Retirement Watch : grandchildren

Why Estate Planning Details are Important

Bob Carlson — Fri, 16 Oct 2009 14:24:00 GMT

In this post we discuss two key issues that don’t draw much attention but are keys to the success or failure of your wealth transfer plans. They probably are not what you’d expect. Meeting a plan’s goals often does not hinge on the “headline issues” of trusts, family limited partnerships, and the like. The nitty gritty details are more important, such as stating who pays debts and taxes, ensuring the estate has enough cash, and choosing executors and trustees. I regularly remind my readers of the details requiring attention and provide recommendations.

Here are a couple of issues that don’t get much attention but deserve more of your time.

A recent court case shows what happens when details are overlooked.

A man owned a farm, sold it, and incurred capital gains taxes. He died before the year ended and before paying the taxes on the sale or filing his tax return for the year. His oldest son was named executor of the estate. It turned out a younger son was a joint owner with right of survivorship with his father of the farm and inherited the rights to the farm's checking account after it was sold. The checking account held the sale proceeds, minus mortgage repayments.

Because the farm and its checking account were held as joint owners with right of survivorship, the younger son automatically became sole owner of the farm business and its assets when the father died. The older son as executor oversaw the probate estate and had control of those assets. But the farm assets never were part of the probate estate, and the executor never had an interest in or control over the farm assets.

Yet, the estate and its executor are responsible for all taxes of the estate and the deceased. In this case, the executor was liable for the father's final income tax return and the taxes due under it. The IRS assessed the executor for the capital gains taxes from the sale of the farm. The executor went to court to challenge this, saying his brother should pay the taxes since he had the money.

The court said it had no choice but to rule for the IRS. The executor is responsible for paying the taxes on the deceased's final income tax return. The brother who served as executor could sue the other brother for the money, but he first had to pay the IRS the money.

Here we have a division within a family and an estate without cash to pay its bills, because the father either didn’t seek advice or received bad advice. The father did not pay estimated taxes that included capital gains taxes on the sale of the farm, and he did not ensure the estate had money to pay the taxes and other bills. He might not have been aware the farm would be included in the taxable estate though the executor had no rights to it.

Several key details were neglected that should be part of every estate plan. Estimate the cash flow for the estate. Be sure there are enough liquid assets to pay its obligations. The will should state who is responsible for paying taxes on the assets. Otherwise, one group of beneficiaries could pay taxes on assets received by another group of beneficiaries.

Otherwise, your estate could end up fighting with the IRS, and your family members fighting with each other. (U.S. v. Guyton, No. 3:07-cv-00273, D.C. Fla, May 7, 2009)

Giving Gifts — and a Lecture

Grandparents are filling only half their roles these days. They are providing financial help to their grandchildren. In fact, they increased their financial aid as the economy worsened. Unfortunately, they are providing financial aid without much advice.

About 63% of grandparents say they provided some form of financial assistance to their grandchildren over the last five years, according to a survey for the MetLife Mature Market Institute, an affiliated organization of MetLife Inc., the insurance company. The assistance over the five years averaged $8,661. The survey was of adults over age 45 who have grandchildren under age 25. About 40% of the gifts went toward "general financial support," while 26% was for educational expenses and 21% was to help grandchildren through major life events. Because of the declining economy, about 26% of grandparents said they increased support for grandchildren.

Despite the generosity with wealth, most grandparents are not generous with their advice and wisdom. About 68% of the grandparents said they provided no financial guidance to their grandchildren. Lower-income grandparents are more likely to give advice, with 83% of those earning $35,000 or less saying they warn their grandchildren to avoid large debts and to maintain financial security. Only 65% of those with incomes between $50,000 and $74,999 talked about finances with their grandchildren.

It is admirable that so many grandparents are willing to give now to help their grandchildren receive educations and establish a firm financial foundation. But it is a mistake to give money or other wealth without some guidance, or ensuring the grandchildren receive good advice elsewhere. Financial literacy is taught in very few schools. Most high school graduates lack basic financial skills such as balancing a checkbook and understanding a mortgage or other debt instrument. If the parents try to provide lessons, the grandchildren are likely to ignore them.

Grandparents are more likely to be listened to, and they can provide a lot of hard-earned wisdom. Grandparents can teach with authority principles such as avoiding debt, starting to save and invest early in life, living within one's income, working hard, and saving both for a rainy day and for specific goals.

Debt management is probably the lesson most grandchildren could benefit from. Their parents, like most of their generation, probably never learned the lessons of how to use credit wisely. Also, the credit picture is much more complicated than it used to be, with many different kinds of debt available but objective information about the credit hard to find.

Grandparents should not give only wealth. They should give lectures and advice. Even a simple request that the grandchild read a basic book, such as The Richest Man in Babylon by George Clason, as a condition of receiving a gift can go a long way. The book is both entertaining and enlightening for most people, regardless of age. But the best advice would be direct from you.

Articles with helpful discussions on my members web site discuss compound returns, mutual funds for small investors, and financial lessons youngsters need to know. Share this and other advice with your grandchildren so they will remember it when key decisions have to be made. It also will make your financial gifts more valuable, making it more likely your wealth is well-used.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Who Will Benefit from Your IRA?

Bob Carlson — Fri, 25 Sep 2009 00:17:00 GMT

One of the most important decisions about an IRA is naming the beneficiary or beneficiaries. There are many candidates for the biggest mistake made by IRA owners, and a leading contender is the failure to name a beneficiary or naming the wrong beneficiary.

If no beneficiary is named, the estate is the beneficiary. When an estate or another non-individual is a primary beneficiary, the entire IRA must be distributed within five years after the original owner's passing. The estate, as the beneficiary, will owe income taxes on the distributions, in addition to any estate taxes due on the value of the IRA. An IRA owner should never fail to designate at least one qualified individual as primary beneficiary and should never name the estate or other non-individual as a primary or contingent beneficiary. The only exceptions are when there is no interest in allowing heirs to use the tax deferral of the IRA and for certain trust that are allowed to defer distributions.

Since new regulations were issued in 2001 and 2002, the choice of beneficiary is not fixed and does not affect required minimum distributions. The major consideration in naming the beneficiary is: Who should receive the IRA in light of the goals, tax issues, and any other factors that are important to the owner?

After deciding on the primary beneficiary or beneficiaries, the owner also should name contingent beneficiaries. These are people who inherit if the primary beneficiaries are not available or disclaim the inheritance. Naming contingent beneficiaries can be part of a good strategy. The estate executor names the Designated Beneficiary of an IRA by the end of September of the year after the owner passed away. The DB's age determines the required minimum distributions for the IRA. The DB must be on the list of primary or contingent beneficiaries.

Naming contingent beneficiaries allows the executor and heirs to adjust the estate plan if circumstances have changed. Primary beneficiaries who believe it is best for the family that someone else inherit the IRA can disclaim their rights. Disclaimers can continue until the "right person" is available to be named DB. That cannot happen unless contingent beneficiaries are named.

Customized Beneficiary Forms

When naming beneficiaries, it often can be best not to use the Beneficiary Designation forms provided by IRA custodians. A number of estate planners draft their own forms and have them reviewed and approved by the custodians.

One value to a custom beneficiary form is it allows the owner to name more than one primary beneficiary and leave them unequal shares, something that often is difficult or not possible with standard forms. A custom form ensures that the form lists all the beneficiaries the owner wants named. Another benefit to a custom form is, if there are disclaimers or premature deaths of beneficiaries, contingent beneficiaries will succeed primary beneficiaries in the desired order and not in an order dictated by the IRA custodian.

While a standard form might work for many people, those with multiple beneficiaries or less-than-standard situations should consider having their estate planners draft custom forms and file them with the IRA custodian.

The IRA owner also should consider who would receive the share of a beneficiary who dies prematurely — either before inheriting a share of the IRA or after distributions to heirs begin. Should the share go to the children of the beneficiary, or should it be shared by the other primary beneficiaries? Or should it go to a different contingent beneficiary?

The choice is up to the IRA owner, but it has to be stated in the designation form. Otherwise, most IRA custodians have a default position they implement absent instructions from the IRA owner. State law also might establish a default position. The IRA owner should consider the issue and make the choice clear in the designation form.

Another issue: Suppose a beneficiary or contingent beneficiary is young or cannot be trusted to handle the IRA properly. Then, it might be appropriate to name a trust as the beneficiary of the IRA. Naming a trust also is appropriate when the intended beneficiary has special needs.

A trust that is an IRA beneficiary must have precise terms in order to take advantage of the IRA’s tax deferral. With the wrong trust terms, the IRA balance must be distributed and taxed on an accelerated schedule. The help of an experienced estate planner is needed to set up the trust properly.

Splitting IRAs

When there are multiple objects of affection, one option is to name them as joint primary beneficiaries. An alternative is for the IRA owner to split the IRA into separate IRAs, naming a separate beneficiary and a group of contingent beneficiaries for each. IRS regulations allow beneficiaries who jointly inherit an IRA to split it. Yet, not all beneficiaries know about this right or are able to agree to execute it. The owner might find it wise to split the IRA now rather than leaving that to the estate administration process.

