CNNFN: Top Incomes Can Be Fleeting

Top incomes can be fleeting
By Jeanne Sahadi
http://money.cnn.com/2014/03/26/pf/taxes/high-income-taxpayers/index.html

There are few lifetime memberships in the exclusive club of high-income taxpayers.

In fact, there's a lot of turnover in the top 1%, entry into which took at least $389,000 of adjusted gross income in 2011 -- a threshold met by nearly 1.37 million returns that year.

Membership can be fleeting because many people are temporarily catapulted into the top 1% or even top 0.5% of tax filers due to a windfall of some kind.

Two examples: proceeds from the sale of a business or from one-time capital gains.

In fact, nearly 60% of those in the top 1% of taxpayers at the start of any 10-year period between 1987 and 2010 had dropped out by the 10th year. That's from a study by the U.S. Treasury Department.

And the Tax Foundation found this: Of those who reported income of more than $1 million between 1999 and 2007, about half only reported income that high for one year.

Make no mistake: They still may be rich. But their incomes fluctuate greatly.

"There are a lot of people who are [at the top] only once in any given period," said Roberton Williams, a fellow at the Tax Policy Center.

Transience is also a characteristic of those at the very tippy top. Among the top 400 taxpayers between 1992 and 2008, nearly three quarters appeared only once during those 17 years, according to IRS data.

There are many reasons why tax filers drop out of the highest income groups:
--They may start to bring in less taxable income once they retire.
--They may have a bad year on their investments and claim losses, which can offset their capital gains.
--They may change the composition of their income, so that more of it is coming from tax-exempt investments, which don't have to be reported on one's 1040.

Indeed, the federal tax return offers no clue to a person's net worth.

For example, the size of retirement accounts and the value of property that has not been sold are not reported on tax returns. While those assets may throw off some taxable income, such as rent, their underlying value is a better measure of wealth.

That's why there's a lot less fluctuation in the top ranks of the wealthy than there is among the highest income households.

Bill Gates' income in any given year may be topped by that of a hedge fund manager, Williams noted. But his wealth remains vast enough to keep him among the world's richest for a very long time.

Aesop Investing

The legendary tale of the tortoise and the hare has forever provided a cautionary warning that slow & steady can win the race.  Recently, I heard this fable applied to finance as well, and, at first, it rubbed me the wrong way.  I was not sure how apropos the metaphor was for investing, despite my own personal preference for “slow & steady” investments like index mutual funds.

For starters, the tortoise and the hare were in a race against each other, and personal investing should not be comparable to direct competition.  In a race as with most forms of competition, there would be a clear beginning and a definitive end.  Additionally, the goal of both competitors would be perfectly aligned, but there would only be one winner.  Immediately, those disconnects triggered a realization of the most applicable lesson to be taken from the same fable for investing.  Looking at what others are doing will lead to a pitfall!

Listening to the success stories (or financial failures) of others is fine, but never take their words as pure fact.  People have numerous ways to perceive the same set of circumstances.  It stretches beyond the basic half-empty/half-full conflicting viewpoints.

Pretend I put $10,000 in a single stock for five years, and that investment went as high as $15,000 at one point, and then as low as $7,500 at a later point, but, at the end of five years, that initial investment was worth $11,000 (ignore dividends and assume no additional money was commingled into the stock during the interim).

In this scenario, I would most likely say my investment made $1,000.  But I could say my investment lost $2,500 or I could say my investment lost $7,500.  Truthfully, I could even say that this investment made $8,500, i.e. $5,000 when it went from $10K to $15, plus another $3,500 when it went from $7.5K to $11.  People invest with blinders, and everybody's blinder is different.  These “blinders” are a conglomerate of our individual perceptions, intentions, and expectations.  Without seeing detailed balance sheets or an audited track record, the facts may or may not be interpreted in the same way.

Therefore, hearing that a turtle has earned $8,500 in an investment when your money only earned $1,000 in an identical investment may be troubling or, at least, perplexing.  But making changes based on only those facts in an attempt to outpace the “competition” will likely send your portfolio into a destructive pitfall.  While many people accept that slow & steady won the proverbial race, the reality is that the bunny shifted focus from what he was doing to where his opponent was.  Investing is not a competition.  Turning it into one is instantly problematic.