Ideas For Clients
- About Charity
- As We Grow Older
- When Our Children Inherit: Should It Be Outright Or In Trust?
- Our Greatest Gift or Cruelest Cut
- Why Financial and Estate Plans Fail
- What the Fiscal Cliff Fix Means For You & Your Family
- The Case For Index Investing By Trustees
We find that clients often derive their greatest satisfaction through charitable pursuits. They also want to instill in their children their own sense of stewardship. While some use family foundations in these pursuits, others partner with a community foundation.
The Community Foundation Serving Richmond and Central Virginia is an excellent resource. It is flexile and inexpensive and, perhaps most important, its staff knows well the constantly changing needs of our region. Using The Community Foundation as a vehicle for a family charitable venture avoids the burdensome private foundation tax restrictions and the expense of creating and maintaining a separate legal entity.
Through a donor-advised fund, a donor can devote tax deductible contributions to specific charitable purposes (both inside and outside the Central Virginia region). Children can be involved as advisors, either immediately or later. A scholarship fund, for example, can be tailored for a specific population or field of study or educational institution, something that is impractical for a private family foundation.
The Community Foundation is overseen by a rotating board of unpaid trustees who are community leaders. Its highly professional staff does not solicit contributions but stands ready to serve donors and their families. They are always helpful, but never pushy.
While some investment firms, such as Vanguard and Fidelity, sponsor tax qualified funds that can serve some of the functions of The Community Foundation, they lack knowledge of local charitable needs and a staff and board available to interact locally with donors.
A donor advised fund or other fund within The Community Foundation can be anonymous or not as the donor chooses. Often funds are established in honor of persons who have meant much to a donor, such as parents, teachers, or mentors.
For donors who already have family foundations, The Community Foundation can be affiliated to increase the tax benefits and to reduce costs and time required of family members while retaining the separate existence of the family foundation and allowing it to pursue a separate investment strategy under its own board.
For more information about The Community Foundation, go to www.tcfrichmond.org, or call Robert Thalhimer at (804)-330-5992.
All of us face at some time reduced capacity. This was recently brought vividly to mind by the death of of Brooke Astor, 104-year-old New York City philanthropist and socialite. We cannot know when this might begin for us or how rapidly it might progress. But we know that with advancing age, the prospect increases. We do our families and ourselves a terrible disservice not to plan for it. Some simple steps, taken when we have full capacity and thus the ability to make good judgments, can be invaluable to a family.
The first consideration should be, Who can and should make judgments for me if I cannot make them for myself?
Often a spouse seems the best choice. If it is, we know our spouse may be unable to act or to continue to act for the same reasons we may need help. This may suggest a child (or children) as the backup, or sometimes primary, choice.
When a child is to be designated, we must ask these questions:
- Does she or he have the necessary financial experience and judgment?
- Does she or he have the time, considering other family or work responsibilities?
- If there are two or more children, will feelings be hurt by selecting just one? Can the responsibility be shared among children (all or some)?
- Would you (and/or the child or children) prefer to have an independent professional involved, perhaps to act with a child or children (or with a spouse)?
Circumstances will suggest different answers in different families and at different times. In other words, there is no one right answer.
What authority needs to be granted?
Usually, a combination of three legal instruments will be needed:
- A general durable power of attorney authorizes the selected person or persons to act in financial matters for you, with a duty to consider first your needs and expressed preferences. (“Durable” means the authority does not end if you are incapacitated). It can authorize gifts, limited according to your intent as to beneficiaries and amounts. It can also authorize placing financial assets in a revocable living trust you create, usually with yourself as initial trustee.
- An Advanced Medical Directive authorizing one or more persons to make health-care decisions for you, in consultation with your doctors, if you cannot make them yourself. The Directive usually includes a so-called “living will” in which you express your desires in the event of an irreversible terminal condition. Here again, a spouse will often be first choice, with children as backup.
- A revocable living trust, containing directions to the trustee(s) to manage and use trust assets for you during your life and thereafter for your chosen beneficiaries.