I frequently emphasize that an estate owner who plans to leave something to charity should consider using the IRA to do so. Unlike other beneficiaries, the charity will fully benefit from the IRA. Charities are tax-exempt. A charity can withdraw the entire IRA balance and not owe income taxes on it. In addition, naming a charity as beneficiary avoids the estate tax. The IRA is included in the estate, but there is an offsetting charitable contribution deduction for the amount left to the charity.

Because non-charitable heirs benefit more by receiving non-IRA assets, leaving the IRA to a charity can be a good deal for all involved. When the estate owner plans to leave part of the estate to charity and there are enough non-IRA assets for other beneficiaries, the owner should consider leaving all or part of the IRA to charity while leaving the other assets to non-charitable beneficiaries.

When considering IRA beneficiaries as part of an estate plan, there are a couple of other strategies I frequently recommend that you should consider as alternatives.

One strategy is to avoid all this by emptying your IRA early. Distribute all or most of the IRA, pay the taxes, and invest the after-tax amount. That gives you more flexibility over how to give away the balance and probably gives the heirs a larger after-tax amount in the long term. This can be appropriate for someone with a large IRA and other income or assets to maintain the standard of living. It also is best if you expect the after-tax account to have 10 years or more to growth and compound before money is withdrawn.

Another strategy is to convert the traditional IRA into a Roth IRA. This does not avoid the choice of beneficiary, but it makes the distributions tax free. Keep in mind it costs money to convert to a Roth IRA.

I have discussed the details of both of these strategies in past issues of Retirement Watch and in my book, The New Rules of Retirement.

Designating IRA beneficiaries is a neglected step in many estates. Take care to designate beneficiaries with care and use a custom beneficiary designation form if necessary. Taking these steps can increase the after-tax wealth of your heirs by tens of thousands of dollars. A will or living trust has no influence on who inherits your IRA or other qualified retirement account. Only the beneficiary designation form counts. Make your designations carefully, update them as needed, keep copies of all forms, and be sure the executor knows where the forms are.

You and Uncle Sam Can Help the Grandkids Buy a Home

Bob Carlson — Thu, 10 Sep 2009 16:35:00 GMT

Home prices are down, and inventories of unsold homes are high in many areas. These are buyer’s markets. That makes this an ideal time to buy a home, or to help a grandchild buy that first home or move up to a larger home. Even better, there is a tax incentive that leverages the help you provide to buy a first home.

Despite the decline in prices, buying a home still is a struggle for many young people. Relatively high interest rates, high property taxes, and tighter lending standards do not help. Helping with a home purchase is a gift that is not likely to be squandered — if the young person makes a significant contribution from his or her own assets. The home also is likely to appreciate at least with inflation over time, and that future appreciation is out of your estate. Helping to buy a home also can free up some of the young person’s income to fund retirement and the education of his or her own children.

To increase the buyer’s cash flow, the government established a first-time home buyer’s credit that is good for homes purchased before Dec. 1, 2009. The credit is up to $8,000 and probably is the main reason for what good news we have seen in residential homes in recent months. For more details about the first-time homebuyers credit, click here.

A home purchase can be assisted without a large gift. Some parents and grandparents help with the closing costs. These can be significant in some areas, because they include various taxes and fees. Others provide all or most of the down payment, after ensuring that the young person will be able to afford the mortgage payments.

The tax law provides several ways a parent or grandparent can help a young person buy a home without triggering high gift or estate taxes.

The tax basics are that gifts are not taxable income to the recipient. Everyone can give up to $13,000 annually to any person without incurring gift taxes. This is the annual gift tax exemption. You can make these gifts to as many different people as you want each year. A married couple can jointly give up to $26,000 annually to a person gift tax free.

Each person also has a lifetime gift tax exemption for $1 million of gifts. Gifts that exceed the annual gift tax exempt amount reduce the lifetime exemption. Any amount of the lifetime gift tax exemption that is used also reduces the estate tax exemption by the same amount.

The gift tax exemptions are the foundations of strategies to help children and grandchildren. Now, let’s look at six specific strategies to consider.

 Perhaps the easiest strategy, at least initially, is to co-sign the mortgage. This amounts to lending your credit rating to the youngster and requires no cash. It is not considered a gift for tax purposes.

Looking down the road, this approach might not be as trouble-free as setting it up is. If the young person stops paying the mortgage, you are on the hook for the payments and there could be gift and income tax consequences for that. Then, you would have to decide whether to make the payments indefinitely; buy the grandchild out of the home; or sue for payment, foreclose, evict the grandchild, and sell the house. Also, the young person's failure to make any payments can adversely affect your credit rating.

 A straightforward gift of cash is the cleanest and most-used strategy. You can give an amount equal to closing costs or the down payment, or a larger amount. These days many lenders will require a gift letter. They want buyers to have their own equity in the home before lending. If part of the down payment came from a gift, the lender might require a letter stating that it was a genuine gift with no strings attached or expectation of repayment.

 Periodically, equity sharing is popular. This effectively is a form of joint ownership, though the home is the principal residence of only one owner. Equity sharing’s appeal is that the grandparents or parents can join in the appreciation or have more control over the situation. Some grandparents need the equity interest to feel financially secure.

Equity sharing gets complicated and requires the assistance of an experienced tax professional. There are many ways the arrangement can be structured, and each has different tax effects. Issues include how much of the down payment each person will contribute; how much of the monthly mortgage and real estate taxes each will pay; and how much rent the child or grandchild might pay to the other owner. Without rent, there is an annual gift from the nonresident owner to the other owner, and that could be taxable. Responsibility must be determined for other expenses, such as maintenance and insurance. A formula for sharing appreciation also is needed.

Because of the complications, setting up an equity sharing arrangement should incur professional fees, and those reduce the amount you can give.

 A low-interest loan can work in situations when you need or want the money in the future and are confident the young person will be able to repay the loan. The young person has use of the money at no interest or below-market interest. You lose only the earnings the money would have earned, if the loan is repaid.

Low-interest loans have no tax consequences if you stay within a safe harbor. One safe harbor is the total low-interest loans to an individual do not exceed $10,000. Another safe harbor is for gift loans between individuals when the total gift loans to that borrower by the lender are less than $100,000 and the borrower has net annual investment income of $1,000 or less. If the investment income is higher, then there will be imputed interest payments between borrower and lender as discussed below, but only to the extent net investment income exceeds $1,000.

If you don't qualify for a safe harbor, then a market interest rate will be imputed. You'll be treated as though interest payments were made at that rate, and those imputed interest payments will be included in gross income. The borrower might be able to take deductions for the imputed interest. Check with a tax advisor about the imputed rates and the details of the safe harbors before making a low interest loan.

Of course, making a loan has many of the same problems as co-signing. If the loan is not repaid, you have to decide which actions to take.

A no-interest loan can be a strategy for avoiding the gift tax exemption limits by making a loan that exceeds the annual exemption but is under the gift loan safe harbor.

Some people make gifts beyond the loan amount that are used to pay the loan or the imputed interest. Each year after the loan, cash gifts up to the annual gift tax exemption are made to the young person and used to make principal or interest payments to the lender.

You want to make a real, enforceable loan. You need to draw up a loan agreement with a payment schedule and should record it against the title to the property. If you do not have documentation, the IRS might treat the transaction as a gift instead of a loan.

 Another option is to buy the house yourself. This is helpful when the youngster does not have a credit history that merits a third party loan. Then, you have several options. You can rent to the young person with an option to buy. Or you can sell to the young person and finance the sale yourself with terms that are affordable to the young person. Another option is to make gifts of equity in annual installments that qualify for the annual gift tax exclusion. Over time, as the young person's credit rating and income improve, he or she might be able to obtain a loan from a third party and buy the home from you.

The advantages of this strategy are that the young person might get in the habit of making regular payments and also taking care of the property. The disadvantages are that the opposite might occur. The payments might not be made and the house neglected. Then, you have to decide which actions to take. The potential for problems is one reason to ensure the arrangement is recorded in legal documents that are filed as required.

 Annual gifts to help pay a mortgage are another simple strategy. You make gifts that qualify for the annual exemption. That frees up the young person's income to fund retirement or his or her children’s education or to pay other expenses. The potential downside is that the young person will become dependent on your annual gifts, and those gifts might have to stop or be reduced at some point. Also, the young person might waste the money in some way instead of using it to build financial strength.

What about triggering jealously among other children? Many wills provide that a child's inheritance will be reduced by any significant lifetime gifts, so over time the children are treated equally.

There are many ways to help a young person take advantage of the weak housing markets around the country. Pick one that best fits your finances and goals.

The Four Goals of Legacy Planning

Bob Carlson — Fri, 14 Aug 2009 00:29:00 GMT

Perhaps one of the worst effects of high estate taxes is the way tax planning diverts attention from other important estate planning issues. For many years, I have stressed that estate planning is about much more than taxes, but most people believe estate planning and estate tax planning were the same thing. Though wrong, it was understandable when the lifetime estate tax exemption was $600,000. Many "modest millionaires" who considered themselves middle class would be hit by high estate and gift taxes without planning.

Unfortunately, the idea that estate planning is all about tax reduction still is widely held. With the estate tax exemption at $3.5 million and likely to stay there or higher, many people simply are neglecting estate planning. Since estate taxes are not going to be a problem for them, they see no reason to put together a plan.

