Wealth Retention Through Tax-Focused Planning: The Next Financial Challenge

By Linda R. Crane

Many women and members of other historically marginalized groups have become affluent as a direct result of taking the fullest possible advantage of access to opportunities that were closed to them in the not-too-distant past. These opportunities include education, jobs, personal loans, business loans, and home ownership. Meeting the challenge to take advantage of these foundation-building opportunities has led directly to professional achievement, enhanced quality of life, social status, and financial gain.

The “secret” such achievers share is the consistent ability to seek and to follow good advice during successive stages of growth as though their lives were and are a continuum on which they are situated at different points at different times. “Go to school!” “Work hard to succeed!” “Save for retirement through your employer sponsored plans!” “Break through the glass-ceiling!” “Save for your children’s education!” “Invest in the stock market!” As a result of sticking to this early habit of following good advice, affluent women and minorities have become successful and are now enjoying the fruits of their labors in record numbers.

As time has passed and as the number of first-generation college graduates and business owners who are enjoying the comfortable lives and affluence that their early planning strategies have brought has grown, there is anecdotal evidence that many are beginning to wonder if there is more good advice that they have yet to receive which will help them fine-tune their existing array of financial and economic assets. We believe that there is a trend developing among affluent women and minorities who are looking for new ways to enhance their financial security and to protect their families, now and through this generation. This explains, in part, the apparent growth in the demand for the services of financial planners and the new marketing focus on wealth “management” strategies.

Financial planners do a fine job. Yet, frequently, the financial planning process does not adequately address the concerns of these clients. This is especially true for clients who are sophisticated investors who are not necessarily looking for new additional investment opportunities or to reallocate their existing portfolios. Rather they are in a market for something that’s new to them, something that they have never been advised to do and, therefore, have never pursued in earnest.

So what’s new? What have women and minorities two groups who have achieved their self-made success because of their penchant for always following good advice not yet been advised to do? What is left for them to do that will add significantly to their ability to enhance the quality of their financial lives? The answer to all of these questions is the same. Affluent women and minorities must now become savvy about how to seek the advice of tax attorneys who specialize in helping their clients retain their hard-earned wealth through the strategic use of the tax laws that will help them to reduce taxes paid during their personal and business lives, and on their estates after their deaths.

I. Protection From Taxes

A. Gift and Estate Taxes

The taxes that erode wealth more than any others are transfer taxes and income taxes. The transfer taxes of greatest concern are gift and estate taxes. Gift taxes are imposed on gratuitous transfers of property made from one person to another while the transferor is alive. Gratuitous transfers made at death are subject to estate taxes. The current federal transfer tax rates range from 37% to 50%. Thus, they can be very onerous. However, many strategies exist for avoiding transfer taxes, or at least for limiting their effect on an estate.

These include irrevocable insurance trusts, charitable remainder/lead trusts, grantor retained annuity trusts, grantor retained unitrusts, defective grantor trusts, family limited partnerships and family limited liability companies.

Besides limiting the amount of tax due, one should also consider who will be responsible for paying the tax. Many traps for the unwary exist in this area. Without proper planning one’s beneficiaries may end up receiving unequal distributions from her estate, even though she intended that each beneficiary would receive an equal portion.

For instance, Parent, who was recently widowed, has $2,000,000 in assets. $1,000,000 is in CDs and the other $1,000,000 is the value of Parent’s small business. Parent has two children, Son and Daughter. Parent intends to give each child one-half of her estate upon Parent’s death. Since Daughter is involved with Parent in the small business, Parent executes a will that leaves the business to Daughter. To treat Son fairly, Parent designates Son as the payable-on-death beneficiary of the CDs. When Parent dies Son and Daughter each get $1,000,000, right? Not necessarily. If Parent’s will is not drafted correctly, Parent’s estate taxes, income taxes, and other expenses could be taken out of Daughter’s $1,000,000, while Son’s $1,000,000 in CDs remain unaffected.

B. Income Taxes

Everyone knows that income taxes can also erode the wealth one has created. The income tax is a separate tax from the gift and estate taxes. That means one asset may be subject to both income taxes and transfer taxes. For example, IRAs, 401(k)s, pension plans, and other tax deferred investments, may be subject to both a 50% transfer tax rate and a 40% income tax rate, if upon the owner’s death the IRA passes through a trust to the beneficiary and other conditions are met. In such a situation the IRA beneficiary would only receive 30% of the IRA, while the government would take the other 70%.

Other severe tax consequences could result if proper consideration is not given to the designation of beneficiaries for tax-qualified retirement plans. For example, if one’s estate is designated as the beneficiary of an IRA, the income tax deferral of the IRA is shortened dramatically; costing the IRA owner’s family a significant amount of lost tax savings. The major benefit of tax-qualified retirement plans is that the income generated inside them is not subject to income tax until it is withdrawn from the plan. Thus, the longer the funds can remain in the tax-qualified plan the more those funds can grow on a tax-deferred basis and the longer one can wait to pay the tax due. The tax laws require that all of the money in an IRA be withdrawn within approximately 5 years after the IRA owner’s death if an estate is the beneficiary. That means all the income taxes attributable to the IRA must be paid within that 5 year period. On the other hand, if the IRA owner’s 30 year daughter is the designated beneficiary instead, the income taxes due upon withdrawal of the IRA funds may be paid ratable over a 53 year period according to the life expectancy table specified in Treasury Regulation SS1.401(a)(9)-9 A-1.

