Sound Investing and Planning
“Do we really need disability insurance?”
By Daniel Harris, RIA Sunday February 28, 2016
When we found out my wife was pregnant last year, we had a discussion about whether we really needed disability insurance. As usual, my wife thought we shouldn’t buy disability insurance and we should spend more money on food and clothes. She rightfully pointed out that compared to other forms of insurance you’ll buy, disability insurance is by far the most expensive. At first, I was inclined to be on the same side as her, but when I looked at the numbers I felt differently. In the end we decided to buy it.
What does disability insurance protect?
Disability insurance generally replaces 60% of your income if you get sick or hurt and can’t perform the major tasks of your type of job. The insurance company is taking on a huge commitment – usually an obligation to pay you $1,000,000 or more if you get hurt. As a result, premiums are usually in the low thousands.
Most disabilities actually come from unexpected diseases or muscle and skeleton problems as opposed to workplace injuries.
Is it worth it? What are the odds of getting hurt and being out of the workforce permanently?
8% of all men will be permanently disabled before age 65.
9% of all women will be permanently disabled before the age of 65.
So basically, if disability insurance costs you less than 8 or 9 percent of the income you are insuring it is worth it. If it is more than that, I think it’s best to self-insure.
What does a real life example look like?
Sally is a 30 year old female, in good health making $100,000 per year. If she can work until she is 65, she will earn an additional $3,5000,000 over the course of her career. She can buy a disability policy that pays $60,000 per year ($2,100,000 over the life of the policy). Her premium at age 30 for a group policy is $4,380 per year or roughly 7.3% of the income she is insuring.
Sally’s Commitment to the insurance company: Payment of $39,420 in premiums from age 30-39 ($4,380 per year in premiums)
The Insurance Company’s Commitment to Sally: Payment of between $1,560,000 and $2,100,000 to Sally if during this 10 year period she gets sick or hurt
Sally’s expected loss (the 9% odds of getting hurt times how much she’ll lose if she gets hurt): $140,400 to $189,000 (Equivalent to a $5,400 annual premium)
What Sally should do: Buy the insurance because the insurance company is giving her protection that is worth $5,400 for the price of $4,380.
Sally’s now 45 and her rates are higher – what should she do?
Her premiums are now 15% of the insured amount or $9,000 per year
What should she do: She should let her insurance lapse because it costs her $9,000 to buy a benefit that is only worth $5,400.
It’s actually a pretty easy decision – the insurance is very valuable but if they charge more than the long term risk you may want to self insure.
So are you saying that you should buy disability insurance if you are a man and they will sell it to for less than 8% a year or 9% a year as a woman?
That’s exactly what I’m saying. Most of us should have disability insurance in our 20’s and 30’s when it is cheap. In our 40’s it is a toss up and in our 50’s we shouldn’t have it anymore in most cases.
The reason is when we are young we haven’t done most of our working and so we’ve captured very little of the $3,500,000 that we might earn. When we are in our 50’s we’re protecting less years of future income and it costs more to protect it so we should let it go in most cases.
I have disability coverage at work – isn’t that enough?
Most disability insurance policies at work only cover the first two years in your own highly paid occupation or field. After that they will usually only pay out the equivalent of minimum wage and they “coordinate” or cancel out with social security so you may only have about $12k a year to live on.
You have to pay taxes on benefits received from an employer paid for disability policy but you pay no taxes on benefits received from an employee or individual paid for disability policy.
Should I buy individual or a group policy?
Individual policies are often more expensive but not always. Principal is usually the cheapest individual policy from what we’ve found, especially for women. Individual policies are flat priced and so the premiums don’t go up but group policies start cheaper than individual policies and get very expensive as you get older. Individual policies have better language for a disability is and are less restrictive.
Generally, if you are in good health and are male you’ll get a better deal on the individual market. If you are female, or in bad health, you’ll usually get a better deal on the group disability market.
What should my insurance policy say?
It needs to be “own occupation” “guaranteed renewable” and “noncancellable.” This ensures that it will actually replace your income and they can’t cancel your insurance as you age. You may also want a “future purchase option” if you expect a step up in salary at the end of your training.
You’ll generally want insurance that is portable or moves with you if you change employers. Individual and group disability policies are almost always portable. Employer paid for policies are generally never portable.
How much disability insurance should I buy?
We recommend taking your annual expenditures and multiplying that number by 25. Next subtract your net worth from that number. Finally, divide that amount by your age to determine how much annual income you need to buy insurance on.
So if you are 30 and live off of $70,000 per year and have a net worth of $50,000 this is what it would look like.
$70,000 x 25 = $1,750,000 in total needs to maintain your current lifestyle
minus what you already have - $50,000
You’ll need to buy $1,700,000 of insurance divided by 35 years until retirement so you’ll need insurance for $48,500 per year.
As you get richer, you’ll need less and less disability insurance.
Any final statements?
Yeah, I don’t know you actual situation – so this discussion is purely hypothetical and I wouldn’t recommend acting on the recommendations you see above. Everyone’s situation is a little different. If you are a client of our firm, I will figure out for you what the best options are given your insurance coverage at work and provide a recommendation about what to do for disability insurance. But I really do think you should seriously consider buying some.
The Investor’s Dilemma – should you buy your investments on the public securities market or the private market? Part 2
By Daniel Harris, RIA, February 25, 2016
The requirement for additional capital contributions
When you invest in a tax advantaged asset on the public market, you’ll never be required to make an additional capital contribution. You may get diluted if they do a secondary offering – but you’ll always get some income without being on the hook for more money.
In the private market, you’ll routinely need to put more of your own money into the real estate or natural gas investment. You may be asked on short notice to come up with $50,000 or $100,000 to fix a major problem. In real estate – I’ve heard the general rule is to set aside 10% of your gross rent for vacancy and 10% for repairs but even while doing this you could still be on the hook for a major capital contribution that exceeds this amount. It’s the trade off for some of the tax benefits you get as a private owner.
If you buy on the public market, you’ll never be asked to anything. The worst that will usually happen to you is that they will do a secondary offering and your share value can get diluted, but this is not very common. Investments fail on both the private and public markets so there isn’t a difference there.
In a private market investment you may need to get involved, especially if you self manage. If you are being your own landlord, you will need to find tenants, properties, get a handyman, evict tenants ect. Some of these things may play on your personal strengths and you may be better than a public company manager at this – but when there is a problem it will be your problem and you will be the person taking a tenant to court to evict them.
Lack of Marketability – why you’ll want at least a 20% premium in annual income for owning a private asset
Public markets, like the NYSE, are by definition extremely liquid. If you sell a stock or a REIT or a MLP, you will have your money in your pocket in 4 business days.
Private markets are less liquid and you’ll need a higher rate of return to account for the fact that 1) it costs more to sell a private market asset [6% in commissions as opposed to a $10 fee for public assets] and 2) it takes longer for a sale to close [a few months as opposed to 4 days]. This isn’t a knock against private markets its just a statement that you’ll want to require a little higher return on the private market to compensate you for taking on some liquidity risk.