The combination of a revocable trust and power of attorney facilitates the most efficient management of your financial affairs during an incapacity and at death. Often the same person or persons serve as agent(s) under the power of attorney and as trustee(s), but not always. Sometimes an institution (bank, trust company or law firm) is included in the trusteeship. Sometimes an individual nonfamily advisor may serve. Here again, your particular circumstances will influence your decision—there is no one solution.
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Suppose a spouse is named to act. What about the inevitable prospect that the spouse’s advancing age will diminish his or her ability to serve? Naming children to sign on as additional decision-makers after a certain attained age of a spouse sometimes makes sense. This may also be desirable for trusteeship of your revocable trust.
Sometimes clients desire to condition the granting of authority under these instruments on a medical determination of their own incapacity. In living trusts, a successor trustee may be authorized to assume co-trusteeship by notice to you or to your spouse. This gives you the ability to say “no,” but avoids the need for third party or court involvement if you do not, or cannot, say “no.”
Once in place, these arrangements should be reviewed from time to time to make sure they continue to be practical as lives inevitably change with the passage of time.
Most of us intend to leave our remaining savings to our children, after taking care of ourselves and our spouse through life. We face the decision, should a child inherit outright, free of all restrictions, or should some or all of the inheritance be protected by a trust and, if so, for how long?
Most agree that a trust as protection against inexperience makes sense until a child attains some maturity, but how much maturity draws differing judgments. As we grow older, our judgment as to an appropriate age for outright inheritance tends to grow older too. Moves from twenty-five to thirty to thirty-five are not unusual.
Sometimes estate and gift tax considerations suggest lifetime trusts for children to shield the inheritance from transfer tax at the child’s death. But even when taxes are not a concern, other considerations may make a lifetime trust the wisest choice, one a child may endorse if she or he considers certain realities of modern life.
Savings inherited outright are easily lost to one of four ever-present risks:
- Uncontrolled Spending. If a child has not learned to be frugal before inheriting, this is the greatest risk. And frugality needs to be learned when young. Sometimes parents know of this problem, but choose to ignore it or to say, “If my child spends it, that’s his (her) problem.” Sometimes substance addiction is a threat. If it is, a parent must remember that recovery is day to day, and the child will always be subject to the possibility of relapse. Mental illness presents a similar concern.
- Unwise Investment. There are countless investment sharks awaiting every child who receives an unrestricted inheritance. Every parent knows this. While making a fortune (small or large) usually involves concentrated risk, keeping inherited savings is best accomplished by minimizing risk through careful diversification and conservative choices of asset classes and allocations among them. Children must learn these concepts and develop the discipline to follow them. Many financial product salespersons stand ready to convince children they have just the products to “beat the market,” but few do and none consistently over time.
- Creditor Claims. In our litigious society, everyone faces the risk of being sued for accidents, alleged professional errors, or unwise contracts—the ways to lose in litigation are countless. Insurance helps, but some risks are not insurable. A trust created for a child can be insulated from the claims of the child’s creditors.
- Divorce. Perhaps the greatest modern danger to inherited savings is loss through divorce. Nearly half of all marriages end in divorce. The divorce laws of the states differ widely. While Virginia’s law is relatively sensible in shielding inherited or gifted savings that can be identified and traced from classification as “marital property” (and as such subject to being divided between spouses on divorce), the rule is subject to many dangerous qualifications. If the efforts of either spouse contribute to the growth of the savings during marriage, a portion will be “marital property.” If the savings are commingled with earnings during marriage, they may lose in whole or in part their protection as “separate property.” If transfers are made to joint ownership, a gift to the other spouse may be inferred. Perhaps most dangerous, if the couple moves to another state with different rules, the inherited savings may be reclassified as “marital property”—Vermont is a prime example. In Vermont, all inherited savings are classified as “marital property” subject to division on divorce. While premarital (or even post-marital) agreements can alter these results, young people entering a first marriage seldom sign them.
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Inherited savings can be protected from all four of these risks by a well-designed and wisely administered trust. If a parent feels a child is capable of wise management, the child can be a co-trustee or even sole trustee of her or his own trust. And trusts can be quite flexible and still protective. For example, a child’s trust can own a residence, art work or antiques for use by the child, or invest in a child’s business or professional practice. A child can also be given the right to specify who will benefit from the trust after the child’s death through a power of appointment. The key is careful design and capable trusteeship, which may be family or professional or a combination.
