A few years ago, I read Thomas Piketty’s book, Capital in the Twenty-First Century. This behemoth of economic research covers the history of income and wealth inequality in Europe and the US. One thing that struck me at the time, and has left a lasting impression, are the statistics on capital vs. wage growth over time and the significance of their implications. His research shows that historically, the rate of return on capital outpaces the economic growth rate (and therefore the growth in wages).
How does this have anything to do with inheritance?
If the rate of return on capital is greater than wage growth, it is more efficient to deploy your money to create wealth than it is to work a w-2 job. Take a person who earns an annual salary of $50,000 and pit him against a portfolio of equity assets earning an average market return resulting in annual earnings of $50,000. Each year, the W-2 person will get a raise equal to the growth rate and the portfolio of assets will grow according to market return for that year. Over the long run, the earnings from the portfolio will grow significantly larger than the earnings from the wage-earning person. Not to mention, the person is spending his days away from his family, losing time that he could have been spending on something he values more.
Now, what if that portfolio is passed on in an inheritance and is not only large enough to provide a steady stream of passive income equal to the beneficiary’s annual needs, but also large enough to continue growing itself in order to provide for the next generation’s needs.
How large would this portfolio need to be? Let’s take a $2.5 million portfolio. If the inheritor withdrew an inflation-adjusted 2% a year ($50,000 the first year, and more each subsequent year to account for inflation), and the portfolio earned the long-term real rate of return for equities of 7%, the portfolio would continue to grow at 5% each year. That means it would double roughly every 15 years, or quadruple every 30 years, which coincidentally is about a generation. Theoretically, the money could provide a steady source of passive income for future generations, indefinitely.
These are the kinds of things I think about when I read boring economic research. That’s not weird, right?
But aren’t most people just trying to scrape up enough money to make ends meet for their own retirement? Sadly, yes, but fortunately, the FIRE community isn’t comprised of “most people.”
So how is someone who adheres to FIRE principles ever going to end up with more wealth than they need if they follow the 4% rule?
The FIRE community strives to accumulate investable assets equal to 25 times their annual expenses in order to have the ability to retire and have their investment income support their expenses. We shoot for the 4% rule because historically it gives us pretty good odds of our money lasting at least 30 years, and probably longer. But unless you are fairly unlucky and suffer a large market downturn very shortly after retirement, chances are the market’s historical real rate of return of 7% will far outpace your 4% withdrawal rate and you will be left with significantly more money when you die than you had when you reached FI.
This raises the question of what to do with that money (told you we’d get there).
The logical answer (at least to me, until recently) is to pass the money on to your children so that they might benefit from your hard work and financial prowess. But if your goal in doing so is for the money to be a benefit to their life, that might be worth rethinking. But we’ll get into that in a minute.
The fact is that if you retire at an early age, withdrawing 4% a year adjusted for inflation and your investments grow at the average annual real rate of return for the stock market of 7%, you will end up with twice as much money in only 24 years.
Let’s look at some numbers. Say you and your spouse have 2 children, retire at 50, and both pass away at 74 (much younger than average life expectancy for a 50-year-old). Each of your children would inherit a nest egg capable of providing that same yearly income that you had been living off of. This cycle could theoretically perpetuate itself for eternity.
There are a lot of assumptions in this specific scenario that work out well on paper but are complicated when you step outside the world of averages and theory. One of the more complicated but thought-provoking, perhaps, is how longer life expectancies will affect inheritance in the not-so-distant future.
So, what are the implications to inheritances when the average life expectancy for a 65-year-old in the US is 84? Well, for one, it means that by the time the average person is done needing her retirement savings, her children will likely be 50-60 years old themselves. And as life expectancies continue to rise, children who receive inheritances from parents will be even older. This isn’t necessarily a problem, but the time when people need the extra financial help most is when they’re starting out on their own: going to and graduating from college, starting a new career, buying a house, or starting a family. By the time one reaches his 50s, he should be on sound financial footing (or maybe even retired himself, if he subscribes to the same FIRE principles that we talk about on this blog!). All this to say that if you’re planning on leaving an inheritance to your children in order to help them succeed in life, your help might be too late.
And who says giving someone money they haven’t earned is the best way to help them in the first place? It turns out, almost no one.
Ever heard of the saying “Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime?” Most people would agree that the best inheritance one could leave would be to pass along skills, not money. Kids would be best-off learning positive work ethic, financial skills, the importance of learning from mistakes, and how to deal with failure. But these lessons aren’t mutually exclusive of giving away your money and don’t answer the question of whether and how to leave an inheritance.