One way to avoid falling into this trap is to think about legacy planning instead of estate planning. Everyone needs a legacy plan, even those with less than $1 million in assets. With a new estate tax law likely to come down the pike this year and stabilize the tax picture, 2009 is a good time to put together your legacy plan.

Legacy planning has four key goals. Consider these goals and how to accomplish them. Working with an estate planner will be easier and faster when you understand legacy planning this way, and it will make meeting these goals easier and more likely.

Financial security for you and the objects of your affection is a priority of legacy planning.

Though few people realize it, putting yourself first should come be the priority of legacy planning. Establishing a legacy involves giving to or providing things (not necessarily money) for others. Yet, you are best able to give to others when your own standard of living is secure. You won’t be able to give to or provide for others when your own situation is precarious. As the plan is developed, keep returning to the question of whether a strategy would put your standard of living at risk under some circumstances. The sharp decline in asset prices in 2008 brought that home to many people.

Once comfortable with your financial security, establish goals for the ultimate disposition of your wealth. Often, the spouse is the first beneficiary of the wealth. After that, children, grandchildren, and charities are the usual recipients of the wealth. You need to decide who will benefit from your estate, the order in which they will benefit, and the amount or percentage of your wealth they should receive.

After determining who should benefit from the wealth, the next issue is how they will benefit. That issue often is determined by the other goals of legacy planning.

Continuing the management and caretaking of the estate is the next goal. If you are like most people, you have been calling the shots if not doing all the management. Too many estates, regardless of their size, dwindle rapidly after the first owners pass them on. Often the successors did not understand how the assets were to be managed or did not share the values and outlook of the founder.

This issue is particularly important with small businesses. The founding owner must decide who will own the business, who will benefit from its income, and who will manage the business. Those are three separate categories and do not have to consist of the same person or people. A key to successful legacy planning for a business, however, is to have a succession plan in place and to follow it. Succession planning is an issue we have discussed in my newsletter, Retirement Watch from time to time.

Even estates without businesses need to address the issue of the stewardship transition. It could be that the people you want to benefit from the wealth are not likely to manage it well over the long term. In that case, you want to consider trusts and other arrangements that separate management and ownership. It is important to recognize that those who benefit from the assets do not have to be the managers.

Protecting the estate is another key element of the plan. This goal is particularly important to small business owners and professionals. They feel a greater need to protect assets from potential creditors and lawsuits. But others might need asset protection from those sources as well as disgruntled family members, irresponsible family members, and ex-family members in divorces.

There are simple, low-cost vehicles that will protect assets, including different ways to hold title to assets, IRAs, annuities, and umbrella liability insurance. These work for estates of any size. For larger estates, there are vehicles that can be used to protect assets, including trusts and limited partnerships. Your fears, needs, and the various methods can be discussed with your estate planner. The key is to identify the assets you want protected and the potential harms from which you want protection. Surprisingly, the size of the estate often is not a factor. Many estate planners report that the worst fights are over the smaller estates.

The legacy plan must address the potential tax burden. Once you have established who should benefit from the wealth, you want to transfer the wealth to them in the ways with the lowest possible tax bill that meet your other goals. For many estates, that has become easier each year for about a decade, but easier tax reduction probably won't continue after 2009.

One reason many people do not develop estate plans is they do not realize how valuable the estate is and the potential tax burden. There often are "hidden assets" that are included in the taxable estate such as annuities, life insurance, IRAs, and some trusts. Other people "forget" about some of their assets or do not know their true value.

Even when federal estate taxes are not a problem, state inheritance or estate taxes could be. A number of states have these taxes, and some impose taxes on estates or assets with values as low as $250,000.

Income taxes on beneficiaries also need to be considered in the plan. For example, the beneficiaries of IRAs face an income tax burden many people overlook. That burden is one reason it might benefit you or your heirs to empty an IRA early, pay the taxes, and put the IRA assets in a taxable account to compound over the years. If you do not consider income taxes, your beneficiaries could benefit from far less of your wealth than you expected.

Planning a legacy involves far more than reducing estate taxes. It is time to start determining your goals and putting your plan together. Once the new estate tax law is final, push forward with the final details and implementation.

Better Strategies for Estate Planning Gifts

Bob Carlson — Fri, 10 Jul 2009 15:07:00 GMT

Gift giving is the surest way to help loved ones of all ages, establish a legacy, and reduce estate taxes when the estate is large enough. Yet, many people are hesitant to make significant gifts to loved ones, because of the potential pitfalls. Those pitfalls, however, can be avoided with some shrewd and creative giving strategies.

Potential givers see several risks in making substantial gifts. The wealth could be wasted or spent unwisely by the recipients. Simple mismanagement by an unsophisticated heir might cause the money to disappear in scams or unwise investments or spending. The wealth also could be dissipated though gambling, substance abuse, or bankruptcy. A common concern is that part of the wealth eventually could leave the family in a divorce.

Many of these risks can be reduced by giving through trusts, but there are many reasons why people do not want to give through trusts. It costs money to set up the trusts and keep them going. A trustee must be located to manage the property. It also is a statement to the beneficiary that he or she is not trusted with the money.

While the risks of giving are real, there are ways to give that reduce or eliminate the risks without the expense and inconvenience of trusts. The benefits of making gifts today can be reaped while protecting wealth from the perils.

529 plans. College savings plans authorized under section 529 of the tax code have become one of the best estate planning vehicles in recent years, while tax law changes have diminished the value of other vehicles. Most states now offer multiple 529 plan options, and any person can set up an account for the benefit of someone else and contribute to it. Plan contributions qualify for the annual gift tax exclusion, which is up to $13,000 for 2009. In addition, up to five years' worth of exclusions can be used in one year for a tax free lump sum contribution of up to $65,000. The money given to the account is out of the donor’s estate. Under many state plans the owner has some choice over how the account is invested.

Income and gains in the account compound tax free. Withdrawals are tax free if they are used for qualified education expenses of the beneficiary.

A distinctive advantage of the 529 plan is the owner can retrieve assets from the account for any reason. There is no tax penalty if the owner asks for the return of the assets, though the plan sponsor can impose a penalty of up to 10%. The owner also can change the plan beneficiary at any time.

Some states limit the duration of an account to a number of years or to the 25th or 30th birthday of the initial beneficiary. Others have no time limit.

A 529 college savings plan provides a tax-free way to remove assets from an estate, place them in a tax-free savings vehicle, and benefit an heir. But the beneficiary has no current control of the assets and can be denied future access if the situation changes. The donor can retrieve the assets if his or her needs change.

Bill paying assistance. Many people hesitate to make gifts because they are concerned the gifts will be wasted. They would like to help loved ones but do not want their gifts funding frivolous expenditures or being lost in unwise investments.

One way to prevent that outcome is to make direct payments on behalf of the beneficiary. The beneficiary never touches the money, and the gifts pay for what the donor intended. For example, checks for education or medical expenses can be written and sent directly to the provider. Some people pay directly for vacations, summer camps, furniture, clothing, cars, and whatever other expenses they want to pay.

Direct payment of gifts qualifies for the annual gift tax exclusion. In addition, qualified education and medical expense payments made directly to the provider qualify for an unlimited gift tax exclusion.

Purchasing services is safer than paying for assets. Assets can be divided in a divorce or sold or pawned to fund other spending. A possible disadvantage is that paying for items might put loved ones in the habit of asking for assistance whenever they want something. A better approach is to have a plan in which the amount and object of gifts for the year are discussed and set in advance, or even multi-year plans are developed.

Home equity loan match. Suppose loved ones need an expensive item, but the parents are not able or willing to part with a large lump sum or want to stay within the annual gift tax exclusion limit. A strategy, if the children have adequate home equity and credit, is for the children to make the purchase with a home equity loan. The parents then can agree to make all or part of the loan payments either directly or by sending money to the children. This allows the parents to help the children, stay within the gift tax exemption amount, and spread the payments over time in manageable amounts. The children deduct the interest if they make the payments.

Expense matching. Some donors to charities make challenge matches. They offer to match, up to a maximum amount, whatever amount the charity raises from other donors for a specific purpose. Parents can do the same with children. If the children need or want a car, for example, the parents can offer to match whatever amount the children spend. The match does not have to be dollar for dollar. The parents can offer to pay fifty cents for every dollar the children pay.

Some parents believe it is important the children contribute some of their own earnings to a major expenditure. The cost sharing makes it more likely that the children will choose wisely and take care of the asset. It also makes the children less dependent on the parents.

Marital agreements. When gifts are not made because the parents do not want to risk that they will be divided in a divorce, parents should discuss this with the children. The problem could be remedied with a premarital or postmarital agreement stating any lifetime gifts or estate bequests received by one spouse will not be considered part of the marital estate to be divided in a divorce. Many parents and grandparents will not make estate planning gifts unless there is such a marital agreement.

Maintaining separate accounts. In many states assets owned before a marriage plus gifts and inheritances are not included in the marital estate if they are not commingled with other assets. Parents should check the state's treatment of the gifts, and then can require that their gifts be kept in separate financial accounts

Trusts. Of course, the classic way to protect assets is by placing them in trusts. In this posting I have offered a number of ways to protect assets without the expense and restrictions of a trust. Trusts can be fashioned to accept tax-free gifts, take property out of an estate, protect assets, and provide incentives for the beneficiaries.

