third tactic, the short-term vacation rental, makes so much sense to consider…
Exception #3: The Short-term Rental
The short-term rental exception (see 1.469-1T(e)(3)(ii)) says if your average rental period equals seven days or less, tax law doesn’t limit your losses.
Example: You buy a Montana log cabin late in the year, get it furnished, and then sign up for a couple of the short-term rental websites. During November and December, you rent the property for a week three different times. Your rental activity averages 7 days and therefore isn’t limited by the passive loss limitation rules.
If you do your depreciation in a way that puts a $63,000 deduction on your tax return? Bingo. You may shelter $63,000 of income without needing to worry about having passive income or middle-class income or qualifying as a “real estate professional.”
Just to play with the numbers so you see how powerful this is, you could use the vacation rental tax shelter to put a big deduction on your tax return every year.
Recycling the example presented earlier, if you purchased a vacation rental every year, you would drop a $63,000 deduction onto your tax return every year.
And by the way? If you wanted to really jack your depreciation deductions? Sure, you can scale. Ten vacation rentals might produce a $630,000 deduction. A hundred vacation rentals? Well, you do the math…
Achieving Material Participation
One other important wrinkle you need to know about.
You can also lose your ability to deduct losses–even losses on short-term rentals–when you lack material participation in the activity. Accordingly, you need to materially participate in the short-term vacation rental activity.
You can achieve material participation in a variety of ways. But typically, you have three practical options:
You or your spouse spend more than 500 hours a year.
You or your spouse spend more than 100 hours a year and no one else spends more hours.
You or your spouse is the only person who substantially participates in the activity.
Let me provide examples so you see how this works.
Example 1: You do all the marketing, housekeeping and landscape maintenance. All totaled, this activity only adds up to 40 or 50 hours a year. However, because no one else does more work than you do, your participation counts as “material” even though the total hours over the year are modest.
Example 2: Your spouse spends about a 120 hours over the course of the year renting or trying to rent a vacation home. You guys use two housekeepers: Mary and Margaret. Mary spends about 80 hours over the course of the year. Margaret spends about 100 hours. Nevertheless, your participation counts as “material” because your spouse spends more than 100 hours a year and no one else (neither Mary nor Margaret for example) spends more hours.
Example 3: Same facts as example two except Margaret retires and Mary picks up all of the housekeeping. This means your spouse spends 120 hours a year while Mary spends 180 hours a year. In this case, your participation does not count as “material.” With Mary spending 180 hours a year, you or your spouse would need to spend more than 180 hours a year.
Example 4: Your property is rented nonstop through the year. As a result, your housekeeper, reliable Mary, spends about 1000 hours a year cleaning and washing. The heavy rental use also requires you to hire another worker who does repairs and landscape maintenance—work that he also spends about 1000 hours a year doing. In this case, you need to spend more than 500 hours a year in order to participate on a material basis.
Final Comments and Caveats
Let’s wrap up this discussion…
The main point discussed above? You can use the short-term vacation rental rules to sidestep the passive loss limitation rules and shelter other income.
You can, therefore, use real estate investing not just to build wealth but to shelter from taxes income from jobs, investments, and even retirement plan withdrawals.
And the only two “tricks” to all this? Well, first, one needs to keep the average rental period equal to or less than 7 days.
And then, second, one needs to establish and superbly document material participation.
As part of the reading I did for those posts, I stumbled on and read business school professor Scott Shane’s book “The Illusions of Entrepreneurs.”
Then, oddly enough, a friend who carefully reads my posts sent me a private message. That message? I needed to read Shane’s book.
In this post, I want to provide a very brief review of Shane’s book. Some find Shane a good counterbalance to Stanley.
But then, inspired by Shane’s book and its title, I want discuss the possibility that some business school professors may themselves “labor under illusions” concerning entrepreneurship.
My Short Review of Illusions of Entrepreneurs
Here’s my short review. Shane presents a “glass-half-full” assessment of small business ownership.
That’s too bad. Shane appears to see self-employment and small business ownership as “mundane,” “boring,” and in many cases a reflection of people misunderstanding reality.
Nevertheless, I give the professor’s book a “B” grade.