Reasons against Leaving an inheritance
Some would argue that leaving money to your kids makes no sense. They haven’t earned the money so why do they deserve to have it, just because you passed away. Others would make the point that if your goal is to bring benefit or happiness to your children, leaving them with a large lump sum of money is the last thing you should do. Look at lottery winners.
Another reason not to leave an inheritance is that it can be messy. Do you split the money evenly among your children or distribute based on need? Will your children agree with your decision of how to split the money or will it be a source of tension among siblings?
One group of people have even pledged publicly that they will not be leaving a large inheritance to their children. It’s called the “Giving Pledge.” Billionaires including Warren Buffett, Bill Gates, Elon Musk, Mark Zuckerberg, Michael Bloomberg, and many lesser known names have all signed the pledge stating that they will leave the vast majority of their billions to philanthropic causes.
Reasons for leaving an inheritance
First off, many people who have received an inheritance feel that they should also pass money on to their own children. They might see leaving an inheritance as the standard or normal thing to do and carry on with that expectation of themselves.
Even those who haven’t received an inheritance, or won’t, might still see it as a normal thing that people do, and so would potentially want to do it for their children.
Another reason to leave an inheritance is that it’s “what good parents would do.” A parent might feel that if they are able to leave money behind for children, they should, as a good, caring parent would. They feel a societal pressure to do so.
A final reason, and in my opinion the only good reason, to leave an inheritance is to set your children up for success and happiness. This success and happiness would come from limiting stress caused by financial pressure and concern. The largest financial burdens to someone starting out on their own are education debt, in the form of student loans, and housing. The average student loan debt for graduates today is over $39,000. Paying off this debt while trying to start a career, and sometimes a family, can take over a decade and severely impact the amount one can save and invest during that time. It is this lower saving and investing in the early years of a career which can have such severe impacts on retirement funds later on due to the time value of money.
In addition to student loan debt, young workers are faced with paying for a place to live for the first time in their lives. Housing, whether you rent or buy, is generally the largest recurring expense in a budget.
If either or both of these expenses could be lessened due to an inheritance, much of the financial stress that they often cause could be reduced or even eliminated.
What is the optimum plan?
While some would argue for leaving as much as possible to your children and some would argue not to leave anything, the best advice on inheritance is likely somewhere in between. It’s probably best for your children NOT to receive a large sum of money when you die. But it’s also likely a benefit for them not to be saddled with education debt like student loans. If you’ve done a good job as a parent and instilled the proper values in your children of work ethic and financial responsibility, it’s probably helpful to get them started off on the right foot financially when they’re just starting out on their own.
I think the first step to this is education. Many parents and grandparents are already setting up 529 plans for their beneficiaries’ education expenses. This is probably the most helpful step you can take.
After funding education expenses, a next step, if you can afford it, might be to help with the down payment on a house, either as a primary residence or as a rental property (or both if it’s a house hack!). No need for your kids or grandkids to waste money on private mortgage insurance if you can help them reach a level of 20% equity.
Another idea might be help in funding a “gap year,” or amount of time for them to travel, see the world, and figure out what they want to do, study, and be when they “grow up.” Many people aren’t sure what they want from life when they finish high school and then end up picking a college, major, or profession that just isn’t right for them. A gap year could help them figure this out prior to wasting time and money realizing it later.
Finally, it might be beneficial to provide an inheritor money with which to experiment in starting a business or investment venture. This could provide a platform for taking a risk without the potential to harm your loved one’s financial future if it doesn’t work out.
Incentive-based, not a handout
Any or all of these benefits might best implemented as an incentive-based reward. This way, your beneficiaries won’t necessarily see the money as a gift as much as something they earned.
Much like a scholarship, education funds could be earned based on achieving and maintaining a minimum GPA. A different plan might be an offer to double or triple any scholarship or grant money they are able to find on their own. This would add in the incentive for them to do some work in funding their own education while also relieving you of some of the total financial burden.
The gap-year funding could also be based on attaining a certain high school GPA or something else such as getting into a specific college or degree program, SAT/ACT scores, certain extra-curricular activities, or holding down a part time job while maintaining their studies.
Finally, the housing payment or business start-up capital could be given based on their ability to graduate within the allotted time, review of a business plan or housing purchase ROI analysis, or other performance metric.
So, what will you do?
How much or how little you ultimately decide to pass down to your heirs is completely up to you. Everyone’s opinion on how best to provide a financial head-start for children and grandchildren will be slightly different. You’ll find little consensus among the personal finance community on the best way to leave an inheritance, if at all. The good news is, you’ll likely have decades to decide what to do with your money after you’re gone.
What are your thoughts on leaving an inheritance? Is it something you’ve thought about before? I’d love to read your opinions on this subject, leave a comment below!