In Estate of Weinberg vs Tax Commissioner – 79 T.C.M. (CCH) 1507 (2000) the tax courts held the lack of marketability of an apartment building means that it should get a 20% discount to what a publicly traded asset should be worth. I think asking for 20% extra in return above what you can get for an equivalent asset on the public market is a good rule of thumb for investing in the private markets.
Lack of control over costs or when you can get your money out
Control is another big difference between the private market and the public market. By control, I mean that you can control your expenses and decide when to sell your asset.
In Estate of Weinberg vs. Tax Commissioner the tax courts held that not controlling what to do with an asset makes the asset about 37% less valuable. If it is both a private market asset (which is 20% less valuable than a public market asset) and you lack control over its major decisions the asset is worth 50% less than an equivalent publicly traded stock. [I realize it doesn’t add up to 57 –there is some overlap in the discounts according to the tax courts].
You can be in the private market and have control, such as when you own real estate as the sole owner and aren’t part of an HOA. However, when you own it as part of a group and are not the managing member you may have to cough up extra money when someone else decides to improve the building. In some group investments, you may not be able to sell when you want to.
In public markets you’ll almost never be asked to put more money into the project and you can always sell. So you get extra control on the public markets and if you aren’t you aren’t going to have that on the private market you should ask for at least a 50% higher return than a public market equivalent in order to compensate you for your lack of control and marketability.
So what type of return would get me to go into the private markets or get me to buy an asset that I could not control it’s costs or sale date
So here are the numbers that I would require to get me to consider any of these assets
Public Market Real Estate: 4.05% after all taxes
Private Market Real Estate when I’m in control (I own it without an HOA): 6.33% in after tax income
Private Market Real Estate when I’m not in control (bought through an HOA or group of some sort): 10.13% in annual after tax income
[I used after tax income here because the tax treatment is different depending on whether you use a publicly traded REIT or a private piece of real estate where you can personally depreciate the asset]
Publicly Traded Natural Resource Investment: 12.12% in annual income
Private Market Natural Resources investment when I’m in control: 15.15% in annual income
Private Market Natural Resource Investment when I’m not in control: 24.24% in annual income
My goal is not to knock the private market – which I think can be a really great place to be. If you hate volatility, the illiquidity of the private market can keep you from selling at the worst times because you can’t just click your mouse and liquidate your investment in a condo or building. Some investors need to be exclusively in the private markets and in bonds in order to do well. Some others hate the private market because they don’t want to have to write more checks or deal with hassles. A lot of investors can have a mix of these assets as the private market sometimes offers better opportunities and the public market sometime offers better opportunities.
But whatever you do, I hope you require at least an extra 20% in annual cash flow above what the public markets pay in order to compensate you for the fact that it just costs more money and takes more time to sell an unlisted asset as opposed to a publicly traded asset. If you go into a private deal where you don’t control the expenses or when you can get your money out, I hope you require at least a 50% premium in annual cash flow above what the public market will pay.
The best investors can keep an open mind and will look at the private market and the public market as viable options at almost all times. They know, that even more than taxes, the price you pay for the asset will really impact what you get out of it – and so you have to know your market well or find someone who does. And they will recognize both markets have their day in the sun and if your personality fits better for one of them (more involvement in improving the asset and continuing capital is required for the private market and less ongoing money and involvement is required for the public market) these are both very viable options for generating a good return on your investments.
The Investor’s Dilemma – should you buy your investments on the public securities market or the private market? Part 1
By Daniel Harris, RIA, February 25, 2016
Virtually all asset classes (real estate, natural resources, stocks, bonds) are available in both private and public market options. What are the differences and which is better?
The answer has more to do with your personality than anything else.
The Five Main Differences between buying on the public market and the private market
1) Tax Treatment
2) The Requirement for Ongoing Capital Contributions
Differences in tax treatment in real estate
Both publicly traded REITs and private real estate owners get to deduct depreciation. The difference is that with a REIT all of the depreciation was already deducted at the corporate level, so all the money they pay to you is taxed at your ordinary income rate, whereas in private real estate you can depreciate the property to shield some (but usually not all) of your rental income from immediate taxes.
For example, in public real estate you’ll get a current yield of 5.79%. There is no shielding of this income and you’ll pay perhaps 30% taxes on this income. You’ll pocket 70% of the dividend or roughly 4.08% after taxes.
In privately held residential real estate you can depreciate the value of your building over 27.5 years. So if you buy a $350,000 building, for the next 27.5 years you can shield your first $12,700 in rental profits from taxes. At a capitalization rate of 4%, which is where the current market is at in San Diego, you’ll make $14,000 in pre-tax profits (assuming you paid cash). You don’t owe any taxed on the first $12,700 and you’ll pay 30% on the final $1,300. Your after tax return is about 3.88% on the private market.
If you sell your asset, that $12,700 you did not previously pay taxes on, may be “recaptured” or taxed at a 25% rate at the time of sale. As I understand the rules, if you never sell your real estate there will never be a recapture.
Differences in tax treatment in natural resources
Both privately held and publicly traded natural resource investments have tremendous tax write offs. The reason is that publicly traded Master Limited Partnerships are pass through entities so all of the income, expenses, tax basis, depreciation and depletion is passed right through to you. If you own an oil well directly or its royalties you will also get the same shielding of your income from tax.
As with real estate, often you’ll pay very little in taxes in the early years of owning an oil well. As far as I can tell, there isn’t a tax difference between owning the oil well directly and owning it through an MLP, except that if you own it directly you might have more control over the expenses. If you own it through a MLP you won’t be asked to put more money in, in my experience, but someone else is making the investment decisions for the property which may impact your tax write offs.
Before you run off and invest in real estate or natural resources purely to try to save a ton in taxes remember this one critical thing…
The IRS does not give out tax deductions for free – you only get them because you’ll have to put more money into the property later so that it can continue to generate income or because you’ll take a big capital loss when you sell the asset because it will be all used up!
What is a building worth that is 70 years old and is crumbling from the inside? What about an oil well with no oil left in it?
Real estate assets don’t last forever. The typical commercial building in New York is only 57 years old, the typical school is close to 50 years old and the typical home is only about 35 years old. The typical oil well will run dry within 35 years. Like an old beater car – once these assets get old they can get really expensive to operate and maintain.
The rate of maintenance on say a school, I think, would be similar to other properties. The materials you build it with just don’t last forever. Here is an example of what is happening to America’s schools and why the old ones will eventually be abandoned.
“According to Ornstein (1994), when a school is 20-30 year old, frequent replacement of equipment is needed. Between 30-40 years old, the original equipment should have been replaced, including the roof and electrical equipment. After 40 years a school building begins rapid deterioration, and after 60 years most schools are abandoned”
[Source: The National Center for Educational Statistics ]
Real assets are great and they can help boost returns and belong in most people’s portfolios in a major way in our opinion – but don’t believe for two seconds that the depreciation is free – you only get the tax write off now because the IRS recognizes that one day your asset will be effectively worthless. In the interim hopefully you’ll get a lot of money off of it and the IRS gives you a break on that money because unlike with a stock – eventually the asset will be used up or fall into disrepair and they account for that in the tax write off.