A prospective small business owner benefits from a sober assessment of the risks and costs.
Professor Shane provides such an assessment. And no long-lasting harm comes from someone criticizing (constructively) your or my business plan.
But those points made, I see some flaws in the logic and between the lines of Shane’s book. This blog post comments on those flaws.
Flaw #1: Conventional Wisdom about Small Business Owner Income Wrong
A first quick flaw to point out and get out of the way. Contrary to Shane’s book, the data actually suggest small business ownership jacks up people’s income.
In fact, on average, the good longitudinal survey data about small business ownership and self-employment says these folks earn a chunk more money than the average person. Maybe 40% more according to one good survey: $72,000 per year for the average self-employed person versus about $53,000 per year for the average traditional employee.
You and I can’t look just at the money. But the money matters. And we should explicitly calculate and consider the extra income self-employment brings.
Note: The data sources and calculations for the above statement and the next statement appear in first Millionaire Next Door post I did.
Flaw #2: Conventional Wisdom about Small Business Wealth Wrong
Another quick flaw: Small business ownership contributes mightily to people accumulating wealth.
Someone who owns their own business for 30 years, for example, on average accumulates about an extra $360,000 of wealth as compared to someone holding a traditional job.
Shane’s book, I think, misses this important point.
This omission possibly highlights an understandable flaw that exists in much of the literature on entrepreneurship. People look at ventures rather than at individuals. That seems incomplete.
Someone who starts three ventures only to close down two of them for poor profitability may look like a failure. But this sequence of ventures may mean an entrepreneur moves from a first unprofitable venture to a second marginally profitable venture to a third strikingly profitable venture.
Flaw #3: Blindness to the Entrepreneurs’ Lottery
A subtle flaw I worry I see in Shane’s thinking? He seems to see only one form of entrepreneurship as truly making sense: Entrepreneurship that pursues giant opportunities and which, if everything goes to plan, delivers windfall results.
Yeah, no, I get it. Those sorts of entrepreneurial outcomes make for great stories. And probably MBA students won’t want to pay $50,000 a year for a program that prepares them to run a dry cleaners or a teriyaki take-out
But don’t the swing-for-the-fence entrepreneurial opportunities, more than anything else, resemble a Power Ball lottery?
I think so. Many play. But practically speaking nobody wins at that level.
Roughly half million businesses start each year in the U.S. Only a tiny handful experience a windfall.
For example, a couple of dozen people become billionaires each year through entrepreneurship (often after two or three decades of hard work and outstanding good luck), at least according to Forbes magazine write-ups (see here and here, for example). That puts your or my odds of becoming a billionaire through entrepreneurship at roughly 1 in 20,000.
Another example? Well, what about an initial public offering where you have founders stock? Good question. Initial Public Offerings (IPOs) in the U.S. run from 100 to 150 companies a year according to Statista. That seems to put your or my odds of reaping an IPO-type harvest through entrepreneurship roughly run 1 in 3,000.
A final back-of-the-envelope calculation and example. What about venture capital startups? Well, the average venture capital fund looks at maybe 100 startups to find one worth investing in (Source: Wikipedia reporting on a Stanford University study.) The chance one of those investments will turn into a game-changing success is about one in twenty accordingly to knowledgeable observers. Link those two percentages together and your or my odds run 1 in 2000. Roughly.
And so here’s the point: Betting on those odds whether as an entrepreneur or public policy maker doesn’t make sense. Playing the odds a few times in a row when you have a 1 in 2000 chance or 1 in 3000 chance of success? Gosh, most every serial entrepreneur shooting for the stars fails.
Note: In comparison, playing the odds a few times in a row when the odds are 1 in 2? That should work for most people.
Flaw #4: Counting Too Much on Cleverness
Can I point out something else that I think you can see in Shane’s work and the work of some other business school professors? (And probably, quite honestly, in stuff I was writing two or three decades ago…Sorry.)
I think you regularly see people believing that if some entrepreneur is just smart enough or just sophisticated enough, that cleverness makes the difference.