Estate owners have legitimate concerns about what might become of their estate planning gifts. These concerns can be resolved with some creative gift giving, enhancing the lives of loved ones while protecting hard-earned wealth.

Avoiding Rags to Riches to Rags

Bob Carlson — Thu, 11 Jun 2009 19:57:00 GMT

The pattern for family wealth seems fixed. Different times and different cultures display the same pattern. The first generation builds wealth, and the second generation shepherds or preserves it. The third and succeeding generations spend until it is dissipated.

There are a few examples of families in which wealth lasted many generations. The fact that people can name these families shows they are exceptions. There are many more families in which little of the wealth makes it past the second generation. The pattern inspired the adages "shirtsleeves to shirtsleeves in three generations" and "rags to riches to rags." These adages have counterparts in other cultures.

After securing their own standard of living, the financial and estate planning concern of most affluent Americans is to provide some financial security for their grandchildren and perhaps later generations. This is possible, but most people try to accomplish it the wrong way.

Estate planning, or wealth transfer planning as some like to call it, tends to focus on the mechanics. Advisors discuss the most efficient ways to transfer assets to the next generations. The emphasis is on reducing taxes and other transfer costs. In recent years, incentives and controls have taken a greater role in many plans. Parents and grandparents seek to transfer wealth in ways that encourage the recipients to develop solid values and a work ethic and protect the wealth if they do not. For example, income or principal might be paid out of trusts only if a beneficiary meets certain goals, such as completing college or holding a job.

The shortcoming of most estate plans is their focus on ways to transfer financial capital. The real, enduring wealth of a family is not financial capital. More important assets to sustaining the family's long-term financial security are intellectual capital and human capital.

Intellectual capital is the accumulated knowledge of the family members. Human capital is the members of the family and their individual qualities and talents.

James Hughes, a semi-retired estate planning attorney, said in Financial Planning that identifying and transferring these non-financial forms of capital between generations is what ensures family wealth will grow through generations. Hughes believes that primitive societies recognize the importance of transferring human and intellectual capital between generations, because they do not have much financial capital to transfer.

Hughes says that primitive societies have formal processes in which older generations initiate younger generations from childhood into adulthood. Older generations seek to identify the gifts of younger members and nurture those gifts. The older members also pass on the knowledge they have acquired. The younger members provide energy to supplement the intellectual capital of the older members.

Hughes believes that estate planning should focus on more than financial capital and the techniques for transferring it. Instead, wealth transfer planning should be values-based and focus on transferring intellectual capital and maximizing human capital. Family mission statements and a governing structure should be established. The governing structure should not be top down or vertical. Instead, it should be more vertical or a combination of horizontal and vertical.

Importantly, there should be a mentoring process in which the older members teach the younger members about the family's values and its techniques for building wealth. Techniques for transferring financial capital, such as trusts, should focus on the very long term, not just the next generation.

Here is an important point that many people get wrong. It is important to transfer principles to the next generation but not necessarily methods of preserving and growing wealth. The methods that will be effective change over time. For wealth to grow over time, strategies must change and adapt. Values can be preserved, but methods might have to change. Each generation needs to do more than preserve and manage what it is given. Instead, it needs to act like the first generation and focus on creating wealth rather than investing and living off the financial capital created by the first generation.

A good example of this process is the Marriott family. The Marriott business empire began as a cafeteria chain, Hot Shoppes. Eventually the company, which was run by the family, invested its earnings in hotels and other real estate. When the cafeteria business seemed mature, it was sold and the family focused on hotels.

After a while, family managers realized that owning hotels was capital intensive and subject to the economic cycle. The hotels were sold. Marriott Corporation now manages hotels under contract from the owners of the properties. Less capital is required; the income stream is more reliable; and the effects of the business cycle are less pronounced. Marriott owns a number of brand names and trademarks it licenses to hotel owners—such as a range of Marriott hotels and Ritz-Carlton. But it does not own many properties.

Marriott Corporation has been controlled by the same family. But it has changed dramatically and continued to grow as each generation has acted as entrepreneurs instead of caretakers.

Each generation must be dynamic if wealth is to be preserved and especially if it to grow. When a generation views wealth or a business as static, the financial capital will begin to decline. That is why it is more important for the first generation to transfer its values and knowledge to the following generations than to transfer financial capital.

There are several ways to do this. In some families the first generation personally transfers the intellectual capital. In other families, formal education and contact with family advisors transfer the values. The transfer process can be informal through daily contact or formally through annual family retreats or other events. In most cases, a combination of these methods should be used.

Few estate planners or other advisors assist in the transfer of nonfinancial capital. Each family must develop a system that works for it.

The real wealth of a family is not its financial capital or its business. Financial capital can be dissipated, and a business must change and evolve to be sustainable. Values and intellectual capital must be transferred from the older generation. The younger generations must add their energy to build on what the earlier generations built. Otherwise the financial capital will dissipate even if the best wealth transfer techniques are used.

The Trickiest Part of Estate Planning

Bob Carlson — Fri, 05 Jun 2009 17:32:00 GMT

ways to efficiently distribute the residuary estate while reducing the probability of a will fight or family dispute. The appropriate method for your estate depends on family dynamics and your understanding of them.

Here are some strategies to consider. You have to decide which works best for your family.

§ If you are confident there won’t be problems, you can leave the residuary estate to the children and let them decide how to divide the items. Or you can name one of the children as executor and let the executor decide how to divide the residuary estate. The will might direct the executor to divide the residuary in equal shares among the children. Or it might direct the children to agree on a division under the executor’s direction. Many families are able to reach an amicable division this way.

If you are afraid emotions might take over, consider one of the other methods.

§ There is one surefire way to avoid conflicts. Direct the executor to sell everything that can be sold and distribute the cash to the heirs. Unsold items would be given to charity. Heirs who want a particular item or items can buy them at the sale. The executor decides on the sale process, and it should be one that does not allow one heir to have an advantage over others in obtaining an item.

§ Instead of listing each item of property and who should get it, you can label items as you decide who should receive them. You might put labels on the backs of artwork and on the bottoms of sculptures and furniture. Though the designations are not legally binding, you can mention them in the will as your preference for the executor to follow, and the executor and heirs usually respect them. Yet, you will have many items that cannot be labeled in this way. Worse, an unhappy family member can switch a label or claim that a label was switched or is not really your handwriting.

§ You can give the heirs an opportunity to agree on a distribution, then provide a back up if they do not agree. For example, the will can state the residuary estate will be distributed as agreed to by the beneficiaries, but if they do not agree within a certain time, the executor will sell or give away the residuary estate.

§ Finally, you can create a lottery system. You can decide on the system yourself or instruct the executor to use a lottery system of his or her own choosing. There are a number of possible lotteries.

The most common lottery probably is for the heirs to draw straws or names to determine the selection order. In the first round, the children each choose an item in the order drawn. In the next round, the selection order is reversed. Then they return to the initial order, and so on. If there are only two heirs, they can flip a coin to determine the first round order. The winner of the flip can be given the choice of either going first and picking one item or going second and picking two items.

Under this system, heirs pick the items that are of most value to them. That might be a problem if you want the heirs to receive equal value, either monetarily or sentimentally. In that case, one suggestion is to have the executor assign a value to each item and keep track of the selections. If heirs end up with unequal monetary values, the difference is made up with cash. Another approach is to allow heirs to choose only from items of relatively equal value in each round. That approach, however, is time-consuming and might not be practical with all estates.

Another lottery strategy is to let the heirs decide how to value items. There are a couple of ways to implement this strategy.

In one approach, each heir can assign a number of points to each item. By giving the items points, they are deciding how important each item is to them. After everything is valued this way, in the first round each person gets one item on which he or she placed more points than anyone else did.

The points assigned to the items are not likely to be equal. The person who assigned the most points to the item that he won doesn't select again. Instead, the others pick one or more items to which they assigned points until the total points of their items equal the total the first person placed on his or her item. For example, the first heir might "win" property to which he assigned 100 points; the second heir might have assigned 70 points to his winning item. The second heir gets to pick one or more items to which he assigned a total of 30 points before the second round begins.

A variation is to give each heir the same number of points as though they were dollars. They use the points to bid for items in the estate. If an item is particularly important to an heir, he might bid all or most of his points to ensure getting it. Under this approach, the heirs might end up with items of unequal economic value. But that should be acceptable because the heirs have determined the personal value of each item. More details on these two approaches are in the book, The Universe and The Teacup by K.C. Cole (Harcourt Brace & Co.; $13.00 paperback).

To make any of these systems work better, most estate planners recommend that in-laws not be involved. They seem to complicate an already complicated process.

If your estate is taxable, you need to keep taxes in mind. Someone must pay taxes on the items in the residuary estate (and the rest of the estate). You need to work with your estate planner to decide where the tax payments will come from.

Distributing the personal items can be the most complicated and difficult process of an estate. That is a reason some people distribute or dispose of many personal items as part of their planning process. One way to improve the results is to prevent surprises. Ask heirs and potential heirs if any of the items are of special value to them. Once you have made a decision, let the heirs know generally how the property will be handled. Estate planners generally believe that estate disputes and hard feelings are triggered more by surprises than anything else.