With that said, the IRS depreciates and depletes assets over at a more accelerated rate than their actual useful life and that is where the true tax benefit lies.
What is your San Diego Real Estate Investment Property Worth These Days? Interview with Jeff Grant Founder and President of Sand and Sea Investments.
By Daniel Harris, RIA, Wednesday February 24, 2016
[I interviewed Jeff Grant about the state of San Diego real estate from an investor’s point of view. Jeff has an outstanding reputation in town amongst real estate investors for his honesty and work ethic. If you are or want to be a real estate investor you should definitely consider giving him a call or sending him an e-mail which can be found on his website. ]
The after tax, after inflation on municipal bonds is about 1.9% a year and the after tax return on publicly traded real estate investment trusts are about 4% per year. How does our local real estate market stack up to the after tax yields on those investments?
Jeff said that you should expect pretax returns of around 4% per year on investment properties in San Diego and after tax returns closer to 2%. So what we are seeing in San Diego closely mirrors what we are seeing nationally and also in the bond markets – low returns across the board for income investments.
I’ve heard that if you move away from condos or single family homes you can increase your investment return – is that true in San Diego?
Not right now. Because condos have high HOAs your monthly overhead is high and it is difficult to create above a 2% after expense and tax return in this market. So many people think they’ll just go out to duplexes or quads to get out from under the HOAs – but those markets are just as competitive right now so you’ll likely only get a 2% return after all taxes and expenses in the smaller multifamily market as well.
How to figure out what your real estate if worth – do sites like Trulia and Zillow provide an accurate view of what you can actually sell your real estate for?
According to Jeff these sites are often “not very accurate” and that their weaknesses “keep him employed.” There are a number of syndicated options and he thinks the best one at the moment is Redfin because they currently provide the most accurate estimates. Zillow, he claims, doesn’t currently account for some real primary criteria such as the height of a building in a downtown condo, or the fact the property may abut a major highway, and it doesn’t fully account for quality of schools in his experience. According to Jeff when they take a listing they look at least 5 of these sites and amongst the five sites they will usually see a range of 40% from the lowest price estimate to the highest priced estimate. He gave an example that a property that he thinks is worth $1 million, one of the five sites will say is worth $650k and the other will say it is worth $1.3 million.
If I come to you, how quickly could I get an idea of what I could sell my condo for?
Within a few hours. There is no secret to valuing real estate. It is valued either by its replacement cost (building a new structure), the income approach or the comps. Downtown is pretty easy because there is enough market activity that they can quickly see what they think the open market will pay.
In contrast, if you own a custom home out in Point Loma, the factors that come into play are the elevation, the year built, the ceiling height, the neighborhood ect.
Are there things an owner can do to increase the value of their property before they list it?
There are two things you can do to increase the marketability or value of your property. First, you can remodel your kitchen or bathroom which statistically creates a 1.5 times return on your investment into the remodel. Second, you can mention in the listing that you’ll provide a credit to remodel the kitchen (such as a $3,000 credit) which actually works pretty well.
If I’m a private real estate investor and have cash what are currently my best options in the San Diego market?
Jeff said that you’ll want to look at any changes in infrastructure or neighborhoods. It’s very hard to yield above 2% after taxes and expenses in this market, but there is potential for appreciation in neighborhoods where there is a major change in infrastructure or something of that sort. What you don’t make on cash flow you might make back later on better than inflation price appreciation.
For these neighborhoods that are becoming potentially more valuable but the market hasn’t fully recognized this, the best investor returns are likely in the $250k to $450k real estate. The $1 million and up market doesn’t have the same fundamental safety as the entry level market presumably because less people can afford to live in or rent a $1 million house. According to Jeff, the reason why the $250k to $450k range is a better investment is because lots of people can afford to rent those types of units, so there is a deep market for renters for this type of real estate.
As a seller does it make sense to sell with the appreciation we’ve recently seen?
If you bought in 2008 and want out now might be a good time. According to Jeff’s studies the real estate cycle in San Diego lasts about 15 years but we’ve seen such strong appreciation he’s not sure if there is much upside left in this current cycle.
Jeff says one way to do this for the long term investor, if they sell, is to stay outside the real estate market for 1-3 years and wait for another dip to hit and then try to take advantage of it.
How long does it usually take to sell an investment property in San Diego from when we first get in touch with you until when we get the money out of the deal?
We’ll list within a week and a half of the seller first getting in touch with us and once sold the buyer will have their money in 45 days. The average property spends 28 days on the market. Anything fairly priced is getting a lot of buyer attention right now.
What if you want to do a 1031 exchange – any advice for people in that position?
Those are tough right now. The best part of the market from an investment point of view is at the $250k-$450k level, but for a 1031 exchange to work, you have to buy a more expensive property than you sold. Most sellers with a 1031 exchange therefore need to buy a property that is worth $500k or more and that just isn’t a good part of the market for investment returns right now.
To generate an attractive cash flow currently you’ll need to improve the property and increase the rent. The deals that will generate a return and work for a 1031 exchange aren’t the ones that you just buy the nicer investment property – you’ll have to put some effort into it.
What are typical financing terms for nonowner occupied investment property in San Diego
You’ll usually have to put 25% down and pay an interest rate of 4.50% on a 30 year fixed for the investment property. Most deals are all cash right now – but if you finance, it usually won’t be through a big bank. There are adjustable rate options too but for the investor a fixed rate loan is better because it makes your expenses more predictable.
Business Valuation and Succession for the $1 million EBITDA and up company -- interview with Todd Poling, Founder and President of Vantage Point Advisors.
by: Daniel Harris RIA, Monday February 22, 2016
In our view, Vantage Point Advisors is the first firm you should be talking to if you own a business that pretax profits in excess of $1 million per year and you are thinking of selling in the next decade.
You can get Todd’s e-mail from his profile page at Vantage Point
Todd is a CPA and is a member of the American Society of Appraisers. He has experience at a Big 8 accounting firm, he served as a managing director of CBIZ Valuation Group (a national firm), and he has also worked as a general manager for a private company – so he’s seen all sides of business valuation. Todd started Vantage Point Advisors in 2005, and this local firm has since expanded nationally to have offices in Los Angeles and Philadelphia.
What jumped off the page to us, when we interviewed Todd was how well he actually knew the financial industry and the way public companies see the world. He also impressed us with how creative he was in proposing ways the make a private business more valuable to a public or large company buyer (who make up the majority of buyers for companies with revenues of $15 million and EBITDA above $1 million). We believe that if you work with Todd – you will probably earn a several fold return on the consulting fee you pay his firm. His fees are reasonable and in line with the industry as well.
Vantage point provides a range of valuation services to companies with between $1 million and $500 million in annual revenue. They have clusters of clients in the $1-$10 million range, the $50-$100 million range and then a few clients closer to the $500 million range. So they are in a position to see the industry from a very broad perspective – which is exactly what you need in a valuation firm.