Finally, even when a parent wants a child to have inherited savings outright, a period of trust protection with a trustee as the child’s mentor on matters of investment and spending may be wise.
We use the term “savings” and not the more currently popular term “wealth” advisedly. The only “wealth” a family holds on to is that which it “saves”—from spending or unwise investment. Not losing capital is the hardest part.
What is the greatest gift we aging boomers or young marrieds can give our spouse and children? And what is the cruelest cut we can inflict on them? The answer is two sides of the same coin.
The greatest gift is to take the time and thought to organize our financial affairs to minimize confusion, unnecessary expense, and unnecessary taxes when we (inevitably) become incapacitated or die. The cruelest cut is not to.
What does it take to give the greatest gift? A bit of effort, beginning with writing down our assets and liabilities in reasonable detail (a form to help organize this effort is included on this website). How are these assets titled, and are there beneficiary-on-death designations for them? These are important details.
Once this information is collected, sit down with your lawyer and talk about these universal issues:
- Who do you want to manage your financial affairs if you become incapacitated?
- Who do you want to make medical decisions for you if you cannot communicate with your doctors?
- How do you want your assets to go (and your debts to be paid) when you die?
- Who do you want to care for any minor children?
Your lawyer will likely then prepare for you a new (or updated) power of attorney, advance medical directive (including “living will” provisions), will and revocable trust. Your lawyer will review how your assets are titled and may suggest changes in form of ownership or in beneficiary-on-death designations. When you complete the process, you will have given your spouse and children that greatest gift, and avoided that cruelest cut.
How much will this cost? That will depend on the complexity of your financial affairs and your wishes and needs. But after meeting with you, your lawyer can estimate the cost. At Word & Word PLC, we do not charge for an initial meeting to discuss your needs if you decide not to go forward with us to complete your planning. And we can usually give you a firm “will-not-exceed” price for our services. (We generally charge on a time-required basis).
Unfortunately, many carefully crafted financial and estate plans fail when the time comes to implement them (on death or incapacity).
Here are some of the most common post-planning errors (or neglects) that cause failure. The failure may be catastrophic or just inconvenient. But occasional attention (checkups) with your financial advisor, accountant, and family lawyer can help you avoid failures in your plan.
1. Titling Mistakes In establishing a financial and estate plan, you will receive advice on how assets should be titled or beneficiary-on-death options arranged. Estate plans frequently fail when there are changes in these arrangements that conflict with estate plan governing documents.
A frequent example involves inadvertent errors when changing financial accounts (certificates of deposit, checking or savings accounts, brokerage or mutual fund accounts, life insurance policies) from one provider to another. The most frequent error involves creation of joint and survivor accounts when the plan requires that assets be titled in one owner’s name (or the name of one owner’s revocable trust). Another example is failure to follow through after plan documents are signed to title assets (or arrange beneficiary designations) as advised. Plans don’t work unless assets are held in a way that conforms to the plan terms. Joint account registration trumps the terms of a will or revocable trust. Your will or your trust may say exactly how you want an asset to go or be managed, but if you title the asset joint with survivorship, the will or trust will not be effective. This can result in unnecessary estate taxes or placing assets in the hands of a beneficiary in a manner inconsistent with your wishes.
2. Titling Mistakes with Residence. Often plans are rendered ineffective when folks change residences. The old residence may have been titled to conform with a couple’s estate plan—say in the wife’s name to use her estate tax exemption. But the couple moves to a new house, and it is titled as tenants by the entirety (joint with survivorship) in the names of both spouses. Real estate lawyers are accustomed to using tenants by the entirety (say 90% of the time) and this sometimes leads to an inadvertent titling error. Fortunately, these errors can be inexpensively corrected if caught in time.
3. Law Changes. A recent change in Virginia law can be a trap. Effective July 1, 2007 real estate devised to a beneficiary carries with it liability for any deed of trust on the property. Under prior law, this liability would be paid from the general estate absent specific direction in a will.
- Change of State of Residence. A change in state of residence requires a review of an estate plan to be sure peculiarities in the law of the new state don’t render a plan ineffective.