Safe Ways to Give Wealth

Bob Carlson — Fri, 24 Apr 2009 12:49:00 GMT

Gift giving is the surest way to reduce estate taxes, help loved ones of all ages, and establish a legacy. Yet, many people are hesitant to make significant gifts to loved ones, because of some potential pitfalls. Those pitfalls, however, can be avoided with some shrewd and creative giving strategies.

Potential givers see several risks in making substantial gifts. The wealth could be wasted or spent unwisely by the recipients. Simple mismanagement by an unsophisticated heir might cause the money to disappear in scams or unwise investments. The wealth also could be dissipated though gambling, substance abuse, or bankruptcy. A common concern is that part of the wealth eventually could leave the family in a divorce.

While these risks are real, there are ways to give that reduce or eliminate the risks without the expense and inconvenience of trusts. As I have stated in past posts, this is a good time to make estate planning gifts, because asset values are down. Estate and gift taxes are based on the value of property. The lower the value of property is when it leaves your hands, the lower the transfer taxes. The benefits of making gifts today can be reaped while protecting wealth from these and other perils. Consider these strategies for structuring gifts.

529 plans. College savings plans authorized under section 529 of the tax code have become one of the best estate planning vehicles in recent years, while tax law changes have diminished the value of other vehicles. Most states now offer multiple 529 plan options, and any person can set up an account for the benefit of someone else and contribute to it. Contributions qualify for the annual gift tax exclusion, currently up to $13,000 per year. In addition, up to five years' worth of exclusions can be used in one year for a tax free lump sum contribution of up to $65,000. The money given to the account is out of the donor’s estate. Under many state plans the owner has some choices over how the account is invested. The IRS generally restricts investment changes to one per year, though the limit is suspended for 2009.

Income and gains in the account compound tax free. Withdrawals are tax free if they are used for qualified education expenses of the beneficiary.

Some states limit the duration of an account to a number of years or to the 25th or 30th birthday of the initial beneficiary. Others have no time limit.

Direct payment of gifts qualifies for the annual gift tax exclusion. In addition, qualified education and medical expense payments made directly to the provider qualify for unlimited gift tax exclusions.

Purchasing services is safer than paying for assets. Assets can be divided in a divorce or sold or pawned to fund other spending. Another possible disadvantage is that paying for items might put loved ones in the habit of asking for assistance whenever they want something. A better approach is to have a plan in which gifts for the year are discussed and set or even multi-year plans are developed.

Home equity match. Suppose loved ones need an expensive item, but the parents are not able or willing to part with a large lump sum or want to stay within the annual gift tax exclusion limit. A strategy, if the children have adequate home equity and credit, is for the children to make the purchase with a home equity loan. The parents then can agree to make all or part of the loan payments either directly or by sending money to the children. This allows the parents to help the children, stay within the gift tax exemption amount, and spread the payments over time in manageable amounts. The children deduct the interest.

Some parents believe it is important the children have some of their own assets in a major expenditure. The cost sharing makes it more likely that the children will choose wisely and take care of the asset. It also makes the children less dependent on the parents.

Trusts. Of course, the classic way to protect assets is by placing them in trusts. In this post we have offered a number of ways to protect assets without the expense and restrictions of a trust. When the strategies discussed here do not meet the donor’s goals, trusts can be fashioned to accept tax-free gifts, take property out of an estate, protect assets, and provide incentives for the beneficiaries.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Asset Declines=A Planning Opportunity - Part 2

Bob Carlson — Fri, 20 Feb 2009 16:46:00 GMT

Last week we discussed how today’s economic distress creates estate planning opportunities. Because of today’s reduced asset values, estate owners can shift assets out of their estates tax at much lower tax cost than they could have a year or two ago. We went over basic strategies for taking advantage of the situation. This week, let’s look at ways to leverage these strategies.

Family loans. Many families like the concept of loans to family members. If you might need the money in the future, a loan lets you provide benefits to family members now while retaining future access to the wealth. The IRS requires you to charge a minimum interest rate on a family loan to avoid income and gift taxes. The minimum rates are based on treasury debt rates. Because the Federal Reserve has been pushing down short-term rates and investors have been reducing intermediate and long-term rates in the flight to safety, the required minimum rates are low. The rates are changed monthly, and depend on the loan's maturity or term. They are known as “federal applicable interest rates” and are published monthly by the IRS in its Internal Revenue Bulletin.

Family loans are very flexible, but here is how one common strategy works. You lend $100,000 to a child for five years. Let's say the law requires you to charge 2% interest. Your child can invest that money for five years. If the investments earn more than 2% annually, the child keeps that excess return. You receive the $100,000 plus 2% annual interest after five years.

Alternatively, you could lend the money to allow a child to buy a home in today's depressed market. You might set the term of the loan at 10 years. There are several actions the child could take by the end of 10 years. The home could be sold at a profit, with the child keeping the return above the interest rate you charge. Or once the credit markets loosen, the child could refinance the home with a traditional mortgage and return the borrowed money plus interest to you.

The benefits of the family loan can be increased with a variation. If you do not need the money to maintain your standard of living, each year you can use the annual gift tax exclusion to forgive the interest and part of the principal. This shifts the money and future appreciation out of your estate tax free over time while enabling your children to benefit from having the cash now.

In some circumstances a minimum interest rate need not be charged on a family loan if the principal is low enough. I won’t go into the details here. They are available in the members’ section of my web site at www.RetirementWatch.com and also from www.irs.gov.

Grantor retained annuity trusts. Today's low interest rates make these trusts a potentially great opportunity.

The grantor creates a trust that pays a fixed income to him for life or a period of years. After that the remainder of the trust goes to the beneficiaries. The present value of the remainder is a gift. The present value is determined by IRS tables, and current interest rates are a factor in determining the amount of the gift. The lower the interest rates, the smaller the value of the gift. If the return actually earned on the asset exceeds the IRS interest rate, the excess becomes a tax-free gift to the heirs.

A GRAT should be created with assets that are expected to appreciate rapidly within a few years or earn high income. Studies show value is maximized by creating a GRAT to last two years. After the trust expires, consider creating a new trust with different assets.

Charitable trusts. If you are inclined to make significant charitable gifts, consider making them now through a charitable trust. In particular, charitable lead annuity trusts are most advantageous when rates are low.

The CLAT pays income to a charity for a period of years. The payments are either a percentage of the trust’s value or a fixed annual amount. After the income period expires, the remainder in the trust goes to the other beneficiaries, usually the children of the trust creator.

The present value of the remainder for the children is a taxable gift when the trust is created. Again, because of today's low interest rates the taxable gift will be less than at other times. In addition, the combination of low interest rates and low asset values create the potential that the appreciation of trust assets will significantly exceed the income paid to the charity and the amount on which gift taxes were paid. The result could mean a significant amount of wealth is transferred tax free to heirs.

The creator of a CLAT can take a tax deduction for the present value of the gift to the charity. Doing so, however, obligates him to pay taxes on the income and gains of the trust. Foregoing the deduction avoids the taxes on the income and gains. The CLAT is irrevocable. Once created, you cannot get the money back or change the terms of the trust.

Today's low interest rates and decline in asset values present estate planning opportunities. Some of these are straightforward and easy to implement. Others, such as trusts and family loans, should be done only with the help of a tax or estate planning expert. Once the current crises end, the benefits from making the moves now could be significant.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Asset Declines=A Planning Opportunity

Bob Carlson — Fri, 13 Feb 2009 19:33:00 GMT

There is at least one silver lining in today's dark clouds—estate planning opportunities are being created. Falling market prices and low interest rates are a great combination for estate planners. If the price depression of the assets is temporary, there is the potential to transfer significant future wealth at a substantial tax discount.

You probably have been postponing estate planning, because of uncertainty about the law and the value of assets. In 2009 or perhaps 2010, the estate tax law probably will be made permanent. The President essentially favors making the 2009 law permanent: A lifetime estate tax exemption of $3.5 million and a top tax rate of 45%. Some details might change, but the final law should be close to that.

Another advantage is that the annual gift tax exemption is indexed for inflation and rose to $13,000 as of Jan. 1, 2009. Each person can give up to $13,000 free of gift taxes to any person in 2009. The tax-free gifts can be made to as many people as you want. A married couple can give $26,000 jointly. In addition, the first $1 million of all lifetime gifts by a person above those sheltered by the annual exclusion are exempt from gift taxes. To the extent the $1 million gift tax exclusion is used, the estate tax exclusion is reduced.

Today's relatively low asset prices highlight a reason to give assets now instead of later through the estate.

Estate and gift taxes are imposed on the value of property. If a mutual fund has declined in value, you can give more shares tax free than you could have before the decline. For example, Dodge & Cox Stock was valued at $132.63 on Feb. 1, 2008. You could have given 90.47727 shares of the fund to someone tax free using the $12,000 annual exclusion. At the recent price of $67.48 you could give 177.8305 shares if you wanted to give $12,000 worth, or 192.6497 to take advantage of the new $13,000 limit. After the financial crisis and economic decline end, the share prices will recover. The future appreciation above the $67.48 price would be out of your estate and into the hands of your heirs with no estate or gift taxes.