We think if you are your family have a business with greater than $1 million per year in EBITDA – you absolutely need to talk to him as your first step in considering selling your business. As a valuation expert, he can tell you, without bias, how you will be perceived by a public or large company buyer and what your options are. More importantly, he can show you how a few small changes might significantly change the buyer’s perception of you – allowing you to potentially get a much better deal in an exit from the company.
Now, I don’t normally give such a long introduction (or provide a transcript of the interview mostly in its full form) – but I think he deserves it. On 2/19/16 Todd and I had a talk about what a company with $1 million + in EBITDA (pre-tax profit) can do to make themselves attractive to a large or public company buyer.
Can you tell us a little bit about the client’s you serve?
“Our client list looks like San Diego with lots of venture backed development stage companies where we value the stock options up to companies with $150-$200 million in EBITDA”
[EBITDA is your pretax profit or stated differently, earnings before interest, taxes, depreciation and amortization]
What kind of clients do you do valuation work for?
“We probably [do] 2/3rds of our work with traditional businesses – you know, closely held family businesses that are close to sale or in a sale or private companies where they have a specific valuation need whether they need to value their debt, or some warrants, or a purchase price allocation or something like that. I would say probably 1/3rd are venture backed type technology or biotech companies.”
Do you guys work for your clients more on a transactional basis, when there is a sale pending or are you always involved in some capacity for their valuation work?
“The best way to think about it is that we’re just purely just a financial valuation firm. And that is important because we’re not an accounting firm and we’re not an investment bank or business broker that is actually selling companies and representing companies for sale. We purely come in on a consulting role to value a business or a business interest.
Why we do that varies depending on the company’s need and generally the type of business or stage of development of the company will dictate what their needs are. For example, for venture backed companies like we talked about it is almost always a stock option or some type of financial reporting need…they’re not coming to us and saying ‘gosh we’re thinking of exiting in five years what might the valuation be.’ Of course the venture backed firms are thinking about exiting – they’re VC backed – they’re going to go public, they’re going to get bought or they’re going to fail.”
How does a traditional family held businesses end up using valuation services?
“You get into your traditional closely held [often family] business which might be as little as half a million or so in EBITDA up to tens of millions or more in EBITDA and the issues they have around valuation are completely different.
They may have a buy-sell issue where a shareholder is leaving. They may have a family succession planning problem or opportunity where dad is trying to transfer 20% interest each year for five years to his son or elements of the family or maybe some internal family and some external not related management team.
ESOP’s, of course, are their own animal.
[They also do valuations for] shareholder disputes, ‘I think I want to leave the company and I think the value of my shares are worth 10 and you want to stay [at the company] and you think they are worth 5’. The buy-sell agreement says that you need to have an appraisal of the shares done – so we’ll come in and value the shares.”
Finally there is “real estate appraisal and fixed asset appraisal which we do not do. Sometimes it is a subset of the business valuation where there may be a real estate appraiser involved as well where we just partner with them”
What about a public or large company exit for these closely held businesses?
“The company says – we’d like to think about an exit in the next 5-7 years and we’d like to sell for $50 million and were interested in
a) what is the valuation today and whether we are in shouting distance of that type of exit and
b) more importantly, what the company needs to look like 5 years hence in order to command that $50 million valuation.”
Do you do these valuations in a one off way – or do you stay with the process all the way until the sale of a closely held family business?
“It depends on when the client comes to us.…every week I’ll get a call from someone in a family owned or closely held business – nice companies, good companies, companies that are on buyers radars or it’s a competitor or a high net worth individual that wants to buy a business or PE [private equity] firm – these are good companies that are names people know.
And they say to me – ‘someone is calling me and is interested in buying our business and they are offering me 4 times cash flow which is $4 million – I need you to do a valuation for us’
…and I’ll say ‘we’re happy to do it – the best we can do is provide you an analysis that will give you a reference point to evaluate the reasonableness of that $4 million offer’
…but you’re dead in the water as a seller because your only negotiating leverage [the owner has] is to say no because you haven’t been proactive and the buyer is in control in that context.
In that case we may do the valuation, we may help them along a little bit in the negotiation although that is typically when I introduce them to a business attorney because now it is more about deal points – you set the price and we’ll set the terms. They may get their $4 million but what if it is 75% in an earn out – they may lose control of everything.
Is there a way for the family to be proactive about the process and give the seller actual leverage in the negotiation?
“So any [business valuation after an offer] is a little less useful than if somebody comes and says we’re finally getting serious about this thing called an exit and we want to
 plan ahead
 want to time the market the best we can
 we want to build our business to sell
 we want to really clean it up and tighten up our management team
 diversify our customers geographical mix or concentration if we have that problem
 start to identify who some of the proper buyers might be
In that case – we’ll do a two phased analysis where we do a current valuation but also a pro forma, sort of reverse engineered exit date evaluation. We’d probably spend 2/3 of our time on the exit date valuation as opposed to the current date valuation because they’re not selling the business today.
…It’s no different from modeling someone’s portfolio who says I want $10,000 a month in income 20 years from now – you have to have that number of what they want before you can show them what they need to be doing now”
So basically the seller comes to you and says I want to sell my business for x amount and you walk them through the steps of what they have to do so they could actually sell it for that amount?
“Yeah – that’s right. We say in order for you to get $50 million five years from now, to keep it simple, you’ll need $10 million in EBITDA if it is a 5 times EBITDA type business. And if you’re at 25% EBITDA margins and then it’s just doing the math and then you can build a trajectory around the business to get there then it gets interesting because you start to identify things like – wow – that’s a growth rate that we can’t even think about achieving with our current scale and team so we have to think about acquisitions or really bringing on capital to augment what we are doing or doing different things.
And then there is risk, you are now talking about a different business. [After seeing what it would take to get the exit you want] you might ask yourself would I rather have a $30 million exit with modest risk than the potential for a $50 million exit with a lot of risk that may tip me over and I might not get anything.
That’s the best case scenario – someone comes in early and we might work with them on an annual or even quarterly basis – we won’t be the only one on the advisory team…there is probably an operational consultant…if you don’t have a board or an advisory board you probably need a third party keeping the management team honest and probably revisiting or at least making sure your tax planning is in order because it is cash in your pocket after taxes that matters most so you are building a business that will have a preferential tax strategy after the exit. Then a financial advisor, a guy like you who is there at the end as well. It all has to get married together. Those are great projects because we can have influence little by little and update the analysis as we go.
A year later when we are doing the first annual update, we look at their projection and they have a five year projection and a discounted cash flow analysis and we realize they are three months behind plan on revenue and the reasons are all the things you always hear: ‘well this customer did this and that customer did that and Sheldon left and blah blah blah.’
Well didn’t we sort of know that? Don’t we all lose customers? Doesn’t every project cost more and take longer than you thought it was going to – so if that is the case why aren’t you modeling that in?
And then they realize that they have to stretch it out and with their modified plan [and now] it’s taking them three years what they hoped to do in two. Well, that has a huge impact on value.