- Changes in Family Members. Divorce, remarriage, death, births: all of these events suggest a review of a financial and estate plan. Too often the review is neglected until it’s too late.
- Change in Investments. The sale of a family company often requires reworking of financial and estate plans. Too often the reworking is neglected until it’s too late.
- Changes in Employment. Often a plan is built around employment benefits. Changing jobs requires a review of financial and estate plans. So does loss of a job or retirement.
As a rule of thumb, individuals should review their assets, liabilities and estate plans with their advisors every three to five years and whenever there are significant changes in family, employment, or financial circumstances or major changes in tax laws.
The last-minute partial fix of the Fiscal Cliff brings good news for families facing estate taxes.
Estate, gift, and generation-skipping tax exemptions were retained at 2012 levels, plus inflation adjustments, or $5,340,000 for 2014. This translates to $10,680,000 of exemption for married couples for 2014. The tax rate was set at 40%, 5% more than for 2012.
Significantly, the “portability” provision, allowing a surviving spouse to use any part of an estate tax exemption not used in the estate of the first spouse to die, has been made permanent. An estate tax return must be filed for the first estate even if less than the exempt amount to preserve portability. Portability does not apply to generation-skipping transfer tax exemption, but that exemption can be used effective at the second spousal death with planning.
Many clients will be able to simplify estate plans. But clients should review their existing plans with their advisors to be sure they work optimally under the new rules.
As a rule of thumb, any plan that has not been reviewed for five years is a candidate for review, and changes in financial or family circumstances are also benchmarks warranting earlier review.
We can tell you without charge if we think you should have a review currently. Call our office today at (804) 282-5124 to schedule an appointment.
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Here are some suggestions in light of the Fiscal Cliff Fix.
- Does your plan warrant modification in light of the (supposedly) permanent exemption increases?
Multiple trusts may no longer be necessary or advisable. Consider whether low cost-basis assets should perhaps be moved to ownership by a spouse in poorer health to assure earlier step-up of cost basis.
- Are you set to avoid probate and assure efficient management if you become incapacitated?
By use of a self-trusteed revocable trust you can assure avoidance of the expense and hassle of probate and assure confidentiality. This is particularly important with assets in more than one state. Often beneficiary designations for employee benefit plans and IRAs can optimize income tax outcomes and avoid probate.
- Would your children (or you) prefer they inherit through trusts instead of outright ?
By leaving a child’s share in a flexible trust she or he can control, and can even be sole Trustee of, you can provide protection against loss of assets in divorce, to spousal inheritance claims, and to creditor claims while taking advantage of generation-skipping transfer tax exemptions. If you believe a child will need or desire help with management, you can provide for a co-Trustee or independent Trustee, if desired, and give the child or others power to change Trustees. We have all witnessed tragic losses of family savings through divorce and creditor claims, especially when children are asked to guarantee the business debts of a spouse, which can be expected. You can, through a trust, avoid these risks.
- Give your spouse and children the ultimate gift. Leave them a well-organized plan and complete information on your finances to deal effectively with your incapacity or death.
We all eventually become disabled, often unexpectedly, but we can with planning minimize complexity for those we love. We and your accountants and other financial advisors stand ready to help. Your family will thank you many times over and you will feel good for having done it. It will also prompt you to think freshly about your investments and asset allocations.
- Use your IRA now for charitable gifts, maybe.
Check with your tax accountant to see if this may be beneficial for you. For 2014, Congress has not yet reauthorized gifts direct to charity from an IRA, but it may before years end.
- Do not use the Uniform Transfers to Minors Act for gifts to young children or grandchildren.
Annual exclusion gifts for 2014 will be $14,000 per beneficiary ($28,000 for a couple). Don’t use UTMA for these gifts because this will give the beneficiary unfettered access at age 18 or 21, the perfect age for unwise life choices with money. You can get the tax benefit with a simple and inexpensive trust. If substantial UTMA gifts are already in place, we have suggestions to minimize their potential harm.
- Check your powers of attorney, advance medical directives and anatomical gift instructions.
Make sure these documents carry out your current wishes.
- Be aware that other (and unfavorable) changes may still lie ahead.