II. Protection from Probate

Another concern many people have is avoidance of probate. Probate is the court proceeding in which a decedent’s will is proven to be her valid Last Will and Testament. The probate process is public. Thus, anyone can access probate records which show how much one owned at death and to whom she left her wealth. In addition, if the process is protracted, probate expenses can consume a significant part of the assets of an estate. However, if one has a trust in which she holds most of her assets, the probate costs can be drastically reduced.

Another similar public court proceeding is a guardianship. In a guardianship proceeding, a fiduciary (guardian) is appointed by the court to manage the affairs of a mentally disabled individual or a minor child. The court supervises the guardian. Many times the costs and publicity of a guardianship can be avoided with a durable power of attorney and/or a trust. Even though durable powers of attorney and trusts can save one money and keep her affairs private, an important aspect of using a durable power of attorney and/or trust is that one can set the rules to govern her fiduciary’s actions, instead of having a court impose its judgment.

III. Providing for Family and Friends

One other concern an individual has is how to provide for her loved ones after her death. Typical issues are education of children, providing the means for beneficiaries to obtain good health care, naming guardians for minor children, and providing for beneficiaries with special needs, i.e. physically and/or mentally disabled, and/or elderly.

529 Plans and Dynasty Education Trusts are two great options that assist with meeting education expenses that were both created only a few years ago. Nevertheless, they have become very popular in a short period of time.

A 529 Plan is a type of savings plan established by a parent, grandparent, or other donor to pay the qualified higher education expenses of a designated beneficiary. The cash contributed to a 529 Plan can be invested in several investment vehicles. In addition, the investments in a 529 Plan are not subject to federal income tax, but may be taxed by individual states if the beneficiary is not a resident of the sponsoring state. Further, if properly structured, the contributions are not subject to gift tax. The designated beneficiary of a 529 Plan can be changed to another family member, such as another child, spouse of the original beneficiary, or first cousin without adverse tax consequences. Finally, funds can be rolled over from one plan to another without tax consequences. The donor may wish to do this due to the investment performance or because of a change in the school being attended by the beneficiary.

The Dynasty Education Trust is another relatively new education planning strategy. It is only available in certain states, including Illinois. A Dynasty Education Trust, if established properly, will never be subject to transfer taxes; though it will be subject to income taxes. However, it can exist forever and provide educational benefits to anyone the creator of the trust chooses, including non-family members.

Similar to a Dynasty Education Trust is a Dynasty Health Care Trust that may be established to provide health care benefits to anyone, forever. As with the Dynasty Education Trust, careful drafting of the trust agreement is required. Thus, professional legal advice should be obtained prior to implementing such a strategy.

Though the purpose of these strategies is to provide for one’s family and friends, it is sometimes important not to provide too much assistance. Giving heirs too much money too quickly may turn them into spendthrifts. Further, giving money outright to special “needs beneficiaries” may disqualify them from governmental benefits, such as Medicare and Medicaid. Again, trusts can be used to prevent all of these potential problems. However, other tools are available as well to accomplish the goal of providing for one’s family and friends. Obtaining the appropriate legal advice is essential to the successful implementation of these strategies.

IV. Plan for Health Care Needs

Many strategies also exist for providing for your own health care needs. A power of attorney for health care can be used to plan for possible disability. A living will, Do Not Resuscitate (DNR) order or Declaration of Mental Health Treatment also allow one to specify before-hand what she wants done should she become unable to communicate her wishes in the future.

V. Philanthropy Desires

Many first-generation wealthy have philanthropic desires. They know first-hand how difficult it is to be successful and may have a strong desire to help the next generation of individuals who are longing for good advice and assistance. Such desires can produce enormous tax savings if carried out properly. For instance, gifts of low basis stock to a charitable remainder trust can avoid recognition of much of the income taxes that would otherwise be due upon the sale of the stock. Additionally, such gifts can be structured not to be subject to transfer taxes; and, better yet, to give the donor a charitable contribution deduction on her income tax return. This is a win/win situation for the donor and for the charity. As if that weren’t enough, the donor can also establish her own charity to be designated as the recipient of the gift and still qualify for the income-tax deduction, avoiding much of the built-in capital gain in the stock.

Creating wealth is hard work, especially for someone who came from modest means. However, the work is not over after the wealth has been created. One should look to protect her wealth from unnecessary taxes and other expenses. To achieve this next financial goal newly affluent women and minorities should now begin to seek competent legal tax counsel to learn how to use their wealth to best serve themselves, their family, friends, and community.

This article was co-authored with Ted A. Koester, J.D.

Tools for Individuals

Estate Planning Goals
          A Checklist

Revocable Living Trusts

          A Visual Overview

Tools for Businesses

LLC Formation Questionnaire

          For Aspiring Business Owners

Wealth Protection

          For Business Owners