But most of the time companies wait too long until someone has called them and that’s natural – you’re busy, you’re working hard, you’re growing your company – you’re not spending as much time on housekeeping and strategic things as you should be.”
Who is the optimal client for this proactive accountability to get a family business ready for sale?
“It doesn’t really matter how big the company or how long they have been around or anything. They need to be a real company…one that is at or reasonably close to $1 million in EBITDA – and that’s not because of us – it’s because the cost of buying a business with diligence and research and from a brain damage standpoint is significant. It’s probably not much harder to review a company with $2 million in EBITDA than one with $500,000 in EBITDA. In fact, you can make the argument that it is probably easier because the data is better, you’ve got a smart controller and assistant controller in a $2 million EBITDA company, the owner is less important, you probably have a compiled or reviewed financial statement as opposed to quickbooks.”
[After that] it’s on a case by case basis – the ideal client is someone who will give themselves time to model and mold their business into something that is really appealing to a buyer.
….As an owner or leader any time you get your status quo challenged it is probably an effective exercise. Going through that process will help the owner identify, and I say that carefully, we’re not the ones who say you need to upgrade your management team – we’re the ones who come in and recognize in the course of the valuation…and we help the owner recognize that they’re going to need a different team to get to the point that they want to get to.
And they’ve all probably known that at some level but they are loyal and they’re busy and its hard to change and they kept a person too long or they really need a $250k CFO not a $175k hot shot controller. They’re trying to save 75 grand, but they are never going to get to the other side of the bay without that CFO. So, I think we help them understand and identify some of the issues that are going to be impediments to getting to the exit that they want.”
What are the things that you see holding certain businesses at lower valuations?
“The usual suspects are team, competitive position in the marketplace whether it is customer concentration, geographic concentration, and things like that. You’re [usually] going to need to grow beyond your current range of fullness in order to get to the valuation that you want to get to.
That always then changes the discussion around capital. You realize your bank is probably not the right bank and they may find out that they have a bunch of SBA loans, just as an aside, wrapped around owner occupied real estate – it’s going to cost them an arm and a leg to get out of just in order to upgrade their banking relationship. And they are like “oh man” right? So it’s a lack of flexibility in their banking relationship. Maybe they need to bring on outside capital in the form of real equity. Those things always come up and then challenge the management team to think or rethink what they are doing along those lines so they can position the business to get to where they want to get.
The last layer of the onion is that risk. I mentioned that a few minutes ago. They may go ‘gosh, you know what, on second thought, I don’t really want to sign up for that’.
It’s kind of like some of these athletes that are great in high school and they go to Kentucky to play basketball or Texas to play football and realize they should have stayed closer to home. It just doesn’t work for their personality. So then you have to say, well, you’re going to need to scale back your expectations and that’s ok. The beautiful thing about owning a company is that you can do what you want. Nobody is going to fire you because you don’t want to grow the business at 20% per year
….Maybe you want to bring in a team and say ‘you know what – I’ve reached my limitations and I need to bring in a team in order to get to that next level and I’m ready to do that now.’ Those are the kind of conversations that invariably come from a [business] valuation and they have nothing to do with valuation – none of those things have anything to do with valuation. They’re byproducts of going through the process and recognizing where you need to be in order to get to that next step, and the following step, so that you can get to the exit you want.
Is the exit typically a public company buyer in the same industry, is it a financial buyer or is it usually a private company buyer?
“That’s an interesting question. It is almost always not an IPO. Very few companies go public for fairly obvious reasons.
…There are basically more or less four different paths [an owner can take when considering an exit]”
“One is sell to a strategic [a buyer from your own industry], two is sell to a financial buyer [like a private equity firm], three is an ESOP or some kind of a management buyout thing, which is an internal transaction, and four which a lot of times owners don’t ever think about is maybe the best transaction is not selling”
“We spend a lot of time helping the [management or ownership] team understand what they have so they can evaluate what they might get and I think that’s lost a lot of time on people where they think about ‘man if I’ve got a $2 million EBIDTA I might think I might get 6 times [EBITDA] from a strategic buyer, I’ll get 5 times from a financial buyer.’ Okay great – are you going to get cash in both of those deals? Or are you going to get an earn out? Is the strategic buyer going to give you stock? Are they going to fire your entire team – is it worth $2 million to ruin 30 years worth of relationships? Those are rhetorical questions that no one can answer other than the seller. But they need to be asked.
…Then you get into things like ESOP and go ‘maybe I’m only going to get 4.5 times [EBITDA] with an ESOP – [but] if I’m an S Corp ESOP – I’m not going to be paying any taxes – it’s on a pass through basis. In California that’s a big deal - if you are clipping along at $2, $3, $4 million in EBITDA – what are you paying – 60%? So [the corporate taxes] goes away [with the use an S Corp ESOP structure] so your 4.5x is effectively a 7 or 8. It not cash in the bank today – you’re going to take a note back and all these other things but it is something to seriously consider.
…Then there is the option to do nothing for now. If you are getting 5x EBITDA in a sale and lets say it’s a cash deal so you get $7.5 million, but there are some transaction costs so now you got $7 million and there are some management people you want to take care of – but you gave up a business that was growing and you were happy and you had a whole bunch of tax benefits because you were running a whole bunch of garbage through the company and, and, and, the list goes on.
So you go ‘gosh, you know if I just keep my company I’ll get that $7 million if I do $2 million of EBITDA this year and $2.5 million next year and $3 [million] after that – I’m going to get my $7 million after tax back in four years and still own my company.
What about a market timing element – are certain businesses in demand at a certain time? Does that impact this process at all? For example – using a public company example – what is an oil company worth in 2006 versus an oil company today? Does that come into the private company valuations in your modeling estimates?
“Yes! And that is a thing that I think is really understated and under appreciated.
…Assuming you have liquidity and estate planning set up so time is on your side, you can time the market [as a business owner] in just about any industry.
You’ll see over the course of a business cycle a 2x or maybe even a 3x differential in multiples [a multiple is the number times your amount of pre-tax profit that equals company’s market value or worth]. If you are in the restaurant supply equipment market you might be in a cycle [where you are worth] 2 times [EBITDA] and you might see a [multiple] of 5 or 6 times in the cycle. If you know that is coming, why would you ever sell at 2? Why wouldn’t you say let’s build my plan so I can get as big and fast and strong as I can, as soon as I possibly can, then recognize when I’m getting close to that peak and the multiples are getting close to the 4s and 5s that’s probably when I want to press the eject button.”
[Todd is basically saying you should wait for good general market conditions to sell. This is exactly what investment bankers and private equity sellers do when clustering IPO’s in mid to late bull markets when there is strong buyer demand and holding back IPO’s when market conditions are negative for a given industry]
As an almost final question, I see your firm does some work valuing assets in family limited partnerships – can you talk about that a little bit?
“On family limited partnerships and discount studies… [they value discounts] on portfolios of business interests or business real estate.
