The Situation
Tom is 87 and in good health. His family is long-lived. What’s the right course of action for his IRA, or at least for part of his overall IRA property?
The IRA is worth $500,000. Because it’s been aggregated with other IRA property, no RMDs (required minimum distributions) have been required from this particular slice of the qualified pie, at least not until now. No withdrawal needs to be made in 2009, since the federales have waived RMDs for this year, owing to widespread portfolio losses during a double-whammy: The bursting of the housing bubble and the credit crisis.
For purposes of this column, it is assumed that RMDs for the customer will be made in 2009 anyway; the IRS forgiveness of 2009 RMDs will be ignored. (For purposes of simplicity, other IRA income is ignored, too; the exhaustion of all other IRA property is assumed. Whether other IRAs have or have not been depleted is not germane, since we are only dealing with transforming this particular $500,000; additional taxable income from other qualified funds would create more inflows and thus more taxes, but the savings effect from the transformation would also be greater; the tide rises or falls proportionately.)
The Formula
The government IRA table says that an 87-year-old has a 13.4-year life expectancy, meaning that to determine the 2009 RMD the $500,000 would be divided by that number, creating a $37,313 RMD for the year.
Assuming taxable income of $150,000, this additional RMD would produce greater income and higher taxes, although the customer does not necessarily want extra income (and most everyone doesn’t want more taxes).
Choice #1: Grin and bear it!
The most common approach is to simply take the money, as per RMD rules, and pony up the extra federal and state income taxes yearly. (Tom is married and so average federal rates for married individuals are used throughout1 — marginal rates seem an affectation, since practically no one pays the top marginal rate.) Calculations result, approximately, in the following:
If Tom can stash his IRA somewhere with a reasonable expectation of earning an average of, say, 8% yearly, the money could last for some years. Even so, if the $500,000 is continued as IRA property, federal and state tax bites could take something on the order of $150,000 over 12 years,2 and that’s a low estimate given 8% annual growth.
We might get lucky and earn 9% or 10% yearly, on average, but, basically, Chart #2 is the approximate 8% picture. Since the federal and state governments will take an ever-increasing percentage, incremental improvements earnings shouldn’t have much effect. Tom and his wife — also a highly successful professional — have children and grandchildren, who all figure prominently in their financial and estate planning.
Enter the SPIA
Sometimes, different is good. Let’s try something unusual, maybe even unique. How’s that sound? (You know me, right? The question is rhetorical — I’m going to plow ahead writing whether there’s interest or not.)
Suppose the IRA is invested in a guaranteed single premium immediate annuity with a cash refund feature. This is a fixed product that insurance companies do very, very well. The annuity is based on the life expectancy of the IRA-holder. Yes, it’s still an IRA, but now it’s an IRA guaranteed to pay out $53,420 yearly for no less than 10 years.3 So, God forbid, if Tom dies after receiving one annual payment, his wife or other beneficiary will receive $53,420 times nine ($480,078), and within days of his passing. On the other hand — and I’m in favor of this idea — if Tom lives longer than 10 years, he will continue to receive $53,420 for as long as he is alive. If Tom takes the payment annually, the equivalent rate is 10.68%.4 If he takes a monthly payment of $4,998, the rate is almost 12% annually.
The Big Kahuna!
Because the money is coming from an IRA, it is 100% taxable. But let’s think for a moment. Since the money from the IRA is not needed, let’s do something with it. Let’s invest it, but invest it in something partially tax-deductible. So, Tom receives taxable income, and then he turns around and invests it in something 85% deductible. How would that work?
That’s better — we now have $53,420 invested each year, and the increase in taxes over the old $150,000 of income is a paltry $2,207 annually.
Wait a minute, run that by me again
Very astute of you to notice, reader; thank you. What was the investment that was 85% deductible — is that the question? The answer: Natural gas. The program I use is usually available at least two times yearly and each offering typically consists of hundreds of natural gas wells, sprinkled through Pennsylvania, with sometimes smatterings in Kentucky and West Virginia. The operators are currently very excited about the Marcellus shale, which seems to run in a jagged line through Pennsylvania. And, yes, natural gas prices are low at the moment. Will prices stay low? I doubt it. Like most things, natural gas prices ebb and flow. For most of the last decade, my customer’s natural gas checks have been in the 10% yearly range. The price may also increase due to weather patterns — cold winters often bring higher prices. There is also demand pressure from utilities, since natural gas burns clean.
