Four wealth buckets of capital

By Scott Keffer

Dr. Caldwell, a prominent surgeon, came into my office and proclaimed proudly, “We’ve found a way to put even more money into my retirement plan! Isn’t that great?”

“Is it?” I asked. “Are you sure that’s what you want to do?”

“Of course.” Then he paused and turned around. “Isn’t it?” he queried, “That’s what I’ve always been told: put as much into my retirement plan as I can.”

“It depends.” I replied, which led us into a discussion about creating and preserving wealth that included the concept of the four Wealth Buckets: your business, your investments, your retirement plans and your investment real estate. Each bucket is different. Each has its own characteristics.

Imagine if someone offered you a $1 million treasure chest. Would you want it? Of course. Now imagine that they told you it was at the bottom of the ocean. Would you still want it? Yes, again. However, in your mind, would it still be worth $1 million? No? Why not? Lack of accessibility. Acquisition costs. Vulnerability to loss. Would you carry it on your balance sheet at $1 million?

And yet that’s what people do when they think about their wealth. They ignore the accessibility, costs and vulnerability.

Before asset allocation and investment decisions, you must have a strategy in regard to your Wealth Buckets. For example, the particular Wealth Bucket determines your Real World Rate Of Return, not your perceived rate of return. What is meant by that? The perceived rate of return is like the big fish that got away. You had him – you just don’t get to keep him. The perceived rate of return is the same. You earned it – you just don’t get to keep it.

That’s why I always say, “It’s not what you earn that counts; it’s what you get to keep. What you get to keep is what you have to spend. To pay the bills. To buy a car. To take a vacation. To give to your kids and grandkids. It’s what you live on in the real world. That’s why I call it the Real World Rate of Return. What did you earn that you can spend after all fees, costs and taxes? That’s the Real World Rate of Return.

After accesibilty and costs, you must also look at the vulnerability of each bucket to attack from litigation and creditors. Finally, you must also take into account the Transfer Rate of Return – how much of your money actually ends up in the hands of your loved ones after estate and transfer taxes.

You should begin with a Wealth Bucket strategy. Ultimately, how much do I want to have in each Wealth Bucket? In what priority will I fund the buckets? In what priority will I access the buckets? Which ones are best to use for lifestyle cash flow? Which ones are best to pass on to my heirs?

From this perspective, let’s look closely at one of the largest buckets for most doctors: their retirement plans. Current estimates show over $11 trillion contained in retirement plans. Many physicians have an inappropriate amount of their wealth in the Retirement Bucket – and it causes major planning problems down the line.

Qualified retirement vehicles have two main advantages: your money goes in before tax and the earnings inside the plan are tax deferred – you do not pay income tax until the dollars are withdrawn.

However, there are a number of disadvantages – some of them serious. From an accessibility standpoint, you are essentially penalized for access prior to age 59 1/2.

Another serious flaw is that a retirement plan is a negative tax converter – it converts all of the growth inside the plan into ordinary income from a tax perspective. The entire balance will be taxed at ordinary income tax rates when you withdraw it, even though typically three quarters or more of the growth comes from capital growth, which is taxed at capital gains tax rates outside of a retirement plan. It means that the amount of tax you will pay on capital gains inside of your plan is more than doubled. Therefore, to access your retirement monies, you will have to surrender almost 40 percent to the taxman.

So, why do we count retirement accounts as the $1 million treasure – when in actuality the spendable amount is only $660,000, not $1 million? Be sure to adjust your Real World Rate of Return for the cost to access those dollars. And be sure to have your li festyle projections adjusted for the impact of income taxation on your retirement monies.

To avoid this tax, many only take minimum distributions from their retirement monies to avoid paying income taxes on the distributions. Some even take less than the required distribution and are subject to a 50 percent penalty for under-distribution. “Not a bad deal,” you say. “How much really is paid in under-distribution penalties?” The last figure I saw reported was $2.4 billion!

How about the Transfer Rate of Return? Three taxes can be levied on retirement monies at the death of the surviving spouse. First, the IRS can remove up to one half off the top through federal estate taxes. Then, the IRS comes back around the block and takes a second pass. The plan balance after the Federal estate taxes is subject to an income tax, called Income in Respect of Decedent (IRD), which can be another 35 percent. Then, Pennsylvania shows up and takes 4 1/2 percent of the entire beginning balance.

These three taxes can confiscate the majority of your retirement monies. You can lose up to a whopping 70 percent to estate and income taxes. Alternative distribution elections by your heirs, so called “stretch IRAs,” can only postpone the tax; it does not eliminate the taxes. Now calculate your Real World Transfer Rate of Return when your $1 million IRA results in only $305,000 to your heirs.

See why the perceived rate of return is so deceiving?

So, get a Wealth Bucket check-up and determine your Real World Rate of Return.

Scott Keffer is president and founder of Wealth Transfer Solutions, Inc., a legacy planning company in Pittsburgh.