For example, someone may own 10 apartment buildings all in separate LLCs. Let’s just say each one of those is worth $10 million in asset value or $100 million in total. If they gift a 2% limited partnership interest in the Master LP, it’s not going to worth $2 million. It is going to be worth $2 million less discounts for lack of control and lack of marketability. So we’ll do that valuation analysis that provides the discount study to the $2 million, pro rata interest, which might be 40% in total. So it might get discounted down to $1.2 million.”
What about Grantor Retained Annuity Trusts – where you zero them out after a couple of years – do you do that as well?
“We do that. There are usually three people at the table when that happens. There is usually a trust attorney or estate attorney, there is usually a tax CPA, and a valuation firm. And we do the appraisal element which is the discount study, the estate attorney does the estate planning work, and the tax accountant is just sort of their in the middle. We’re not qualified to do the legal or the accounting.”
Thank you for sharing your insights with us
“Does it make sense to index treasuries?”
By Daniel Harris RIA, Saturday February 20, 2016
Index funds have made a big push into the bond markets in order to save costs for investors. What most investors don’t know is that the index fund is often dramatically more expensive than going direct and buying the bonds directly from the government through an online brokerage firm. You can usually buy your government bonds for free from an online brokerage firm and have no costs of maintaining an automated bond buying program often called an “automatic roll” where when one bond matures, your online broker buys the exact same bond the next week at the next auction.
By contrast, the latest trend in this is the tremendous growth in the assets under management of the very short-term US Treasury bond ETFs. These funds generally hold treasuries that mature in less than a year and most the bonds in the funds mature in the next 3-6 months. These funds pay an after expense yield of only 0.10% and cost 0.15% per year to operate (to buy a security that the government will sell to you without any transaction costs).
Additionally, if you buy through an index fund you’ll also have to pay a standard brokerage commission ($7 or so) when you buy and sell these ETF’s. These funds have seen tremendous inflows – having drawn in roughly $2 billion in client money in the last month or so which is an up to 80% increase in their asset base.
Index funds aren’t free – it’s just as expensive to send out a prospectus for a very short-term bond fund as it is for a stock fund. You still need a major accounting firm to do the fund’s tax calculations and audit your books. You still have legal requirements to comply with – as a result even in very short-term treasury bonds you have to pay 0.15% in fees in many cases even though you can generally buy their underlying assets without paying any transaction or maintenance costs.
For example, every Monday or Tuesday, the U.S. government sells a ton of short-term treasury bills at auction. This past week the government sold $30 billion in 6 month Treasury Bills directly to the public. Everyone gets the same price. The most recent batch of Treasury Bills that mature in August of 2016, were just sold for with a 6-month yield of 0.21%. In August when these bills mature – you can buy another set of 6-month bonds that will also likely pay 0.21% in interest. So every year you are getting 0.42% in interest on your bonds – which is at least 4 times what you’ll earn on your money market account or a comparable maturity short-term treasury bond etf.
At online brokerage firms, there is generally no charge to buy treasury bonds so long as you buy them directly from the government at the auction and not from some other bond investor on the secondary market. Usually you only need to keep $3,000 in the treasury bonds to get this service for free.
Alternatively, people like me can always reinvest your maturing bond portfolios very easily at virtually no cost to you. It’s so easy for me to buy at the auction that it takes virtually no work but it often more quadruples your yield compared to if you bought treasuries through an etf. By using a person to buy at the auction you can make a conscious decision of whether to but the one-month, three-month or six month treasury bill based on the expected yield at that auction. Or, by using a brokerage “automatic roll” program you select one of these maturity dates and the broker will automatically purchase the same maturity bond over and over again regardless of changes in yield until you tell it to stop.
How can your brokerage firm and I underprice the major index fund companies on your bonds? Easy – every index fund has its own legal structure, which the investor is forced to pay for. We don’t have these expenses – so we’re much cheaper or sometimes even free.
Now, the same fund company that charges you 0.15% for low yielding bonds, will probably charge you 0.07% for a large cap US stock index fund. So you get stuck with higher costs on a less productive asset. They aren’t being dishonest; their firm has higher costs in auditing treasury holdings because they are turned over more frequently so the audit takes more work. So the legal procedures are expensive and not really justified when you can buy the assets directly through your brokerage firm and have $0 in transaction or maintenance costs.
Doing it yourself or through an inexpensive advisor for convenience will likely quadruple your annual interest received from 0.10% to 0.42%. The market is full of these little anomalies where you can save money by something slightly differently.
For some investors, particularly those who invest in private real estate, or need their money soon, maintaining a bond buying program is a good idea as we can precisely match maturity dates with when you need your money to make down payments or commitments to your real estate projects. A very efficient bond buying program, using highly liquid and very safe investments will almost always boost the yield of your money while you aren’t using it, while taking extremely little risk. It also saves you the time of having to find the bonds that fit your needs and putting in all the orders yourself. If you’d like to learn more about our bond buying programs and what it costs (it’s super cheap) simply e-mail us and let us know of your interest.
“Why economic game changes are common but stock market game changers are rare”
By: Daniel Harris RIA, Thursday 2/18/16
One of the things that I find with a lot of clients who come to me is that they don’t really know the odds of the game they are playing. To help you out, I’m going to lay out the odds of an investment loss if you invest in large U.S. company stocks. These odds are derived from historical experience. I’m going to talk about how severe the losses have been in the past and how common it is to lose money in U.S. stocks.
What are your odds that you make money in a given year investing in the S&P 500 (data is from 1926-2015)
Odd of making money in a given year: 74%
Odds of losing money in a given year: 26%
So, as you can see historically, you’ve had a nearly 3 in 4 chance of making money in any given year when buying the S&P 500.
If I lose money how likely am I to lose money in a given year and how much am I likely to lose (data is from 1926-2015)
Remember the odds are you make money almost ¾ of the time. But what are your odds of a big loss?
In any given year, you have only about a 6% chance of having a loss of greater than 20% and a 94% chance of losing less than 20% or making a profit.
Stated another way, in all years in which you lose money your odds are about 2 in 3 that you’ll lose less than 10% and 3 in 4 that you’ll lose less than 15%. Even when you lose money – it’s uncommon to take a loss of more than 15% and its more likely than not that your loss will be less than 10% in any given year.
Odds of a loss this severe impacting you in any given year (out of 90 years of data 1926-2015)
0-5% loss in portfolio value in a given year: 6% chance
5.1%-10% loss in value in a given year: 11% chance
10.1-15% loss in value in a given year: 3% chance
15.1%-20% loss in value in a given year: never happened before
20.1%-25% loss in value in a given year: 2% chance (happened in 1930 and 2002)
25.1%-30% loss in value in a given year: 1% chance (happened in 1974)
30.1%-35% loss in value in a given year: 1% chance (happened in 1937)
30.1%-40% loss in value in a given year: 1% chance (happened in 2008)
40.1%-45% loss in value in a given year: 1% chance (happened in 1933)
Now you might be wondering – isn’t this an overly simplistic way to look at investing? Are past returns predictive of future outcomes?