This strategy applies to real estate, small business interests, and other assets that have declined in value over the last year or two. If the steep declines of the last year are temporary, this is a rare opportunity to shift assets out of your estate at a fraction of their real or long-term value.

Before giving an asset, however, determine your tax basis in it. Under gift tax law, your heirs will take a tax basis equal to the lower of your basis and the market value at the time of the gift. If the asset has declined below your basis, it makes sense for you to sell it, deduct the loss on your tax return, and give the cash proceeds from the sale. Or if you are concerned that the heirs will spend a cash gift, buy an investment that is not substantially identical to the one you sold and give that new asset. That generates two tax benefits. You deduct the current loss against your income, and all future appreciation is out of your estate.

The best assets to give are those in which you do not have a paper loss but that are likely to appreciate significantly once the financial and economic situation improves. By giving such assets you are likely to transfer the maximum amount of wealth to future generations at the lowest tax cost.

Because of the potential to shift a significant amount of future appreciation to your loved ones at today's relatively low values, it makes sense to give more than the $13,000 gift tax exemption and begin using the lifetime $1 million gift tax exemption. If you do not need the assets to maintain your standard of living and know you eventually will leave them to your children or other heirs, consider making the gifts now. You will be able to transfer far more assets tax free at today's values than you could have in the recent past and than you will be able to after appreciation resumes. Your heirs will end up with far more wealth, because the taxes on your estate will be much lower than if you retained the assets and let them be taxed as part of your estate.

Those are the basics for taking advantage of today's economic distress. Next week we will discuss ways to leverage these strategies and the current economic environment.

Taking Advantage of the 0% Capital Gains Tax Rate

Bob Carlson — Fri, 30 Jan 2009 22:21:00 GMT

For the two lowest tax brackets, the tax rate in 2008 through 2010 is 0% for qualified dividends and long-term capital gains. This compares to the 15% top rate others will pay on those types of income. Single taxpayers with taxable income up to around $33,000 and married couples filing jointly with taxable incomes up to about $65,100 qualify for the 0% rate. The 0% rate applies to any long-term capital gains that qualify for the 15% rate for other taxpayers, not to just to gains on publicly-traded stock.

But there is a lot of confusion and misunderstanding about the 0% tax rate.

It is not an all-or-nothing situation. Because the tax rates are graduated, even some taxpayers with incomes above the threshold could have some income taxed at the 0% rate.

Many retired couples have taxable income below $65,100. Suppose a couple normally has taxable income of $30,000. In 2009 they realize a long-term capital gain of $70,000, bringing their taxable income to $100,000. The first $35,100 or so of that capital gain is taxed at the 0% rate. The rest of the gain is taxed at the 15% rate.

Keep in mind that interest from tax-exempt bonds is not counted in determining the threshold, so well-off taxpayers can qualify some or all of their qualified income for the 0% rate.

This situation provides opportunities for low-bracket retirees to realize some long-term capital gains on asset they otherwise might not held and pay a 0% rate on at least part of the gains. There also is an incentive to switch some investments to dividend-paying stocks that qualify for the 15% rate for other taxpayers.

Another opportunity presents itself for taxpayers who are supporting parents in a low tax bracket. The taxpayers could give some appreciated securities to the parents, who sell them and pay 0% tax. The amount given should stay within the annual gift tax exclusion amount of $13,000 to avoid owing gift taxes or using part of the lifetime gift tax exemption.

Gifts of appreciated securities also could be made to children in low tax brackets, but the gifts would have to be made to adult children. Congress changed the law on the Kiddie Tax to prevent high income parents from giving securities to their minor children to sell and pay 0% capital gains taxes. To avoid the restrictions, the children must be over 21, or over 23 if they are full-time students. The restrictions also can be avoided if the children do not qualify as dependents on their parents’ tax return by providing more than 50% of their own support and earning income. Youngsters who do not meet those exceptions must have incomes less than $1,800 to qualify for the 0% rate.

Couples receiving Social Security benefits will have to be careful when executing these strategies. Increasing taxable income through the recognition of long-term capital gains also could make more Social Security benefits subject to income taxes.

In most cases, the additional tax on the Social Security benefits will be quite low and will make the effective tax rate on taking the capital gains just a few percentage points. Even so, one should run the numbers to determine the effect such a transaction would have on the full tax picture.

A taxpayer needs to consider the non-tax picture before plunging ahead to take advantage of the 0% tax rate. There must a reason for selling the asset other than to cash in the gains at a low rate. The difference between the 0% rate and 15% rate is going to be small in actual dollars, especially considering that only the gains below the taxable income thresholds for the lowest brackets qualify for the 0% rate.

Yet, if someone planned to sell the asset in the next few years, needs to reposition a portfolio, or has a new opportunity, taking a look at how to qualify at least part of the gain for the 0% rate is worth doing.

When deciding which assets to sell, one strategy is to sell stocks or other assets with the least amount of capital gains. Normally, with a tax-advantaged strategy one wants to maximize the gains taxed at the low rate. But there is a ceiling on the amount of gain that qualifies for the 0% rate each year. The goal should be to generate the maximum amount of cash at the lowest tax cost. By selling assets with the least appreciation, it is possible to free up more after-tax cash than if assets with higher appreciation were sold. This is a good strategy for retirees who are deciding which assets to sell to pay for their expenses the next few years.

The main problem now for most people will be to find assets that have capital gains in them. But those who have held assets for a long time likely have gains they have not recognized.

The 0% tax rate is tricky. But there are many retirees who qualify for it, and they should review asset sale strategies.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com.

The Neglected Step: Preparing Your Heirs

Bob Carlson — Fri, 23 Jan 2009 19:17:00 GMT

Many estate plans ultimately fail. The problems are not with the plans. The owners spent a fair amount of time and money preparing and executing the plans. They are sound plans that, if properly executed, would meet the goals.

The problems with many estate plans tend to occur in the final stage. One final stage problem is the heirs are not prepared to receive the wealth. They mishandle it. Or they did not know what was intended, so they do the wrong things. The results are squandered wealth, overpaid taxes, and lost opportunities. Inheritance mismanagement usually falls into one of three categories. Each of these types of mistakes could be avoided if estate owners understand their heirs and take the time to prepare them for the inheritances—or prepare the inheritance for them.

§ Not knowing the rules. Sometimes heirs can reap the full intended benefits of an inheritance only if they know to take certain actions, or to avoid other actions. This often is the case when the tax law is involved, as when an IRA is inherited.

For example, heirs must know not to allow the IRA custodian to retitle the IRA in their names. The deceased owner's name must remain as part of the account name if the heirs want to maximize tax deferral. Heirs also must know when to begin required minimum distributions, how to compute them, and which paperwork to complete. Otherwise, they lose the benefit of the tax deferral. They have to distribute the entire IRA within a short time and pay income taxes on the distribution.

IRAs are not the only area where heirs need to know what to do. They are one major example. Unique assets—businesses, real estate, collectibles—often require special treatment. Or the original owner has unique knowledge about how to maximize the follow of these assets.

An estate plan should ensure that heirs have the advice and information they need to make the right decisions and make them on time. I have long recommended that part of an estate plan include a letter to the executor and perhaps heirs with the basic instructions and supplemented by a notebook containing the appropriate documents, contact information, and any detailed instructions. The executor should know your intentions so these can be explained to the other heirs.

The heirs might not want to follow your advice. They might want to take all the money out of the IRA and spend the after-tax amount, for example. But they should do so knowing the alternatives and fully considering them.

§ Inheritance as a shrine. Some heirs will not use, change, or spend an inheritance. They view it as a legacy their loved one intended or as a memorial of the loved one. They come to believe that any change of the inheritance is a sign of disrespect or a loss of the final connection with their loved one.

Heirs in his mindset might be unwilling to make any changes in an investment portfolio. If they inherited a portfolio overloaded with a particular stock, they feel obligated to hold all the shares of that stock regardless of what is happening with the company. The company might be well past its growth phase and in decline. But the stock is considered the family legacy and not to be sold. Or they believe that the entire portfolio was never supposed to be changed. As the markets and the securities in the portfolio experience changes, the heirs will not allow any changes.

The truth is that many people do not sell long-term holdings during their lives because they do not want to pay the capital gains taxes. They know when heirs inherit they get to increase the tax basis to the current fair market value and can sell without paying taxes. But they do not communicate this to their heirs, so the heirs think the asset had some special value or meaning.

The same attitude might be taken towards assets such as real estate or collectibles. The heir might inherit the family vacation home. Perhaps the heir cannot afford to own and maintain it or does not have the time or money to visit it very often. But he or she believes it would be improper to sell the home. So instead of being a valuable asset it is a cash drain that produces neither financial nor personal benefits.

Once again, the solution is to make clear your thoughts about an asset and your advice. There are few assets that you should expect heirs to hold indefinitely and pass to their heirs. Assets that fall into that category should be clearly identified. You should explain why the asset is unique and should be held, so heirs can tell when circumstances have changed. You also should leave enough other assets so the heirs have sufficient income to pay any costs of ownership. If the heirs do not have the knowledge to properly manage inherited assets, such as an investment portfolio, recommend one or more sources of advice to guide them. Do not let your inheritance to them become a burden.