This fact: Good research from economist Jay Zagorsky suggests something like IQ makes a modestly positive difference in terms of your or my income. Roughly $234 to $616 per IQ point. (As compared to the average person with a 100 IQ, someone with a 130 IQ earns roughly an extra $6,000 to $18,000 a year.)
But that same research indicates that IQ makes almost no difference in terms of your or my wealth. Zagorsky, in fact, calculates that each extra IQ point adds maybe $83 of wealth. Which he says basically counts the same as zero.
In any case, connect that dot to the sort of wealth-creating entrepreneurship that some business school professors like to focus on, and you see the problem. One struggles mightily to argue that clever matters much in terms of wealth creation whether through entrepreneurship or some other wealth creation activity.
Flaw #5: Missing Benefits of Low Competition Environment
A final niggle: My sense is Shane sees many small business owners simply as bunglers running unsophisticated operations.
I’m not sure that’s fair or even true. But ironically that caricature of the “Millionaire Next Door” small business owner hints at something useful: These businesses often operate in an environment with a much lower level of competitive pressure.
As a result, developing a winning strategy and maintaining a competitive advantage works more easily in the small business arena.
You and I probably need only a modest advantage to compete against the guys down the street or across town: a little better website… one or two more talented team members… or maybe just a slight head start.
In comparison, big firms need big competitive advantages. Tesla Motors and anyone else wanting to start a car manufacturing company, for example, needs a giant competitive advantage to successfully battle with Toyota, General Motors and Mercedes Benz.
That easier-to-achieve competitive advantage eases the requirements for your firm’s success.
Let me share two comments to close.
First, the small business ownership flavor of the Millionaire Next Door theory doesn’t work for everybody. (Shane, I absolutely must acknowledge, does a good job of rebutting this type of thinking.)
You therefore want to consider small business ownership when your current job doesn’t deliver the income or experience you want. And then keep in mind, of course, that no job is perfect just as no small business is perfect.
A second comment: Some wealth-building strategies and some career plans let you follow simple recipes for success. But small business ownership doesn’t work that way.
We’ve got a free, downloadable retirement planning guide, for example, that explains how you can easily prepare for financial independence (Grab a free copy of that guide here: Download Thirteen Word Retirement Plan.)
Similarly, some career plans (like “go to law school and join a big law firm”) essentially require a person follow a clear-cut credentialing process and then apply for a job. That’s another example of a pretty formulaic approach. (These paths may be easier to describe than they are to follow, something highlighted here.)
Small business ownership, frustratingly, doesn’t work like that. The process burdens you with more complexity, uncertainty and stress in terms of your planning and the execution. (In the bargain, of course, you probably bump your income and get a practical way to build wealth.)
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Recently, a friend (not a client) asked about getting started with a retirement plan.
The awkward part of the question? Though successful in his small business, he’s late to begin preparing for retirement. Mid-fifties.
The good part of his situation? Lots. He enjoys an impressive income. The business sits well-capitalized. Life’s big expenditures–college for the kids, a house and so on–are already taken care of.
The one problem? That lack of retirement savings.
I didn’t have a good answer when first asked the question. But after thinking about the issues since our conversation, a handful of thoughts come into focus for my friend and anyone else in a similar situation.
Thought #1: Get Handle on Anticipated Social Security Income
The first thing to do? Get a good estimate of the Social Security benefit he and his spouse will probably enjoy.
This bit of advice ranks as important for everybody of course. But it becomes critical for small business owners. Many of these folks have used S corporations to save on payroll taxes… which was good… But that tax saving gambit depresses the Social Security benefit someone receives in retirement.
You can get the exact benefit formula at Social Security Primary Insurance Amount web page, but the benefit formula roughly pays you an amount equal to 90 percent of the first $11,000 you average plus 32 percent of next $56,000 you average plus 15% of the next $66,000 you average.
Example: Someone who averages $11,000 a year over their work years receives a benefit equal to roughly 90% of $11,000 or roughly $9,900 annually.
Example: Someone who averages $67,000 a year over their work years receives a benefit equal to roughly 90% of the first $11,000 they earn (roughly $9,900 a year) plus another 32% of the next $56,000 they earn (roughly $17,900). The total benefit for this person equals $27,800.
