Saturday, September 25, 2010

Not Rich at $250K - It's How You Live, Not What You Make

There has been a lot of talk lately about a recent post from a University of Chicago professor wherein the Professor mentioned that he made more than $250K, but did not feel "rich".  Here's Above The Law's take on it - as well as the take from Sweet Hot Justice and the ABA.  Some commentators have been critical of the Professor, but let's take a look at his situation as a way for young associates and those considering law school to gain insight into what their life will be like if they are lucky enough to win the law school lottery and earn top dollar.  I previously talked about why 145K/year does not go as far as new law grads think it will, but now we can get an example of what life is like for a lawyer more than 10 years out of law school.

First, read the articles linked above and let's set the context.  The Professor is a 1998 graduate of law school and spent time at Kirkland & Ellis (which typically pays top dollar.)  He is also married to a doctor who apparently also makes at least a $100K/year contribution to the home.

The first thing that I note is that although the Professor has been out of law school for 12+ years and spent time at K&E, he and his wife still have more than $500,000 worth of student loans.  We don't know the exact split of who brought what debt to the marriage, but the existence of the debt even after 12 years in practice should help disabuse law students of the unrealistic idea that they will somehow just "pay back their student loans in 3 years or so."  Here's someone making top dollar with a wife working a high-paying job and they still have $500K in loans after 12 years - yikes!

For $500K in loans, assuming an interest rate of about 6.8%, they pay $34K/year after taxes (most likely about $51K/year pre-tax) IN INTEREST ALONE!  It's hard to know what the actual total payments are, but figure an additional 20K/year after taxes has to go to principal (about 30K before taxes.)  This means that about $80K of their pre-tax income goes to loan payments.

What's my point?  Student loans are just a monkey on your back that you will be carrying for decades.  The Professor has been carrying his for 12+years - and will probably be carrying it for 20 more.  For those considering law school, recognize that this means you - even if you win the "good job lottery" that is harder and harder to win these days.
 
Second, we note that the single biggest expense for the Professor and his wife are TAXES!  More than $100K/year.  In my experience, potential law students - and even young associates - are consistently underestimating just how big a bite taxes take as your income increases.  For example, remember those things like personal exemptions and loan interest deductibility that you get to deduct at lower incomes?  Well, they disappear when you go higher.  Also, the Alternative Minimum Tax (AMT) starts to take a much bigger bite.  But it's not just federal income tax - it's state income tax, Social Security, and Medicare taxes (FICA), too.  Right now these probably consume about +40% of the Professor's income.

What's the take-away?  When you see those high salaries that lawyers "bring home", immediately discount them by 40% just for taxes - and then another $40K/year for student loans - $80K/year for two married partners with large student loans.  For example, 2 married lawyers with combined salaries of $400K probably only have about ($400K * 60% - $80K= $160K) to spend for the year.  Toss on 401k contributions of $16.5K each, and the amount is down to $127K.

Don't get me wrong - that's still a lot of money.  However, it's a far cry from the $400K that many law students and young lawyers think that they will have to spend.

Third, the last thing that struck me about the articles is that the Professor mentions that his second biggest expense is his mortgage - and that it is less than $100K/year, but more than his student loan payment - and that his property tax is about $15K/year.  According to Bankrate, the P&I payment on a $1.5M home loan over 30 years at 5% is about $96K/year.  $80K represents about a $1.3M home loan.

Also, I am generally familiar with the Chicago real estate market and (although some suburbs deviate and are more expensive) a home that requires about $15,000/year in property tax  probably costs somewhere in the $1.2-1.7M range.

This leads us to two points:  First, even though the Professor has been out 12+ years and his wife works as a doctor, they probably don't have a large percentage of equity in their home.  Second, the the Professor owns too much house.  The total housing expenses including mortgage and tax are near to or in excess of $100K/year - which is frankly too much.

In summary, even if the Professor and his wife are paid $400K - as some commentators have suggested - they are most likely out about $100K in income taxes, $100K in mortgage and house taxes, and $80K in loans.  That gets them down to about $120K, which after private school for the 2 kids (probably about $30K/year), a 401k contribution ($33K/year), and some base living expenses for food, utilities, cars, etc (figure $3000/month = $36K/year) - the Professor and his wife are left with a total of $21K.

That's still a lot of money, but it's not the $400K that many people focus on.  The Professor and his wife aren't living a high-class lifestyle of trips to Europe, a Ferrari, champagne and caviar - although they are living a very comfortable upper-middle class lifestyle. 

Analysis:
The Professor does not feel "rich" because the majority of his family's income is being diverted and is not spendable by him.  More specifically, the huge majority of his income is going toward taxes, student loans, and real estate.  Really only about 30% of his income is his to spend - and after lifestyle expenses, only about 5% is left.

With regard to the taxes, law students and young lawyers should be aware that the problem only becomes worse the more you earn.  The percentage can really ratchet up as you advance in practice and it will most likely be your single biggest expense for your entire working career (unless you make a poor financial choice like buying too much house!)  When you think about your future "salary", discount it at least 40%, and with the potential elimination of the Bush tax cuts and the additional surcharges, maybe 50% would be more accurate.

With regard to the student loans, I have never seen a law student/young associate actually be able to accurately predict how long it will take them to pay off the student loans - including myself - we always under-estimate.  When I graduated law school, I made a very careful calculation of payoff time - and I am pretty good with the whole "math" and "estimating" thing, as well as being very frugal.  However, it still took several years - and my initial estimate was too low by about 10%, which translated into several months.  Also, keep in mind that law school is three times as expensive now as when I went to law school.  Further, of the people that I graduated with who were very adamant about being able to pay off their student loan debt in "3 years", about 40% of them still have student loan debt about 15 years later - and I am only counting the ones that have had high-paying jobs the whole time.