§ The windfall mentality. There are some people who, after receiving a windfall, do not feel the need to manage it for the long term. They view it as found money that should be used to justify taking higher risks, satisfying short-term desires, or purchasing items they would not buy with their own income or assets. Heirs with these attitudes usually go through an inheritance fairly quickly and spend it in ways that provide little for the future other than memories.

If you do not mind your loved ones treating their inheritance this way, there are no steps you need to take. Leave them what you have and let them do as they please.

You might know your loved ones well enough to realize that they will not take a windfall mentality with their inheritance. Some people are reassured after discussing the issue with loved ones and reiterating their hopes in a letter to heirs.

If you do not want the inheritance treated as a windfall and do not feel assured that your heirs will manage it properly, consider a trust. The trust can limit the spending of the heirs and preserve the assets for the future.

The bottom line is if you have intentions or preferences concerning an inheritance, you should say so. Either discuss it with your heirs now or state it in a letter to them as part of your estate plan.

Some good advice to give heirs is that they first should use an inheritance to eliminate their debts. Next, the assets should become part of their retirement fund or their children’s college funds. If they are well-funded for retirement, they can consider spending it in other ways. But providing a comfortable retirement should be their first use. If the inheritance is spent, the preference should be on items that increase wealth instead of on depreciating items that temporarily enhance life style. If you are leaving IRAs or either tricky assets, be sure the heirs are properly advised on the tax implications and other decisions.

Finally, whatever assets you leave try to ensure they are managed properly. If your heirs do not have enough knowledge, recommend some trusted advisors who can steer them toward good decisions.

Bob Carlson is editor of Retirement Watch and www.RetirementWatch.com where this article originally appeared. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Trustee Strategies for the 21st Century

Bob Carlson — Fri, 16 Jan 2009 17:04:00 GMT

Trusts are part of more and more estate plans. Often trusts are used to hold and manage assets for younger generations.

Sometimes the beneficiaries are too young or inexperienced to manage the assets. Other times the older generation is afraid the younger generation might not resist temptations to spend direct gifts.

The success of an estate planning strategy involving a trust often hinges on the choice of trustee and the structure of the trustee’s job. The intentions of many estate plans have been stymied when the wrong trustees were appointed. A trustee can ignore or misunderstand a trust grantor's intentions. Or after a professional trustee or trust company is appointed, the original professional trustee might disappear in a series of promotions, job shifts, or corporate mergers. The new trustees are not as well-versed in the trustor’s intentions. Changing trustees is an increasingly common problem with all the havoc in the financial services industry.

Trust grantors need to give as much consideration to the choice of trustee as they do to the other details of the estate plan.

One strategy becoming more and more popular is to appoint more than one trustee or to divide the trustee duties among two or more trustees. There are different ways to use this specialization approach.

The original way to divide duties among trustees was simple. An institutional trustee would be appointed to handle the administration and "back office" duties. This trustee would retain custody of the assets, implement the investment transactions, prepare tax returns, and perform other duties of this type. The other trustee often would be a family member or trusted advisor to the family. This trustee would decide on the amount of distributions and make investment decisions or hire investment advisors.

A variation is to appoint co-trustees, usually one family member and an institutional trustee. The trustees have equal power. No action can occur unless each trustee agrees to it. In practice, the institutional trustee defers to the family member on issues of distributions and sometimes on investment strategy. The family member reviews the tax returns and other documents but defers to the institution on their preparation.

Still another variation is to appoint a committee of at least three trustees, usually selected from family members, friends or advisors, and an institution. The trustee agreement might require unanimity for any decision or allow an action to proceed after at least two trustees agree.

More recently, trust creators have been carving the trustee duties into separate compartments or roles and appointing a separate trustee for each role. Each trustee has sole authority over his or her sphere of responsibility.

The most logical division of duties is: investments, distributions, and administration and recordkeeping. The administration and recordkeeping (which includes custody of the assets) normally is assigned to an institutional trustee. Sometimes an account is opened with a broker or mutual fund, and the family CPA handles the taxes and recordkeeping. The other two functions can be assigned to either individuals or to committees of trustees. A committee of family members, perhaps with a third party such as a family advisor, might determine distributions. Another committee or perhaps a trusted financial advisor can make the investment decisions or hire investment managers.

The functions also could be split among institutions. A money management firm could be the trustee that oversees investments, while a bank or trust company could be in charge of custody, administration, and recordkeeping.

A variation is to appoint one or more persons as trustee with oversight of one of the functions, but the trustee is allowed to hire or delegate to others the actual performance of the functions. For example, a person or committee could be the trustees who oversee the trust's investments. Instead of making the individual investment decisions, they could hire money managers or consultants or otherwise delegate the details of the portfolio. Delegation does not relieve the trustees of their fiduciary responsibility for the results. They have to hire carefully, monitor the performance, and make changes if performance is unsatisfactory.

The advantage of splitting the trustee duties is specialists oversee each function. An institution likely is best at administration, custody, and tax preparation. Family members and friends probably best know the grantor's intentions regarding distributions. Specialization of investment management should reduce risk and increase returns.

There also are disadvantages with splitting trustee duties.

Costs are likely to increase with multiple trustees. Friends and family members might serve without compensation. Institutional trustees, however, often offer lower fees for a package deal that includes all trustee duties. They won't proportionately reduce costs to perform only the administration, custody, and recordkeeping, for example. An investment specialist firm also might or might not charge more than an institution would to manage the portfolio.

If something goes wrong with the trust the legal ramifications of dividing trustee duties are not settled. It is important to delineate each trustee's duties and responsibilities in the trust agreement. This could increase the cost of creating the trust. Part of the agreement should include a dispute resolution procedure that eliminates or reduces the risk of court action or of actions not being taken because trustees cannot agree.

Several states have changed their laws to encourage split trustee duties. Delaware, South Dakota, and a few others have laws establishing what they call "directed trusts" that allow a split in trustee duties. Under these laws, trustees in one area are not liable for improper actions of trustees in the other areas.

Income taxes also might rise with multiple trustees. A trust is considered resident in the state where the trustee resides. If there are multiple trustees and they reside in more than one state, each state might claim the trust as a resident and impose income taxes. Research on the issue is needed before trustees are selected.

An increasingly popular tool is to appoint a trust protector. This function is common in foreign trusts and recently made its way to the U.S. A trust protector is not a trustee but is a third party who oversees the trust and trustees and has broad power to protect the trust. The protector may remove and replace a trustee, change the trust's home or situs, resolve disputes between co-trustees, veto investment decisions, change trust distributions, change trust terms under unforeseen circumstances, resolve disputes between trustees and beneficiaries, or even terminate the trust.

Not all states have laws recognizing or defining the protector role. There are unresolved issues such as: What are the trustees' roles when the protector has such broad powers? Who, if anyone, oversees the protector? There also needs to be a mechanism by which a successor protector is appointed.

Trustees can mean the difference between the success and failure of an estate plan. Today, trust grantors have far more options than they did only a few years ago. They must carefully consider not only the choice of trustees but also the structure of the job.

Four Estate Planning Mistakes to Avoid

Bob Carlson — Fri, 19 Dec 2008 20:03:00 GMT

Estate planning and tax reduction will be returning to the front burner for many people. Congress was unable to pass a permanent estate tax reduction in recent years, but a permanent law is likely in 2009 or 2010.Changes in Washington made permanent repeal of the estate tax unlikely, but something similar to the law as of 2009 is likely to be permanent.

As readers re-focus on their estate plans, they should take care to avoid the four main types of errors committed by estate owners. These errors do not concern taxes or probate. The most common mistakes involve family dynamics. These mistakes either create harmful relationships within the family or lead to mismanagement of wealth. Even an estate plan that eliminates taxes can fail if it does not avoid these mistakes.

Giving too soon. Many estate owners allow heirs full access to their inheritances when they become adults or shortly thereafter. Some parents or grandparents reason that the heirs are adults. They can drive, vote, and join the military, so they should be trusted with their inheritances. Others believe the heirs have shown themselves to be responsible and will be able to handle the inheritance.

Being mature and responsible is not the same thing as being able to handle a relatively large sum of money. Young adults, even mature ones, rarely think about the long term, or they might treat something given to them differently from the way they treat something they earned.

Some parents and grandparents say they aren't concerned about what happens to their wealth. They are going to give the money to the people they want to have it. Whatever happens to the wealth is not their concern.

Yet, giving an inheritance too soon can be bad for a young person. The heir might believe that the money will last forever and neglect career opportunities or engage in some personally destructive behavior.

The damage from giving money too soon is most likely when the young person has not been involved in discussions about money with the older generations and has not learned how to handle money. Parents and grandparents should realize that managing an allowance is not similar to investing an inheritance and establishing a long-term spending policy. Estate owners need to take care before giving a young person unrestricted access to wealth.

Giving too late. Some estate owners will not make lifetime gifts, no matter how financially comfortable they are. This can create several problems. One problem is that children or grandchildren might not receive anything until they are nearing their own retirement. Receiving the wealth earlier, or at least being certain of receiving it, might have changed life decisions. The wealth could have helped enhance their lives and those of their children. More importantly, giving only through the will leaves the children to manage the estate at the same time they are coping with their grief.