Example: Someone who averages the $132,900 FICA limit a year over their career receives a benefit equal to 90% of that first $11,000 (or $9,900), 32% of that next $56,000 (or $17,900) and then 15% of that last $66,000 (or another $9,900). The total benefit for this person equals roughly $37,900.
Note: Your spouse typically chooses to either receive his or her own Social Security benefit or 50% of your Social Security benefit.
Thought #2: Size the Needed Retirement Nest Egg
My next thought: My friend needs to quantify the size of the retirement nest egg he and his spouse want.
A reasonable rule of thumb to start? His family needs maybe $20 to $25 dollars of savings for each $1 of retirement income they want their portfolio to generate.
Example: If someone wants (say) $75,000 of retirement income and anticipates $35,000 of Social Security benefits counting both spouses, the family wants to draw about $40,000 from a retirement savings nest egg.
To generate $40,000 of income, a nest egg probably needs to be between $800,000 (that’s 20 times $40,000) and $1,000,000 (that’s 25 times $40,000).
By the way, I’m thinking you use the “25 times” rule for a 30-year retirement and the “20 times” rule for a 20-year retirement.
Thought #3: Guesstimate Small Business Sales Value
Hopefully my friend can sell his business for a much needed chunk of savings.
A small business, by the way, often sells for somewhere between two times and five times earnings. The average, according to the BizComps database, runs about 2.5 times earnings.
Example: If someone’s small business earns $100,000 a year for the owner, the business’s value probably falls between $200,000 and $500,000. And a good off-the-cuff guess says the business’s value probably sits right around $250,000.
Note: The value won’t include cash or accounts receivable or real estate. And the seller will need to pay off any accounts payable or notes payable.
One wrinkle to remember? If a small business sells his or her business for $250,000, he or she will owe income or capital gains taxes on much or all of the proceeds. A 20% tax, for example, might reduce $250,000 of gross proceeds to $200,000 of after-tax proceeds.
Obviously, however, whatever a business owner gets from the sale of the business becomes a big chunk of the retirement nest egg.
Example: If someone needs $800,000 of retirement savings but $200,000 of this comes from the sale of a business, that means he or she also needs another $600,000 of additional savings.
Thought #4: Calculate Required Retirement Plan Contributions
You’ll need to calculate how much you need to save and for how long you need to save.
The table that follows shows the amounts someone accumulates if they save the “50 or older” maximum in an IRA account, a Simple-IRA account or a 401(k) account for a given number of years.
Note: These amounts come from The Finance Buff’s blog post 2019 401k 403b IRA Contributions. (Check out that blog post for more, easy-to-digest details about pension plan limits.)
The table assumes, by the way, that you make the largest contributions at the end of the year and earn a 5 percent real (adjusted for inflation) return: $7,000 into an IRA, $16,000 in a Simple-IRA or $25,000 into a 401(k). I ignore employer matching contributions in the calculations below to simplify. But these amounts might add another little chunk to the annual contribution.
Years of Saving
Just to make sure you understand this table, note that even saving for 20 years in an IRA doesn’t get my friend to $600,000. Rather, the estimated 20 year future value equals $231,461.
To get $600,000 of retirement savings, my friend either needs to use a 401(k) plan and save for roughly 16 years (so until age 70).
Or my friend and his spouse need to both save into a Simple-IRA for roughly 14 years. At 14 years, each might accumulate roughly $313,578. Double that amount and you’re just over $600,000. Again, though, that means working until age 70 or so.
And one final observation connected to the preceding table: My friend and his spouse could both save into a 401(k) (so that’s $25,000 a year each) for roughly 10 years. That allows each spouse’s 401(k) to grow to roughly $314,447. Combined, their 401(k) account balances equal roughly $629,000.
Note: My friend asked me where to save this retirement balances when I shared above comment. My suggestion? A cheap target retirement fund from Vanguard or Fidelity. (More information available from this free download: Thirteen Word Retirement Plan.)
Thought #5: Augment Retirement Plan Contributions with Mortgage Paydown
A tangential thought: If someone wants to save more than is possible with a retirement plan, paying down debts helps.
Paying off a 5% mortgage on a house equates to a 5% return.
