The Bogleheads' Guide to Retirement Planning (45 page)

Your estate planning should focus on the estate limits discussed earlier. If you die in 2009 having close to $3.5 million or in 2011 and beyond with close to $1 million in assets and prior taxable gifts, consult with your attorney and accountant to see if an estate tax return would need to be filed. Anyone having an estate over $1 million, and not planning on dying before 2011, should consult with an attorney to determine what steps would be appropriate to minimize the burden of estate taxes after the act sunsets at the end of 2010.

By the way, the estate and gift tax laws are a political football. The tax code may have changed by the time this book is published. Consult an estate-planning attorney for up-to-date information.

Now that you know what the estate tax liability is, where does the money come from to pay the tax? The most obvious source is from the estate itself. However, those assets may not be liquid. The heirs can also pay the taxes if they have cash or perhaps take out a loan. The Treasury will grant an extension of the time to pay, with interest.

If there are illiquid assets and no cash to pay the taxes, consider establishing an irrevocable life insurance trust (ILIT). As its name suggests, an ILIT is an irrevocable trust created to hold life insurance. Typically, a mother or father would purchase life insurance on their lives for the benefit of children. The annual life insurance premiums are paid with annual gift exclusions and do not count against the lifetime gift exclusion.

The proceeds of the life insurance policy can be borrowed from the trustee of the ILIT, or assets can be sold from the estate to the trustee of the ILIT to raise money to pay the estate taxes upon the death of the insured.

Once the tax has been paid and property has been distributed to the heirs, what is the basis of property that is subsequently sold by the heirs? Property acquired from a decedent receives a basis equal to the fair market value of the property at the date of death of the decedent or six months later, whichever is used as the estate valuation date. If it is sold for less than the fair market value at the estate valuation date, a capital loss deduction is potentially allowable to the recipient. If the property is sold at a gain, there will be a capital gains tax to pay (an exception is made for assets sold in a tax-sheltered inherited IRA account). The tax code allows beneficiaries to use a long-term holding period and pay long-term capital gains, even if they have held the property for only a short time.

The Treasury taxes gifts of property from one person to another over a certain annual amount. The reason for taxing large gifts to another person is to protect the tax revenue stream. If gifts were not taxed, you could give away all of your property during life and avoid the estate tax entirely.

Congress allowed certain exceptions to mitigate the harshness associated with taxing gifts. Here are three examples:

The basis of property acquired by gift is the same as it is for the original owner who gave the gift, with one exception. If the basis is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss, the basis is considered be the fair market value.

Assume a person gifted you common stock worth $100. If the person giving the gift had a basis of $50 on the stock, then your basis is $50. If the person giving the gift had a basis of $200, then your basis is $100. Your basis is either the original basis or the fair market value at the time of the gift, whichever is lower.

There is a great degree of utility in making lifetime gifts. The effective tax rate on gifts is much lower than the effective tax rate on property transferred at death. This fact is not obvious from looking at the tax tables, as the same table applies to both categories of transfers. However, because the tax is not paid out of the gift for transfers occurring at death but is paid by the transferor for assets transferred during life, the effective tax rate is much lower for lifetime gifts.

By transferring property that is appreciating, all the future gain and any income generated are permanently transferred out of the estate of the donor, as long as the donor lives for an additional three years. Otherwise, the gift can be viewed as a gift made in anticipation of death and will be included back in the donor’s gross estate. If it is anticipated that property is going to appreciate in value, then it is better to give it at a time when the value is low to take full advantage of the tax code.

A gift tax return must be filed if the succeeding year gifts are made in excess of the annual allowable deductions. No tax will be due, even though a tax return is required, until the amount of lifetime taxable gifts exceeds $1 million. A gift tax will be due on an annual basis once the $1 million threshold is exceeded.

The GSTT is a separate system of taxation that taxes transfers to a special class of persons known as skip persons. A skipped person is generally the child of a donor. In short, the estate tax skips every other generation in large estates.

Here is a little history. After the adoption of the estate and gift tax, enterprising tax attorneys and accountants came up with a means of partially avoiding it. Congress’s plan was that as each generation died, estate tax would be paid on what was transferred from the preceding to the succeeding generation. Needless to say, that prospect was unappealing to persons of substantial means.

To ameliorate the wealth-sapping effect of the estate tax, a new class of trusts, often referred to as dynasty trusts, was invented. In a dynasty trust, assets were placed into trust, and since according to the rule against perpetuities no trust could last forever, the termination of the trust was set for two, three, or perhaps even four generations in the future. In the meantime, the trust paid out all its income to each generation of beneficiaries, but no principal was paid out. As a result, your great-grandfather put his assets into a dynasty trust and provided that income would be paid to your grandfather, your father, you, and finally your children.