The Obama Administration still has a wish list for changes in the estate and gift tax areas that could be brought forward as part of coming budget and debt limit debates. This suggests using now the still available advantages, such as lack of control discounts and short-term grantor retained annuity trusts.
- Remember taxable gifts are still 30% cheaper.
For those who can afford to pay gift tax, the 30% rate advantage of gift tax over estate tax still applies if the donor lives three years after making the gift. The advantage lies in the way the two taxes are calculated. With estate tax, the tax money is included in the taxable base – in other words, one pays estate tax on the estate tax money.
We would be pleased to respond to your questions and help you update your estate plan. Call our office at (804) 282-5124 to schedule an appointment.
The following statement is provided pursuant to U.S. Treasury Department Regulations: This communication is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that the Internal Revenue Service may impose on the taxpayer.
This is the case for index investing by Trustees, told through a case study, hypothetical but typical.
Bob Jones dies a resident of Lynchburg, Virginia on January 1, 2012, age 50, survived by his wife Sally (45) and children Rob (15) and Ann (14).
Bob leaves in a revocable trust $5 million of cash and concentrated marketable securities, to be held in a trust.
The trust will pay Sally an annual unitrust income of 4% for life.
At Sally’s death, the trust divides into two equal flexible lifetime trusts for Rob and Ann and their descendants. Each can control where her or his trust goes at death through a broad non-taxable power of appointment (to anyone but self, estate or creditors).
Bob names Sally and his brother Ed as Trustees, with authority to name successors.
Bob has escaped estate tax and his trusts will likely escape estate tax and generation-skipping transfer tax at Sally’s death and the children’s deaths, thanks to available estate tax and generation-skipping tax exemptions.
The assets have a new cost basis of their values at Bob’s death, so can be sold by the Trustees without income tax consequences.
Sally and Ed face an immediate momentous decision: How to invest the family’s wealth.
Ed has long been a student of investing but is not a professional investor. Sally is smart and well read on investments but has no specialized training or experience with investments.
The family lawyer (you, the reader) has a practice concentrated in estate planning and fiduciary administration. You go to Virginia’s Uniform Trust Code (§64.2-781 through §64.2-790) to refresh your memory on the duties of the Trustees.
You read in §64.2-781 that the Trustees must follow the prudent investor rule.
They must use reasonable care, skill and caution, must consider the portfolio as a whole and set an overall investment strategy with risk and return objectives considering: (1) economic conditions, (2) inflation or deflation, (3) tax consequences, (4) the role of each holding in the context of the whole portfolio, (5) expected total return, income and appreciation, (6) other beneficiary resources, (7) the needs for liquidity, regular income, and preservation and hopefully appreciation of trust capital, and (8) costs (§64.2-782).
The Trustees must diversify the trust investments (§64.2-783). The Trustees must promptly review the trust assets and put a plan for investment in place in a reasonable time.
Sally, Ed and you are keenly aware they cannot, nor can any other person, predict what tomorrow brings.
Sally and Ed’s first decision: Should they make all the investment decisions on their own, as Bob had, or should they delegate, and if so, to what extent and to whom (§64.2-788)? If they delegate, they must exercise reasonable care, skill and caution in: (1) picking agent(s), (2) setting the scope of the delegation, and (3) monitoring the agent(s) performance. They and the agent(s) must adopt, keep current and follow an investment policy statement.
If they do these things, Sally and Ed should avoid personal liability to the beneficiaries for the results.
Sally, Ed and you meet to discuss a plan.
They consider their choices if they delegate:
- They have been approached by Bob’s long-time bank which offers agency investment management services through the Private Bank Division. So have other banks with trust powers. All propose active management with fees starting at 1.25% per annum plus the fees and costs of actively managed mutual funds of up to 1% per annum proposed for all asset classes except domestic large cap equities where individual company securities are proposed.
- They have been approached by registered investment advisors (“RIAs”) which propose similar arrangements at comparable costs. All advocate active management.
- Sally, Ed and you have read Burton G. Malkiel’s A Random Walk Down Wall Street, The Elements of Investing by Malkiel and Charles Ellis; and their and your favorite, Unconventional Success, A Fundamental Approach to Personal Investment, by David F. Swensen, Yale’s world-beating endowment manager. They have also read John Bogle’s books on investing (Bogle founded Vanguard Funds). All these books advocate index investing.