Thought #6: Work the Numbers to Avoid a Panic Attack
A final thought: When someone puts off saving for retirement until their 50s–as many people do–running the numbers may cause a panic attack.
But rather than panic, what someone needs to do is choose the least bad option of the following three choices:
Work longer so one can make more years of annual contributions and (just as important) support fewer years of retirement.
Save more (and so spend less during your work years).
Downsize one’s retirement income requirements (which may mean one should also spend less during the work years).
You get to pick whichever option makes most sense in your situation. But these three comments. First, you ought to look at the option of working longer if that’s available, something I’ve talked about in more detail in The Big Benefits of Entrepreneurial Longevity.
On February 1, 2019, the IRS published a corrected version of their final regulations for Section 199A (available here).
The corrections include a handful of minor editorial tweaks. All helpfully flagged in the published document using revision marks. But one particular tweak makes sense to point out and discuss for many, many small businesses.
Do You Have Multiple Trades or Businesses?
That tweak? Well, as you may know if you’re reading this, you need to calculate the Section 199A deduction for each separate trade or business.
You can’t just add up the business profit from all your trades or businesses and multiply that sum by 20 percent even in the simplest case. Rather, you determine the profit of each trade or business, multiply just that trade or business’s profit by 20 percent, and then add up the individual trades’ or businesses’ deductions.
That requirement begs an obvious follow-up question: How do you or I determine whether one or more than one business exists?
The first version of final regulations published in mid-January suggested you needed to look at each situation carefully and apply a variety of tests.
But one important test? Do the activities keep separate books?
The Language Change: No Longer a Separate Requirement
But that “separate books” requirement dropped out of the corrected version which appeared in February.
Here’s the edit to that first language:
Section 1.446-1(d)(2) provides that no trade or business will be considered separate and distinct unless a complete and separate separable set of books and records is kept for such trade or business.
The revision added the underlined words and deleted the crossed-out word.
That’s interesting to me. And significant, I think, for three reasons.
No Requirement for Separate Books
The first obvious significance? You or your client don’t need separate books. You need separable books.
For example, to put this in terms of QuickBooks, the most popular small business accounting software program, you don’t need separate QuickBooks data files or separate QuickBooks Online subscriptions for each business.
Rather, you need to be able to set up your QuickBooks accounting records such that you can separate different trades or businesses.
My suggestion? I think you use your chart of accounts to allow for the required separation.
You would want different asset, liability and equity accounts for each trade or business. You would also want different income and expense accounts. (The different accounts should allow for “separable”-ness.)
An example? You would want separate bank accounts.
Another tip for QuickBooks users? I think you would want to use different invoice templates for each trade or business (probably showing different trade or business names).
A landscaper doing both maintenance and then design and wanting to treat these activities as separate and distinct trades or businesses might have one set of accounts for the maintenance business and another set of accounts for the design business.
Remember the Edit
Another significant thing, I suggest, you want to remember about all this?
I think you keep copies of the first draft and then the revised draft of the final regulations to document the editorial change.
If you ever find yourself in a discussion with an IRS auditor about whether you can within one QuickBooks file handle multiple trades or businesses? Hey, you want to point to this editorial change. You want to be able to back up the regulations require not “separate” books… but “separable” books.
No, I know. You can call me a scared-y cat on this. Because I am.
Separable Not Enough
One final thing to say here–though you probably already know this. You don’t create or prove separate trades or businesses merely by making the financial data separable.
The “separable” thing is necessary. It is not sufficient.
The IRS and Treasury set forth a number of other requirements.
For example, and here I quote, they “believe that multiple trades or businesses will generally not exist within an entity unless different methods of accounting could be used for each trade or business under §1.446-1(d).” You and I want to consider that.
Another thing to consider? While multiple trades or businesses can be conducted within one entity, a trade or business “cannot generally be conducted across multiple entities for tax purposes.”
And then this remark: In a discussion in Regulation 1.199A-5(c)(1)(iii), the IRS talks about a landscaping business that can’t treat its maintenance activities and design consulting activities as “separate” and then about a veterinarian who can treat the veterinary medicine practice as separate from a dog food business.
