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JANE-AUSTEN

This week I’ve been reading Claire Tomalin’s Jane Austen: A Life. That’s risky for me to admit, as surveys show the female/male ratio of “Janeites” runs about 25:1. Mockery from readers may be unavoidable, and even deserved.

I think one of the most interesting aspects of Tomalin’s biography is how it shows the Austens and their neighbors as a case study of the Lower Upper Class.

Tomalin describes the Austens’ neighbors as:

“pseudo-gentry, families who aspired to live by the values of the gentry without owning land or inherited wealth of any significance… families who merely happened to be where they were at that particular time, some floating in on new money, others floating out on their failure to keep hold of old.”

Even though Tomalin wrote about families in 1790s Hampshire, I am hard pressed to think of a better description of the lives of the Lower Upper Class in America today.

For discussion purposes, today’s Lower Upper Class enters retirement with an asset base between $3 million and $10 million, and adult children of this class usually inherit more than $1 million each, but less than $5 million.

A qualitative view on those numbers is that in this class, there is usually a safety net of financial and/or human capital that’s sufficient for one generation, but not for more.

In plain terms, if children of Lower Upper Class parents are tripped up by bad luck, circumstances, events, and/or bad choices, the grandchildren will face a substantial risk of downward mobility.

On the upside, upward mobility is a distinct opportunity. As in Austen’s time, marriage to a high-earning spouse can create a pleasant shift into the Upper Class (Pemberley then, Palo Alto today?). Or, a successful run in an emerging “New Economy” business can create abundant wealth (the East India trade then, tech companies today?).

It’s hard for a family to stay in the Lower Upper Class over several generations – descendants tend to move up, or move down, but not simply tread water.

Successful inheritance strategies for this class need to manage volatility in descendants’ outcomes, and variability in their situations.

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Miami-Nassau sailboat race, 1947Broadly speaking, I have observed Upper Class families use three types of inheritance strategies: deferral, ad hoc gifts, and income streams.

Deferral is a traditional strategy: pay to raise and educate your child, and then give them not very much (if anything) until they inherit as your survivor.

Ad hoc gifts are transfers for a particular purpose, such as paying off credit cards, covering club assessments, grandchildren’s tuition, buying a vacation home, or capitalizing a business.

Income streams are arrangements (often using trusts, or partial ownership of businesses or rental real estate) that provide ongoing income to the child.

As an aside, please bear in mind that by “Upper Class”, I’m referring to families in which children could inherit more (sometimes, much more) than $5 million each. Especially if parents can transfer that much wealth to each of two or more children, the parents themselves are likely in a substantially secure financial position, even after making lifetime transfers to their children.

For discussion purposes, this creates freedom to focus on how wealth transfers affect children, rather than parents.

Each type of inheritance strategy presents pros and cons.

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class-frost-reportAlthough class is discussed frequently and openly in Britain, it makes many of us on this side of the Pond uncomfortable. Even so, class in America has been covered humorously by Paul Fussell, and with great color and insight by the New York Times.

Because I am a trust and estates lawyer, my practice offers a fascinating perspective on a particular aspect of class: how inheritance affects adult children.

To quantify and explore representative effects of inheritance, I built a model illustrating how the balance sheet of a relatively high-earning professional can be expected to change over the professional’s working and retirement years.

Let’s call our professional Henry, for lack of something more fun. Assume that Henry is a likeable, industrious guy, and graduated as a superstar from “school” (i.e., high school!) in Louisville, from one of the usual suspects. Assume further that Henry studied finance at Notre Dame as an undergraduate, worked for two years in asset management in Chicago, and went to Kellogg for his MBA.

In the real world, Henry might be a spectacularly successful founder of a hedge fund, but that creates “noise” in the model, so let’s assume that Henry instead works as a well paid mutual fund manager in progressively more responsible positions over the course of a stable and successful career, earning a solid income that allows him to pay his student loans (for the model runs in which those apply) and “max-out” his 401(k) contributions.

The model assumes a realistic current rate and repayment terms for student loans, and what I believe is a realistic long-term projection of investment returns under current market conditions. (If you play around with the model, you can easily modify the student loan interest rate and investment return parameters, if you’d like to.)

Although it’s a simple model that ignores period-to-period volatility in investment returns, I think that’s not a material drawback for its purposes, which are to illustrate the substantial life cycle planning effects of inheritance events on adult children.

The model shows different life cycle outcomes for Henry, the same guy with the same career, depending on his being part of three different classes: upper middle, lower upper, and upper.

No class taxonomy is necessarily accurate, and all run distinct risks of being obnoxious.

With that caveat, for our discussion, I sort among the classes by one independent variable only: the amount of parental provision for children (whether by education funding or inheritance).

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college-belushiThe expense of college for children and grandchildren is a troubling issue for almost all of my clients.

I think this is because at an instinctual level, long before crunching any numbers, clients know what the charts below show: college costs have gone truly exponential in the last one and a half generations, far outstripping increases in the earning power and asset base of the upper middle and lower upper class.

college costs vs income

incomesBecause the issue is concerning, clients often have a strong instinct to do something, anything, to address the problem. As a result, their attention often turns to Section 529 plans.

To evaluate how useful these might be, it’s useful to review their key features.

A 529 plan (sometimes known as a qualified tuition program) has a designated beneficiary and is set up to allow you to either prepay, or contribute to an account established for paying, a student’s qualified education expenses at an eligible educational institution. Total contribution limits to 529 plans vary by state, but generally are at least $300,000 (Kentucky’s is $350,000).