While they aren’t a guarantee of course, they give you a pretty good idea of how prices have swung around in the U.S. stock market in the past and it’s historically been a pretty good predictor of future returns. You’ll notice the really bad years are not randomly distributed – rather they come after periods of asset price inflation (1930 and 1933 happened after the roaring 20’s stock bubble; 1974 happened after the 1960’s stock market bubble and the craze for conglomerates; 2002 and 2008 happened in the aftermath of the tech stock equity bubble). This is why we try to warn out clients to not overpay for stocks (or any other asset class) – because that is how you get majorly burned in investing.
You can get a string of bad years together – which similarly happens a lot after asset price run ups. While a lot of investors are very focused on fees – we find that very few investors naturally focus on what actually matters – how likely they are to take a 30-45% loss in a given year. Those losses really hurt, and while you recover from them, we really think that you should try to do what you can to avoid them where possible.
So what about those economic game changers…
While the odds are 74% that you’ll make money in any given year, and 22% that if you lose money, you’ll lose less than 15% of your portfolio value in a given year – the odds are actually high that you will experience a rare event in the real economy.
Here are some examples
The covered period has seen 3 separate equity bubbles and collapses
The covered period saw 30 Year US Treasury Bond rates range from 15.21% and as low as 1.58% (which recently happened in January 2015)
The covered period has seen a period of rationing, has seen us temporarily losing in a major World War and fighting to a stalemate in two other wars
The covered period has seen a nuclear arms scare
During the covered period, the economy experienced deflation 11% of the time in five separate periods (1926-28, 1930-32, 1938-39, 1949, 1954) and we nearly experienced deflation in 2008
The economy experienced hyperinflation (10% or more growth in the interest rates) 5% of the time and in three separate periods (1946, 1974 and 1978-79).
So what is the take away?
I want to you understand that weird economic events like hyperinflation or deflation, low or high interest rates, rationing, wars, and other seeming unique events happen with a much higher frequency than we think they would.
Alternatively, big stock market losses are actually much less common than we think. The historic odds are 91% that you will either make money in stocks in a given year or suffer a single digit decline in your portfolio value. It’s for this reason that smart investors know that stocks are usually a good deal and the actual risk has been much lower than what we usually perceive.
If you want to get our analysis on whether your odds of loss are higher or lower than these historical odds feel free to get in touch with us.
So I decided to become an insurance agent
By Daniel Harris, RIA, Sunday February 14, 2016
So I decided to become an insurance agent. Let me tell you what that entails and see what you think.
1) I apply to become an insurance agent – as a regulated field – the state department of insurance overseas me, the insurance companies and our behavior. They fingerprint me and make me sign a consent form to receive service of process.
2) I sit in a class for 4 days as the teacher teaches us about insurance. The teacher is a portly, middle aged dude who dresses and acts like he came straight from the Sopranos. He wears a different pastel color polyester tracksuit to teach the class each day (true story - the guy who taught my insurance class actually dressed like that).
3) After sitting through class and maybe studying an hour or two a night afterwards – me and my fellow classmates take an 85 question multiple choice test about insurance. I get 40% of the multiple choice questions wrong, but that isn’t a problem, you only need to get 60% right to become an agent where I live.
4) Now comes the fun part – I have to contract with or be appointed by an insurance company to sell their product. The insurance company has all the power in the relationship and only lets me work for them if I sign what many lawyers might consider to be a contract of adhesion. Here are the terms:
A. You, insurance agent, are an independent contractor and we, big insurance company, are not your employer. You work for a broker appointed by us, who we call our broker or managing regional director. Despite the awe inspiring title, our contract with him states that he is not an employee of our company either.
B. We, big insurance company, agree to pay you $2,500 per month or roughly $30,000 per year to sell our products. However, this isn’t a salary – this is a debt you owe us. You will be working for us for free and you will be in debt to us from day one. We may charge you for pencils, office space, computer use time and various other expenses at our discretion. Although we are not paying you for your work, we may charge you for what we feel it costs us to train you.
C. Although you are an independent contractor per our contract – we have a right to fine you if we don’t like what you do. We may charge you up to $2,000 per event at our own discretion. If you don’t have commissions to offset this it becomes a debt that you owe the company. You may have negative earnings from your engagement with the company.
D. We hold ourselves out to the world as a company you can trust – and that these are our employees – but almost everyone the customer interacts with is not actually employed by our company. If you were an employee we would be legally responsible for your behavior, as employers typically are under the law, – but we can get around that by making you an independent contractor – so that is what we are going to do. If you lie to a customer or break the rules, we can simply terminate your contract and say we didn’t know that you were lying to customers. Moreover, the general agent, broker or managing district manager who hired you is expected to rent office space, pay for employees, and take on debt to help sell the company’s products but we have the right to terminate his contract at any time for any reason. He will not be reimbursed for the debt or expenses he incurred in order to sell our insurance products even though the office carries our name, logo and branding and we create the impression to the public that these are employees of our firm and we will be responsible for their actions.
E. The only compensation that you will receive from us is a percentage of your gross premiums written – so write lots of premiums. We hope you will sell products like permanent life insurance or variable annuities that we may know are bad for the customer but are extremely enriching to us. For example, if you sell a whole life “permanent” policy we may pay you up to 85% of the first year premiums plus 7.5% of premiums received for the next 8 years. If you sell a term policy we will pay you 85% of your first year premiums and no money after that. If you sell a variable annuity we will pay you up to 8% of the premium amount in commissions.
F. We can require you at our discretion to sell a certain number of products of our choosing, to your customers in order to keep this contract with us.
Now of course, this post was satirical – I’m not applying to be a life insurance agent and this contract is not from an actual insurance company. However, many of the clauses I used in it were pulled from real publicly available contracts between the insurance companies and their brokers. You don’t have to search far on the Internet to find that many of these firms really do put their agents in debt and don’t actually pay them.
I tend to think that where you see high commissions and draconian business practices you usually will see really crappy products being pushed as well. Where there is smoke there is usually fire. I’m extremely cautious about the life insurance industry given their commission structure and business practices.
I feel that instead of just improving their product, many insurance companies decided to take a two prong strategy of paying high commissions (which takes money out of the customers pocket to the benefit of the agent but not the customer or the insurance company) and virtual contracts of adhesion which puts the agents in debt and puts extreme financial pressure on them to act in the insurance company’s best interest and to the detriment of the customer.
Not surprisingly, life insurance has been in a major decline for 50 years. In 1960, 70% of American owned life insurance, by 1992 that number had fallen to 55% and by 2010 that number was down to 44%. These companies have lost 40% of their relative market share in the last 50 years.
I believe for 99% of the population (those currently under the estate tax limit) a little bit of term insurance from one of the good guys in the insurance business is the way to go. Permanent and universal life insurance policies are usually not written in the customer’s interest, in my view, and they as well as variable annuities should be reviewed carefully even years after you bought them.
How will we pay for James’s College?
By Daniel Harris, RIA, Saturday February 13, 2016
I’ve been really lucky in my life and I’ve had two wonderful things happen to me.