Sally and Ed consider making all the investment decisions themselves, and investing through ETFs and index mutual funds. But they are concerned about their skills at asset allocation – selecting the index products to invest in and setting the proportions. They have read that these decisions are the key determiners of long term results. So they set out to interview registered investment advisors specializing in an indexing approach.
They find this is a small but fast growing sector of the vast investment advisory industry, the participants in which are commonly referred to as ETF Strategists. After interviewing several firms, they decide to use a hypothetical firm we will call “INDEXERS”, which utilizes ETFs to implement a low-cost, low-turnover tactical asset allocation strategy. Their investment approach is modeled after the successful strategies long employed by investment teams at large universities to manage their endowment assets. The underlying investment philosophy emphasizes the importance of:
- Broad diversification by asset class, geography, market capitalization, and style, thereby reducing the volatility of expected returns,
- Minimizing investment management cost and reducing manager selection risk by utilizing index ETFs rather than active management, and
- Avoiding the temptation and risk associated with trying to time the market by following a policy to remain fully invested through market cycles.
The popularity of index fund investing has grown significantly in recent years, and index mutual funds and ETFs have captured significant market share from active management strategies. Underlying this trend are several key factors, including the substantially lower cost, improved tax efficiency, and transparency of index funds and the poor track record by most active managers to match, much less beat, their relevant market benchmark. As outlined in the following chart, this tendency for active managers to underperform passive indices has proven consistently true across asset classes, market capitalization, geographic regions, and both short- and longer-term time periods.
All Bob’s trust’s holdings are sold and invested in one of the portfolios run by INDEXERS early in 2012. INDEXERS will charge a management fee of 0.6% (or 60 basis points). The ETFs it will use have low weighted-average expense ratios of approximately 0.1% (or 10 basis points), which have fallen significantly in recent years due to competition among index fund providers. The “all-in” cost of management is approximately 0.70% (or 70 basis points), well below the comparable costs of investing in actively-managed mutual funds or actively managed investment programs of Private Banks or RIAs.
While it is always a challenge to back test performance data, it is interesting to consider how Bob’s trust would have performed over the past five years under an indexing strategy compared to a strategy that employed active management. As a proxy for an index strategy return, we have assumed that the trust was invested 70% in a broad global equity ETF (Vanguard Total World Stock ETF, ticker VT) and 30% in a diversified domestic bond ETF (iShares Barclays U.S. Aggregate Bond ETF, ticker AGG), and that these funds were rebalanced annually. The following provides a summary of the historical returns, growth in principal, estimated unitrust distributions, and investment management fees and expenses that would have been experienced under this indexing approach.
Developing a similar analysis to assess performance if Bob’s trust had been invested in an actively-managed strategy with a typical Private Bank Department or RIA is somewhat more challenging, since there is no way to accurately calculate the historical returns that would have been generated. However, Morningstar’s World Allocation category, which is Morningstar’s peer universe of actively-managed mutual funds that pursue a global balanced strategy, seems a reasonable proxy. The following provides a summary of the historical returns, growth in principal, estimated unitrust distributions, and investment management fees and expenses that would have been experienced by the Trust under this traditional, actively-managed approach.
What have Sally and Bob achieved with their decisions?
- They have diversified and rebalanced annually.
- They have kept investment management costs low and minimized capital gains taxes through low portfolio turnover and opportunistic tax loss harvesting. Since annual portfolio turnover for most index funds (typically 2%-10%) is much lower than that of most active managers (typically 50%-150%), indexing strategies tend to be more tax efficient and to provide better after-tax returns than active strategies.
- They have increased the aggregate unitrust distributions to the family compared to an active strategy.
- They have better protected the real purchasing power of the trust assets compared to an active strategy.
- They are able to monitor results on a daily basis through INDEXER’S internet portal.
- Perhaps most important, they have avoided the risks associated with selecting and monitoring active managers, which over time have historically underperformed the market as shown by the charts.
The most common barrier in moving from active to index investing is capital gains taxes. But this barrier does not exist after the owner’s death because his or her assets get a new cost basis of date of death values. The barrier also does not exist for IRA or 401(k) assets.