On the death of your children, all money in trust would be paid to your grandchildren. That meant that estate tax would be paid only on the death of great-grandfather and again on the death of your grandchildren. No estate tax would be paid on the death of your grandfather, your father, you, or your children.

Thus, with one document, the dynasty trust, great-grandfather denied Treasury four applications of the estate tax. What a wonderful result! However, Congress felt the practice of establishing dynasty trusts to be abusive and enacted the generation-skipping transfer tax to tax transfers to intermediate generations and to preserve the government’s revenue stream.

The GSTT is very complicated, and only a broad brush overview can be given, which unfortunately will have to leave out many details and exceptions. For that reason, consult with your tax attorney or CPA if you intend to leave any money to anyone who might be a skip person to see what taxes might be due and to take advantage of any planning possibilities inherent in the tax code.

Many volumes have been filled with explanations of how the tax code works, and it is confusing. However, you don’t want to pay any gift, estate, or GST tax that you don’t owe. If you think you have sufficient assets that would require tax planning to avoid the estate and generation-skipping transfer taxes, it is wise to read a few books and then visit a qualified estate-planning attorney to investigate legal means to mitigate the impact of these taxes on your estate. Don’t delay, as the Reverend Ford said in
Pollyanna
, “Death comes unexpectedly!” and with death, most planning opportunities are foreclosed.

It can be very hard to be truly objective about money, insurance, and financial planning. Perhaps you need technical advice or someone to help you stay on track. Or perhaps you and your spouse have very different beliefs about money and risk. You may need an objective outside opinion. If so, it might be a good idea to seek the services of a financial adviser.

There are many different types of advisers, and some work better in some situations than in others. This chapter will help you understand different types of financial advisers, how they work, how they are paid, and how to choose one for the need you have.

Financial advisers can help deal with a wide range of financial issues. Many people have a hard time balancing the desire for spending with the desire to leave an estate. Sometimes people are overly optimistic about how much they can realistically leave for their children or for charity. Other people underestimate how much they need to maintain their standard of living in retirement. If you have difficulty developing or sticking to a plan, a financial adviser may provide the discipline and oversight you need to succeed.

You may also be an excellent saver with a strong moral impulse to save too much and find it stressful spending on the things you need. Or maybe you need help balancing the need to take risk with your willingness to take risk. An objective outside opinion can help.

Often spouses have two very different levels of risk tolerance or spending priorities. These differences can lead to uncomfortable discussions, especially when the risks show up during declining markets. You and your spouse may even have different levels of interest in financial planning, leading to a situation where the interested spouse has total control of the financial planning decisions. If the interested spouse passes first, the less interested spouse may be stuck with a financial estate he or she is not prepared to manage. A good financial adviser can help with all of these situations.

There are several situations where investors may need the services of a financial adviser. In some cases, investors simply need technical guidance. For example, investors with large or very complex estates who lack the experience to manage those estates—and realize that fact—work with tax, legal, and financial advisers. Another situation where a financial adviser could be helpful is when an investor basically knows what to do, but just wants help doing it.

People who do not desire or need a particularly complex retirement plan may still benefit from a financial adviser. There are those who lack the time, patience, or discipline to successfully create, implement, and maintain a plan. Others are not interested in investment management or financial planning. People do not always act rationally with regard to their money, and some people hire professionals to keep them from making emotional mistakes. A financial adviser who deals with many investors facing similar difficulties can be helpful.

However, some individuals who would like to delegate their financial planning to a professional might be better off without one. It depends on the adviser you hire and what their real agenda is. You could unknowingly hire an adviser who takes high risks with your money, chases performance, or sells high-cost financial products that benefits the adviser rather than you. For example, an adviser fee of 1 percent or more will drain assets from your accounts, and that lowers the safe withdrawal rate from your portfolio.

Take the time to find a professional who shares your values and understands your goals. If you understand how the financial services industry works, your search for a good adviser will be much easier.

Money management and financial planning are two significantly different services that are often bundled together. Money management services center on investment choices. Financial planning deals with just about everything else.

Money management is usually most attractive to higher net worth investors. Investors who seek money managers often delegate the entire investing process to their manager by giving the manager discretionary authority. This means the manager makes all investment decisions in an account. A discretionary money manager is typically paid a small annual percentage of the account asset value. Other money managers may not have discretionary authority over their clients’ accounts. Those managers simply carry out their clients’ requests. Nondiscretionary advisers are paid in a variety of ways, such as an annual fee or commissions from the products they recommend.