Investors should know that once they have invested $53,420, (or any amount, for that matter) it’s gone. The investor gets the tax deduction, usually 85% or 90%. Cash flow typically begins 12 months later (the company has, after all, to actually drill the wells before anyone gets paid). There is no cash value, although there are hardship provisions if emergency strikes, and the cash flow may also be sold.
Natural gas wells can produce for a long time, although there will be a gradual tapering-off of production. I estimate that a reasonable monthly income will continue for 10-15 years, or more.
Only about 75% of natural gas income is typically taxed owing to depletion.
Now what happens?
The idea would be to grow the money by investing the income in something that seems recession-resistant and likely to remain so for 10 or more years. The nomination? Self-storage real estate. When times are good, people store expensive stuff — wine, cars, paintings, etc. When times are bad, people downsize and — guess what? — store stuff.
The self-storage program I use is a non-traded REIT currently paying a 7% dividend. If we reinvest some or all of the dividends more money builds and the newly-created money does not reside in an IRA. We could also invest in slices of mutual bond funds, or split investments among self-storage, municipal bonds and managed futures. Whatever is done, the dollars could build in the following way (and the chart assumes that growth/dividends equal 7% yearly and that 2% of that is withdrawn to settle taxes). Remember, there is no income from the drilling program for about the first 12 months. Another 2% is withdrawn from the new non-IRA fund for taxes as well. In other words, we are using about 28% of the money on both sides of the equation for state and federal taxes.
What happened?
Basically, a fund of $429,000 was built, with an added natural gas investment of over $850,000; all by using unneeded income from an IRA. We established a program to minimize taxes and keep the total tax rate percentage low. While things could be better or worse (I anticipate that the actual return of self-storage real estate, given reinvestment of some dividends, will be in the 12% net annual range) over the period shown, the argument illustrates that there are alternatives for IRA property, particularly when income is not needed.
Tax changes
Tax policy changes from time to time. However it is unlikely that incentives for natural gas drilling will be removed. If they are, new rules will probably “stick” to solar or wind energy, and the investment posture can be modified. If that happened, it is likely that existing natural gas wells will become super-valuable. One government job is to encourage energy production of one kind or another.
The following chart shows how much can be accumulated simply by investing the net after-tax RMD at 5%, which is simpler than the natural gas plus self-storage (or whatever) program illustrated here. However, with the natural gas/self-storage plan, Tom builds a total amount of “stuff” that equals $1,284,236, compared to $684,878, the result for paying taxes and investing only the net RMD.
The test
The way to test is to take the net amount from the IRA, after taxes, and invest it each year. Yes, initially, the result looks better using this simpler method. As stated before, however, the $429,000 fund in Chart #4 has related income from over $850,000 of natural gas investments and lifetime income from a single-premium immediate annuity. Did I mention lower taxes? While Tom is alive, he receives $53,420 yearly. And he’s building a non-IRA fund that should spin off $40,000 for a number of years; even when it peters down to $20,000 or even $10,000 yearly, someone will be happy to receive the income and enjoy paying tax on 75% of what’s received.
The most important consideration in the plan is to realize that the non-IRA fund can receive funds for years and years. If self-storage averages around 12% yearly, and natural gas ultimately returns to higher income levels, the non-IRA fund will produce larger numbers by far than shown here. Even at 5%, the fund can continue building (or producing income) based on gas production.
Despite Chart #5, remember that, for example, in the 5th year, with the annuity program, we still have $267,100 in protected future payments, plus $267,100 in natural gas investments (the years balance) and we’ve maintained a relatively low tax rate. To that $534,200, add $29,483, the approximate net after-tax value of the self-storage investments at the end of the 5th year. While one can’t spend the capital invested in the natural gas investment (although one company I used for years bought back, in 2005 or 2006, virtually all of its ’90s retail business at about 70% of the original prices paid, and everyone kept the healthy dividends they had received).
The income in the natural gas/self-storage arrangement should out-perform the invest-the-RMDs-only strategy by a fair margin. If the gas produces $40,065 and one stops the self-storage and begins to take the income,5 even at 5% net, it should produce $21,474. So, the estimated approximate combination income for the natural gas/self-storage plan is $61,539, which is far greater than the estimated approximate $34,244 from the competing invest-the-RMD strategy.
Whether one likes this natural gas plan or not depends on how he or she wants to control taxes and produce future income; in any event, I think self-storage is an excellent investment for the next 10 years or so, whether one uses the natural gas plan, or simply invests the residual after-tax RMD, and it could be worthwhile to mix the investments among three choices, including perhaps managed futures, municipal bond packages, or even a leasing program.