First, I got the benefit of a first rate education at Stanford University. Second, a few months ago my
wife and I were blessed with a beautiful baby boy who we love deeply. Being the planner that I am,
I immediately started to think about what we could do we to help James have as good of a college
education as we had.
My first thought was what does college actually cost and how much money do we need
to set aside for various university options for James. Here is how much we need to set aside in
before tax earnings for each of the following options. In brackets I placed how much we need to
save starting this year. Each year that amount needs to be revisited and adjusted up with actual
rate of educational inflation costs.
Option 1: James attends community college for 2.5 years and finishes up at San Diego State while living at home – Cost: $47,000 [Need to save $2,136 per year]
Option 2: James attends San Diego State for college and lives at home – Cost: $56,030 [Need to save $2,546 per year]
Option 3: Attends the community college for 2.5 years and attends UC San Diego for 2.5 years -- Cost: $73,020 [Need to save $3,319 per year]
Option 4: James attends UC San Diego and lives at home -- Cost: $101,000 [Need to save $4,590 per year]
Option 5: James attends UC Berkeley and lives with family – Cost: $150,000 [Need to save $6,818 per year]
Option 6: James attends a UC school (say UCLA) in a city where we have no family and lives in the dorms and an apartment – Cost: $190,000 [Need to save $8,636 per year]
Option 7: James attends my alma mater, Stanford and lives in the dorms as all students do – Cost: $420,000 [Need to save $19,090 per year]
As you can see college can be pretty affordable if you take the cheapest option and it can be very expensive if you take the most expensive option. If you shoot for the middle – a UC level undergraduate education you need to save $3,319 per year for the local UC or $8,636 per year for an out of town UC. The big difference is that room and board makes up a substantial amount of the expenses for paying for college.
There are three ways to pay for college; the first two have some tax benefits.
Our first choice: Coverdell ESA
The best is an Educational Savings Account. Most electronic brokerage firms have these and they don’t cost hardly anything to have. The downside is that you can only put $2,000 per year in them per beneficiary per year. Like all forms of college savings, you fund it with after tax money but like the 529, none of the gains are exposed to capital gains tax so long as your kid uses the money for college. They must use it to pay for education by age 30. As the parent you control the account until they are 18.
This account is best because it has no fees other than commissions and you can invest in almost anything, which you can’t do in a 529. You can only fund it if your Modified Adjusted Gross Income is under $220,000 as a married couple. If you are above this income level you can’t contribute to the Coverdell ESA. We use the Coverdell ESA whenever we are eligible and put the full $2,000 in whenever we can. We will always put our first $2,000 in the Coverdell ESA if we are eligible.
Once we’ve filled up the Coverdell ESA then we will fund the Utah Education Savings Plan (529) and invest in growth assets that are selling for attractive prices
The second best option is the Utah 529 Plan. The 529 Plan should always be held in the parent’s name in our opinion. The reason is that under FAFSA kids are expected to contribute 20% of their assets to college whereas parents are only expected to contribute 5% of their assets each year. It may not do much to get you scholarships or financial aid, if you have a lot of assets, but putting a 529 in your own name and naming yourself as the beneficiary gives you better control of the money and reduces the expected student contribution for the cost of college.
By far, the best 529 plan is the Utah Education Savings Plan. The Utah plan is the cheapest plan that has a truly diverse menu of investment options. There are some really cheap plans but they accomplish this by only letting you invest in really big companies or the types of assets that have lower capital gains. You need a plan with both domestic and international growth assets – which Utah is the cheapest plan to have both. The main advantage of the 529 is that you don’t pay taxes on capital gains – so to benefit from that you need to invest in assets that will generate lots of capital gains. As you get closer you can get more conservative but you should be investing 100% in growth assets at the start to benefit from the tax-free compounding.
You might wonder – why aren’t we using our in state plan, the California Scholar Share Plan for James? Our reasoning is that there is no tax incentive to use the California plan because unlike most states you don’t get a California state income tax deduction for contributing to the California Scholar Share Plan. So, as a California resident, all state plans are the same for us from a tax point of view. Therefore, we might as well use the cheapest state plan with the best investment options (those that can grow the most). Utah has great options and only costs 0.20% to 0.60% to operate even with fund fees. California’s fund options are not good in our opinion and can also be a little bit more expensive.
How will we invest James 529? We will use Utah’s customized static option that lets you put together a portfolio of index funds from Vanguard and Dimensional Funds. You can only change your investment selections twice a year – but we will only change them once a year. We will buy what is cheap and growth oriented in order to maximize the tax-free capital gains in the account (which is the primary benefit of having a 529).
How much will we put in a year? Our plan is to try to fund it with $3-$8k per year which should either pay for or help pay for a good UC education. Parents can put away up to $28,000 per kid per year – so long as each parent contributes $14,000 each. If you start early – you can send your kid to Stanford (you’ll only need to set aside around $19k a year for that) on the available amount of annual contributions.
I wouldn’t expect a lot of investment gains above the rate of inflation for two reasons. First, last time I checked the rate of educational inflation was about 5% per year so even quickly growing assets will only grow a little bit more than the cost of school. Second, you don’t have much time to make the money compound – if you can grow the money at 7% a year, or 2% a year above the rate of educational inflation – your account will take 36 years to double in value. The tax advantage is valuable but the account simply cannot grow enough in the 18-22 years until the money will be needed – so I believe that you’ll need to contribute at the suggested levels to pay for school.
Option 3 – UGMA/UTMA
As you can see – unless you are paying for medical school there is no need to go outside of a 529 to fund your kid’s education. Our goal is to help James with this undergrad and pay a lot of the costs if we can – but grad school is on him. If it is economically worthwhile he can fund it.
My parents have discouraged us from using a 529 because they feel college is overpriced and you pay a penalty if the money isn’t used for college education.
Just to clear the rules – the penalty is assessed on gains inside the 529 from investment profits – there is no penalty if you withdraw your 529 contributions. You can pull out your contributions tax free for any reason according to my understanding of the rules.
If you do pull out the profits on the investments and don’t use it for education, you will be taxed at your ordinary income rate on the gains and will have a 10% penalty added to them. So essentially when you use a 529 you are betting your investment profits on the fact that your kid is going to go to college – you aren’t betting your principal.
A UGMA/UTMA account is an account that you set up for you kid and your control until they turn 18. You and your spouse can contribute up to $14,000 a year each per year ($28,000 as a married couple). You can use this to transfer money to your kid, which he can use for any reason. Until he is 18, the parents will manage the account – after he turns 18 he owns the account and can spend it on whatever he likes.
By contrast, in a 529 owned in the parent’s name – the parent controls the account forever. You can give the money to any relative to educational expenses – including your grandkids. James, for example couldn’t take the money when he is 18 to go buy a McLaren or explore his artistic side without our consent. If we don’t approve of what he wants to spend the money on we don’t have to release the money. This is why Linda and I prefer the 529 for him.
Instead of looking at the 6 figure ticket price for a college education – we have broken it down into small manageable goals and we think by using the right structures and the right investments we can help buy James a top rate college education for $4-$8k per year. I hope you can do the same for your little bundle of joys as well!