At a minimum, parents and grandparents should discuss their plans with the heirs. The heirs should be given some idea of what they will inherit, when they will receive it, and suggestions about how to handle it. Ideally, children receive portions of their inheritance over time so they get used to it and learn how to manage it.

Too many controls. Some people like to give and retain control at the same time. The classic way is to leave wealth to a trust with controls and incentives. These trusts can be beneficial. They encourage young people to stay in school or hold jobs in order to benefit from the wealth. They also spread out distributions, so people become comfortable with the wealth and learn how to manage it. But the trusts also can go too far.

An incentive trust might penalize someone whose passions do not include higher education or a high-paying job. Or the trust might be written so narrowly that it does not take into account a number of situations that could arise. Some trusts actually are written so that beneficiaries feel encouraged to have additional children. Restrictive trusts also can breed hostility and frustration among the heirs as they get older and realize their parents or grandparents did not trust them to act responsibly.

Incentive trusts can be useful in some situations. But their creators must carefully consider the incentives and how the trust will be administered. An incentive trust generally should be a way of safeguarding assets until the heirs are likely to be mature enough to manage the money. It should not be a way to control people for life or be a substitute for imparting values during life.

Giving too much. Warren Buffett used to say that his goal was to give his children enough money that they can do anything but not so much that they can do nothing. In some estates, the children receive the entire estate without real consideration of other options, including other family members or entities outside the family, such as charities.

If the children have done well on their own, it might be better not to give them everything. Or if the children simply are not responsible, they might be better off with a relatively small inheritance.

There can be benefits to both the family and the estate owner from considering several generations and beneficiaries outside the family when there is enough wealth involved. For example, the charitable contributions can be structured in ways that get the heirs involved in the giving and teach them about philanthropy.

Giving unequal amounts. There is another problem in some estate plans that is not really a mistake but needs to be carefully managed. Estate owners need to be careful when giving unequal amounts to children.

There can be good reasons to give unequally. Perhaps a child has done very well financially and does not need the wealth. Or one child might have demonstrated that he or she cannot be trusted with an inheritance. But unequal inheritances can create hard feelings toward the parents. They also can create animosity and jealously among the siblings. The situation can be more inflamed when there is a family business. Often, one or more siblings are not qualified to have a significant role in the business, or the parents believe that one person needs to be in control.

Most of these problems can be minimized through communication. Parents and grandparents need to make their plans known ahead of time. This gives everyone a chance to become familiar with the plan and allows for questions and discussion. It also gives a child or grandchild the opportunity to demonstrate that the plan is wrong.

Some estate planners recommend having social workers or psychologists help with the discussion, having the discussion moderated by the estate planner, and even videotaping the discussions.

One goal of estate planning is to get assets to the intended beneficiaries in an efficient way. But this should be done in ways that do not harm family members or make family relationships worse. It can be done in ways that improve family dynamics.

Bob Carlson is editor of Bob Carlson's Retirement Watch and author of The New Rules of Retirement and Invest Like a Fox...Not Like a Hedgehog. This posting is adapted from materially previous published in Retirement Watch. www.RetirementWatch.com

Maximizing the New Roth IRA Opportunity

Bob Carlson — Fri, 17 Oct 2008 22:05:00 GMT

The markets created an opportunity for investors to convert traditional IRAs to Roth IRAs. The opportunity will last only as long as the financial crisis lasts and markets are bearish. Investors who converted their IRAs into Roths earlier this year probably should reverse them and consider converting again next year.

The benefits of a Roth IRA are well known. There are no front-end benefits such as a deduction for contributions. Only after-tax money can be contributed to a Roth IRA. But earnings compound tax-free within the Roth IRA. In addition, qualified distributions from the Roth are tax free. A qualified distribution is one that is taken the later of five years after the Roth is opened and after age 59½. In addition, the original owner of a Roth IRA is not required to take required minimum distributions after age 70½, though beneficiaries who inherit Roth IRAs are required to take RMDs after inheriting them.

A traditional IRA can be converted into a Roth IRA. In 2008 and 2009, the IRA owner must have adjusted gross income under $100,000. (Those with higher AGIs will be able to convert in 2010 and later years.) In addition, the owner must pay a conversion tax on the converted amount. The amount converted is included in gross income as though it were distributed. There is no 10% early distribution penalty on the converted amount if the owner is under age 59½.

This is a good time to consider converting, because the bear markets in 2008 drove down the value of most IRAs. A traditional IRA can be converted into a Roth IRA at a much lower cost than a few months ago and probably at a lower cost than sometime in 2009 after the markets recover.

Converting a traditional IRA to a Roth IRA is not for everyone. When does it make sense to convert a traditional IRA to a Roth IRA? There are several factors to consider.

§ How will taxes on the conversion be paid? The conversion is more valuable and passes the break-even point faster if the taxes are paid from non-IRA accounts so that the entire IRA is converted and begins compounding. If part of the IRA must be distributed and used to pay taxes, it takes longer for the conversion to pay off. In addition, if the owner is under age 59½ and uses a distribution from the IRA to pay the conversion taxes.

Because assets outside the IRA should be used to pay the taxes, it might make sense to convert an IRA over a period of years. Determine how much cash is available outside the IRA to pay income taxes this year, and convert the appropriate amount of the IRA for that level of taxes. More of the IRA can be converted in later years as cash is available to pay the taxes.

§ How long will the Roth IRA be left to compound before distributions begin? The goal in making the conversion is to have more after-tax wealth in the long-term. To accomplish that the converted amount must be allowed to compound its income and gains to make up for the taxes that were paid. If conversion taxes are paid from a taxable account and the IRA earns at least 8% annually, it takes at least seven years of compounding to reach the break even point. A longer compounding period generates more after-tax wealth for the owner than keeping the traditional IRA would have. A lower rate of return means a longer compounding period is needed to break even.

§ Will the tax rate be different when distributions begin? If the tax rate will be lower than in retirement than it is today, it might not make sense to pay taxes at today's rate unless there is a substantial compounding period. But if you anticipate higher tax rates in retirement, converting at today’s tax rate is profitable.

§ Will future Social Security benefits be taxable? If the taxpayer estimates having a high enough retirement income for benefits to be taxed, a conversion could reduce those future taxes. The Roth distributions are not included in gross income under current law while traditional IRA distributions are. If IRA distributions will be a big part of retirement income, shifting them to a Roth could save the Social Security benefits from taxes.

§ Will required minimum distributions from the traditional IRA exceed spending needs? When an owner has a large IRA and enough assets outside the IRA to meet living expenses, it might make sense to empty the IRA early. This is discussed in more detail in my book, The New Rules of Retirement. The RMDs force unneeded distributions and increase income taxes for both you and eventually your heirs.

An alternative to emptying the IRA early is to convert the IRA to a Roth IRA. This is not possible for many owners of large IRAs because of the $100,000 income limit, but it will be possible in 2010 when the income limit is removed.

§ What will state income taxes be? Not all states exempt Roth IRA distributions from income taxes. This should be checked before a conversion is undertaken.

Many mutual funds and other financial services firms have calculators on their web sites to help determine if converting to a Roth IRA will increase after-tax wealth. A good calculator also can be found at www.rothira.com. A few other calculators with no ties to financial products or services are at www.datachimp.com, www.volition.com, www.dinkytown.com, and www.customcalculators.com. Financial planners of course can provide calculations.

IRA owners should consider each year whether a conversion would be profitable. After a conversion is done, the IRA and tax situation should be monitored. The owner might want to reverse the conversion. Those who converted traditional IRAs to Roth IRAs earlier this year should consider reversing the conversion, known as a recharacterization. You would want to recharacterize the IRA because the conversion taxes are paid on the value of the IRA at the date of conversion. You will be paying taxes in April on a value that no longer exists.

The conversion can be reversed any time before the due date for the tax return for the year of the conversion, including extensions. The extension date can be used even if the taxpayer files the return by April 15. This means if you converted an IRA in 2008, the recharacterization can occur any time up to Oct. 15, 2009, regardless of when the 2008 return is filed. If the return was filed and taxes on the conversion paid, an amended return can be filed to get a refund of the conversion taxes.

Once recharacterized, the IRA can be left as a traditional IRA, or in the future it again can be converted to a Roth. The second conversion cannot be made in the same year as the original conversion. A second conversion also cannot occur until more than 30 days have passed since the recharacterization.

There are a couple of times when a taxpayer might want to reverse a conversion.

One reason to recharacterize is that income for the year (excluding the converted amount) unexpectedly exceeds $100,000. A conversion is not allowed when modified adjusted gross income is more than $100,000. When income exceeds $100,000 a taxpayer who wants the benefits of a Roth IRA has to recharacterize and wait for another year when the $100,000 threshold isn’t breached.

The other reason to recharacterize as we said is that the value of the IRA declined after the conversion.

Before beginning a conversion plan, check the fees charged by your IRA custodian. Some will charge for each conversion and recharacterization. Also, be sure the custodian does not impose restrictions in addition to those of the IRS. If your custodian could impede your plan, switch custodians. Another point: IRA custodians often are backed up with requests near the end of the year and cannot process them all promptly. Some transactions IRA owners want done by Dec. 31 are not completed because of the back log. Make your decision and process your paperwork early.