Contributions to 529 plans are not tax deductible for Federal purposes, and (unlike certain other states), Kentucky does not offer state income tax deductions for contributions. Nonetheless, 529 plans do offer a limited income tax benefit, in that account earnings are not taxed until withdrawals occur. In addition, distributions made from 529 plans for qualified educational expenses are not income taxable.

On the down side, distributions from 529 plans that aren’t for qualified educational expenses are income taxable, and incur an additional 10% penalty (which the IRS euphemistically describes as an “additional tax”).

In simple terms, then, you can think of a 529 Plan as somewhat like a Roth IRA for education, with no income limitation on contributions. Our recent post explored whether Roth IRAs really are all they are cracked up to be in many situations.

This post similarly estimates a plausible upper bound on the tax advantages a 529 plan might offer (compared to saving for college in a taxable account), and compares the potential benefits to negative aspects of these plans – notably, their many restrictions, limits, and fees.

Let’s suppose that when a child (Harriet) is born to taxpayers in the highest marginal state + Kentucky income tax bracket of 49.4%, her grandparents are trying to decide whether to contribute $350,000 to Harriet’s 529 plan, or instead put it in a trust or other taxable savings “wrapper”, earmarked for college costs.

I built a model, available here, showing the account’s alternative performance inside and outside the 529 plan.  If you like, you can download the worksheet and use your own parameters for tax rates, investment costs, projected inflation rates, and 529 plan costs, to produce a forecast better tailored to your situation.

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marshmallowIn the late 60s and early 70s at Bing Nursery School on Stanford’s campus, Walter Mischel conducted the famous “Marshmallow Experiment” on delayed gratification. Preschoolers were offered a choice between one marshmallow or cookie right away, or two if they waited about 15 minutes.

When researchers tracked down study participants as adults, they found that the children who had waited for the larger reward tended to have better life outcomes, including higher test scores and educational attainment, and lower rates of obesity and addiction.

By offering a choice between Traditional and Roth IRAs (but probably without intending to) the Federal government has created a vastly scaled-up version of the Marshmallow Experiment.

Traditional IRA and 401(k) contributions offer current year income tax deductions as an immediate reward.  In contrast, Roth IRAs offer a promise of long-term income tax savings as delayed gratification.

In contrast to Mischel’s willpower-virtue-success narrative, however, it’s not straightforward that choosing the Roth will necessarily produce better outcomes – that depends on the relationship between many factors. We explore some of those issues below.

To set the stage, a brief recap of some of the rules on Roths is helpful.

  • Contributions to a Roth IRA are not deductible.
  • Qualified distributions from Roth IRAs are tax-free.
  • If your income isn’t too high, you can contribute to a Roth IRA at any age.
  • Roth IRAs do not have required minimum distributions.
  • If you are single, and your modified adjusted gross income is below $116,000, you can contribute up to the limit.
  • If you are married and file a joint return, and your modified adjusted gross income is below $183,000, you can likewise contribute up to the limit.
  • The limit is $5,500 per year (or $6,500 per year, if you are over age 50).

Especially when discussing IRAs (whether Traditional or Roth), there is always a tradeoff between being clear, and being comprehensive. For the full nuances behind the summary above, you can consult the IRS material here.

If you reduce your tax-deductible contributions to a Traditional IRA or your 401(k), and contribute to a Roth instead, that decision has an opportunity cost: the income tax deduction you don’t get.

What’s the size of that opportunity cost? The answer tends to vary on a case by case basis for any given family, for reasons lurking within Form 1040.

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Silicon-Valley-map_If you have been working since the late ‘90s, you have probably collected some great stories about exercising stock options and other equity-based compensation.

Some are unqualified success stories, like the time my college roommate’s father pulled up outside the college dorm in a brand-new zippy BMW convertible (top down, naturally), and told us to come along for a ride.

As he drove away, engine roaring, the remark he tossed towards us, cracking a huge smile, was: “Boys, never forget: Options…are good.”

It felt that way in 1998.

The summer after that car ride, my roommate interned at a major investment bank, and on a very hot day, I visited him in Manhattan. A major topic as we walked around Central Park was how wrapped up he was in the EToys.com IPO.

By the fall of 2001, I was in a torts classroom in the middle of Silicon Valley, sitting next to a former EToys.com millionaire. The day after the IPO, he’d gone shopping for Porsches. During the six-month post-IPO lockup, EToys.com cratered. large_logoThe Porsche never happened, and my friend lost $2 million on paper. As a 1L, he drove a “vintage” Chrysler LeBaron – and I respected his good sense of humor about the whole episode.

By spring 2003, a tweedy, erudite professor in my Corporate Acquisitions class interrupted the regularly scheduled programming about hostile takeovers (how’s that for a an 80s throwback?) to offer unprompted, emphatic advice:

“Many of you sitting in this room will end up working as in-house counsel at startup companies, and you will receive options. I am telling you today that you will hear a lot of advice to the contrary, but this is what you must do: as soon as the options vest, exercise them, sell all the shares, and diversify. Just make a decision today that that’s what you’ll do, and your life will be easier.”

We are shaped by the stories we hear, because they help us make sense of a complicated world.

Stories like the ones above from the left and right sides of the tech bubble’s bell curve are entertaining, and pretty useful. How you react to them says a lot about your behavioral tendencies, and your risk preferences – which are critical decision elements about stock options and restricted stock.

Nonetheless, it’s important to also have a robust objective framework when making key life cycle planning decisions about exercising stock options and selling shares: When to exercise? When to sell?

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