There, the IRS and Treasury say this about the dog food business,
Animal Care LLC also has separate employees who are unaffiliated with the veterinary clinic and who only work on the formulation, marketing, sales, and distribution of the organic dog food products. Animal Care LLC treats its veterinary practice and the dog food development and sales as separate trades or businesses for purposes of section 162 and 199A.
The way I read this? If you want to separate out activities into their own trades or businesses, you want things like “separate employees” and for the activities to be treated in the real world as “separate trades or businesses.”
I’ve got to get to preparing tax returns. But two final quick comments.
First, if you are going to break-up the typical small business amalgam of activities into separate trades or businesses, I think you want to make sure the business owners have good accounting skills and systems. Many small businesses find a decent balance sheet hard to produce. I would imagine many more would find a “separable” requirement too difficult to achieve.
Second, if you do try this, I suggest you re-read (or read?) the final regulations’ discussions about how to account for and allocate income, expenses and assets between multiple trades or businesses. That information should help you channel the logic and thinking of the IRS and Treasury.
Over the last year, you’ve surely read or heard that many long-standing deductions go away.
In this short blog post, I’m going to review these lost tax deductions.
Knowing which deductions you no longer get to take should make preparing your tax return easier.
In past, taxpayer potentially received a roughly $4,000 deduction for each person in the family. (High income taxpayers lost some or all of this by the way.)
For 2018, the personal exemptions go way. No more. So count this as the first and one of the biggest lost tax deductions under the new law.
Like personal exemptions, moving expenses no longer count as deductions. Sorry.
Home Mortgage Interest
The new tax law limits the mortgage interest deduction for new mortgages. You only get to deduct the interest on the first $750,000 of your loan.
Note: Old larger mortgages probably get grandfathered, so interest on those loans probably can still be deducted. But you’ll want to understand the gritty details. (See this blog post for more information:New Mortgage Interest Deduction Rules.)
Home Equity Loan Interest
A related potential lost tax deduction? Unless a home equity loan counts as a mortgage (because you used the home equity loan money to buy, refinance or improve your home), the new tax law says you don’t get to deduct interest on a home equity loan.
State and Local Income, Property and Sales Taxes
The new tax law limits the itemized deduction a taxpayer gets for state and local taxes to no more than $10,000.
These state taxes include property taxes and then either state income taxes or state sales taxes.
Anybody living in a state with income taxes or high property taxes—probably the so-called blue states—will very likely experience this lost tax deduction.
Casualty losses including theft losses no longer work as deductions—except if the casualty loss occurs in a presidentially declared disaster area for something like a storm, fire or earthquake.
Note: The casualty loss math often makes a deduction problematic even if you can claim the deduction. You ignore the first $100 of any casualty loss. (That doesn’t count.) And then you only get to deduct the remaining casualty loss or losses (the amounts leftover after the $100 write-off) to the extent they in total exceed 10% of your adjusted gross income.
To simplify, if your adjusted gross income equals $100,000 and you experience one “presidentially declared” casualty event, only the part of a casualty loss in excess of $10,100 becomes an itemized deduction.
Miscellaneous Itemized Deductions in Excess of 2% of Adjusted Gross Income
In the past, you got to take a handful of miscellaneous itemized deductions to the extent they together totaled and exceed 2% of your adjusted gross income: un-reimbursed employee expenses, tax preparation fees, investment expenses and so on.
But no more. These deductions have also been eliminated.
Three Final Comments about Lost Tax Deductions
All the lost tax deductions sound bad, but you won’t know whether you pay more tax until you look at the new tax law’s other effects. For one thing, for the next few years at least, individuals calculate their income taxes using a schedule of lower tax rates.
As another example, business owners get a series of compensating tax breaks that should more than make up for any lost itemized deductions. (The big new small business tax deduction is the Section 199A qualified business income deduction. This deduction essentially says business owners don’t have to pay income taxes on the last 20 percent of the business income they earn.)
Third, finally, probably many middle-class households won’t actually be “hurt” by the lost tax deductions. Why? Many won’t itemize any longer. Rather, they will take the new greatly enlarged standard deductions: $12,000 for a single taxpayer and $24,000 for a married couple.