*The numbers, percentages and tax calculations throughout this column are approximate and were loosely examined by my good friend, Roger the CPA. Life expectancy may seem unrealistic, but the 87-year-old in question, imaginary or not, seems in robust health, and at least one of the ideas is to maximize income regardless of longevity; that works even if survival is but a day or so after the contract is issued.
Also, many annuity iterations would ensue in a real case, instead of using one off-the-shelf income number. According to the Bureau of the Census, there were 96,548 centenarians on Nov. 1, 2008. By 2050, there are expected to be more than 800,000. (If I make 2050, I’ll be 111; I might even be crotchety and difficult. Please stay tuned.)
Broker’s Bookcase
Rich — The Rise and Fall of the American Wealth Culture, by Larry Samuel (AMACOM, 2009). According to Slate, Larry Samuel is “the anthropologist of plutocrats.” Since 1990, he has consulted with Fortune 500 companies and major ad agencies.
Samuel’s book is not just about wealthy people controlling the government, but that’s part of the story. Not many poor people run for public office these days, do they?
Did you know that the monthly tab for household help at one Newport home in 1920 was about $1,500? That was for 20 people, and one of them was called a useful man. I love the “useful man” description — it gets the job idea across. Why does Bill Gates need a $53 million home and 30-car garage? Were the ’80s like the 1920s? Why do some of the wealthy like conspicuous consumption and others (like Bill Gates’ friend Warren Buffett, for example) shy away from it?
When you get into the elephant-bumping parts, when the moneyed folks meet and greet, you’ll see that the rich are just like everyone else, they just have better parties and bigger houses. (Every time I read or hear about Bill Gates’ mansion, I worry about how it gets cleaned. Me, I like my privacy and wouldn’t want an army of folks dusting the rooms in the castle all the time, although I confess that I finally, two months ago, got my wife to give up doing all the cleaning, and now a nice young woman comes once weekly; I continue to be the commanding general in charge of dishes). Opulent super parties — like Malcolm Forbes’s 1980s bash in Morocco — still happen, but not nearly as often (and, these days, at least one party-thrower eventually got in big trouble for spending company funds).
The super rich seemed to have invented themselves around the time of Woodstock. In 1968, there were 100,000 U.S. citizens worth “a cool million or more” and — the author says, quoting Fortune — that 153 of them were worth $100 million or more, or “centamillionaires.” Today, 1968’s $100 million is chump change; big wealth is measured in billions now. Another thing that happened in the 1960s was a new obsession for privacy and non-ostentation. The super-rich started driving Buicks, and avoiding unseemly and vulgar displays of wealth. Like everything, though, the behavior of some of the wealthy is subject to the usual tugs of the ebb and flow of society, and 20 years later, ostentation was back in fashion. Doubt me? Consider the three-item 1980s $650 breakfast in Houston (caviar, milk and potato skins).
Rich may or may not help your financial planning practice, but it’s a doggone interesting read. The folks in Rich, by the way, don’t seem to act anything like my clients, rich or not. Let me know if they are like yours, okay?
This information is intended for financial professionals only, not the general public. This is not a solicitation to buy or sell any specific security. Mr. Hoe may have positions in the securities or other investments discussed.
Richard Hoe, CLU, ChFC, AEP,
has been an investment professional for 40 years, and is a registered representative and investment advisor representative. He is a member of the adjunct faculty at the California Institute of Finance, a graduate school at California Lutheran University. Readers may e-mail Richard Hoe at richardhoe@richardhoe.com.
Footnotes:
1. Since there is great variance among state income tax rates — some states even don’t even have income taxes — they have been largely ignored in the calculations.
2. Since state income taxes are ignored, this rather loose estimate includes federal taxes and estimated state taxes, with the latter being calculated at 5% — the overall combined federal and state tax for 12 years would likely be in a range of from $130,000 to $165,000, depending on one’s resident state.
3. I used a major insurer to develop this rate — a company that’s been around and healthy since the 1800s. If the company somehow managed to fail (unlikely), such annuity payments should be subject to protection from state guarantee funds.
4. In other words, an equivalent rate — and this is somewhat disingenuous but is a part of many insurance proposals — one would need to earn 10.68% on a $500,000 investment to receive $53,420 yearly. Of course, if one did, one would also have the $500,000.
5. By the time all of the investments converted to income, down the road, there would likely have been two or more separate self-storage program investments, since the number of investment years is typically limited in each program.