The bottom line is that the student loan debt is going to be with you for years and years - but also that you can either choose to bite the bullet in the early part of your practice and live super-frugally for several years to pay off that loan debt - or you are going to have to carry that monkey (and its interest) for your entire working career.  That is, one big difference that the Professor could have made would have been to live a lower lifestyle for maybe 7 of those 12 years that he has been out in order to pay down his loans - maybe then he would not have $80K/year (about 20% of his income) walking out the door and he could reclaim that 20% for investment or other expenses.

With regard to house, don't buy a big one.  Even if you can "afford" it in that they will give you a loan, it will consume a huge amount of your income - and the mortgage is forever.  Also realize that after a few years, your salary stops going up (the Professor's salary is not going to double any time soon) so the thought that you can buy bigger now and that it will be easier to pay off in the future stops being true pretty quick - especially in light of the expenses of a wedding, kids, etc.

My final thoughts are that the Professor's situation is a good illustration that 1) many people have wild over-estimates about how much they will have to spend, even if they are lucky enough to win the big firm job lottery, 2) as a lawyer, you never make so much that you don't have to worry about lifestyle expenses - taxes will kill you and that house is too big for you, and 3) pay the piper up front to free up your cashflow later.  Plan to live like a student for the first 10 years in practice - seriously - if you can actually do it, then you can avoid the situation that the Professor and his wife have gotten themselves into.  Their cashflow out is killing them - especially for student loans (which they could have paid off) and mortgage (which they could have lessened by buying a cheaper house and/or putting more down).  In both situations, the Professor and his family would have been better off if they had lowered their lifestyle expenses to accumulate more cash during the last 12 years.  He would feel a lot "richer" now if he had lived a lot "poorer" then - although admittedly it is so very, very hard to do when people see the big numbers coming in

7 comments:

  1. Jay Foonberg touches on this problem in his book. When you have a good income, there is a tendency to spend money on certain luxuries, but then psychologically those luxuries start to become necessities.

    This guy could move his family to a more modest house, but it would be very difficult, mentally speaking. In his mind, he would have to admit to himself and to his family and friends that he made a mistake. Or that he's not as succesful as he thought he was.

    It should be emphasized that when you spend money on some good or service, you aren't just losing the money. You are also creating an expectation in your brain that you will continue to purchase that good or service in the future.

    ReplyDelete
  2. 5:43 - Great comment! Consciously or not, once people start spending money on a luxury, they are creating an expectation that the luxury will continue in the future. It's something that everyone should be on guard for.

    As for the book, are you referring to his book "How to start and build a law practice" or some other book?

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  3. I paid my student loans off four years ahead of my own ten year schedule. When decided to go to law school I figured $40K a year would be my salary. I ended up doing better than that, but using that 40K starting salary as my method for choosing a law school make a big difference.

    Instead of going to a T14 I went to a TTTT. I could not justify the added cost of a T14 over what I paid at my school.

    What is sad is that it's now over 10 years later and I still do not believe any law degree to be worth more than $60K.

    ReplyDelete
  4. I like this blog because it is really non-partisan in it's stance nor whiny in its tone. I went through one year of law school at a tier 2. After working for a judge in the local area and not only seeing the state of the legal industry but also a frank talk with the judge about my job prospects, I decided that it was irrespnosible of me to continue using my parents money to fund this venture.

    I just met with this judge again, and she was frank with me, the legal industry in America is almost like the U.S. auto industry 30 years ago. There will always be a U.S. auto industry but currently it is one tenth the size it was 25 years ago. That is one thing many of these law school kids do not realize, not only is there an axial shift in the legal industry, there are the problems that this entry highlights, even if you attain this lottery ticket job, it really doesnt provide the support that one expected in law school.

    Keep up the good work managing partner, I think that this blog is probably the most helpful to potential law students, if only I had read it before making that $50,000 mistake.

    ReplyDelete
  5. 4:42 - Wow! Great work! Your experience shows a heck of lot more realism that just about anybody that I have talked to lately that is thinking of going to law school. I note that you went 10 years ago and that the cost of law school has tripled in real dollar terms since then. The reasonableness of your projection being so at odds with my more recent feedback, it seems to go to something that I have been thinking about for a while - specifically, are reasonable people self-selecting themselves out of going to law school? When I look at your plan, I doubt you needed anyone to tell you to think about the future when you made your law school plans because you already were. Maybe people who can do this math for themselves are already staying away from law school - and that's a reason why it seems like very few people that I talk to that are thinking about going to law school seem to have much of a clue - the ones that have a clue have already decided against it, so I don't get a chance to talk to them.

    Here's a question for you - it's 10 years later and salaries have been stagnant in real dollar terms, but the cost of law school has tripled. Would you still go to law school?

    ReplyDelete
  6. 5:35 - First, thanks for the compliments! Second, great job: 1) getting a job with a judge while in law school to get actual experience, 2) critically reviewing the state of the industry and inviting the judge's comments, 3) honestly accepting reality and not trying to think that the odds will somehow be different for you, and 4) stepping up and making the hard choice to pull the plug. It takes a lot of guts and maturity to make those choices. Did you have previous work experience before going to law school? You attitude seems much better than a lot of undergrads that I talk to.

    Second with regard to your auto industry example, it prompted my next post - check it out and let me know what you think!

    ReplyDelete
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