Benefits of Financial Planning:
Financial
planning may give you peace of
mind, maximize of
current and future financial well being, prepare you for future
emergencies, take care of estate planning, prepare for children's
education costs, avoid tax traps, minimize the effects of stock
and real estate bubbles and crashes.
Investing:
A study by Dalbar in the 1990's showed that the
average investor made only 3% when the market went up 17% a year
because retail investors sold at the bottom in a panic and bought at
the top in a panic. If those investors had been guided by a
professional they might of at least been encouraged to get an index
fund to get the market's rate of return. Or possibly a professional
advisor could find a mutual fund that could do better than an index
fund.
Tax Planning:
Further, there are tax traps that cost
investors money. For example: getting a capital gains distribution from
a mutual fund that is going down in value, losing capital gains
treatment for assets in IRA's, buying allegedly tax-free Munis only to
find that they have AMT tax, getting a big mortgage on their residence
and then finding later that the interest deduction is not allowed for
cash out refinances exceeding $100,000 over the original purchase
mortgage, buying rental real estate with a negative cash flow and then
being denied the tax deduction because AGI was too high, using borrowed
money to fund a money losing business and then having the tax deduction
denied due to basis rules, paying higher than expected tax on capital
gains for commodities and collectibles.
Risk Management:
Risk management, which may involve buying insurance,
is important. Example: a person with no disability insurance became
handicapped about ten years before his intended retirement and could
not work for three years. His after-tax opportunity cost of lost wages
was $240,000, which forced him to sell his stocks and that triggered
taxes of $35,000 which in turn created a need for more selling of
stocks. This damaged a balanced investment portfolio which caused a
need for additional investment changes to rebalance to a smaller net
worth portfolio. He had only stocks in his taxable account and to
remain balanced he would need to buy some stocks inside of his IRA, and
when those go up he will not get capital gains tax treatment when he
makes a qualified retirement distribution when retired.
Education Planning:
Paying for college is
extremely expensive. Education Planning maybe able to
help. It
covers 529 Plans, tax
credits for education expenses, investment planning for education
costs, and tax deductions or tax favorable treatment related to education
expenses. To do education
planning correctly requires a
good knowledge of income tax planning. To set up an asset allocation
for a 529 Plan requires special effort since changes inside the 529
account are allowed only once a year (except for during 2009 only).
Investment allocations need to be balanced between a need for the
higher returns from stocks on one hand contrasted on the other hand
with the fact that a tax-free vehicle is best used for bonds, so it may
be better to keep stocks out of a 529 Plan. Also the risk of a stock
market crash hurting your child's education budget are serious, so that
is another reason to consider bonds for the allocation. Further
complicating the allocation decision is that many 529 Plans have
limited choices of expensive funds, so that implies it is best to use a
state plan that has a cheap bond index fund and use the 529 Plan as a
place to fulfill the "global" (big picture) bond allocation. This means
when funds are spend from the 529 Plan that the client would need to
re-allocate more of his other funds into bonds, assuming the goal was
to maintain the same proportion of bonds. 529 Plans require
documentation that college expenses are legitimate and busy immature
students may not want to verify petty purchases, so it maybe best to
limit 529 Plan spending to a few large easily documented expenses.
Regarding
integrated financial planning, the 529
Plan future contributions should be examined to see how it effects
estate planning. This is because contributions are subject to the
annual $13,000 tax-free gift limit and it may be best for high net
worth clients to refuse to give funds to a 529 Plan and instead give
each year $13,000 of FLP units to their heirs. Anyone can gift funds
for tuition without gift tax if they write the check payable directly
to the college, instead of to a 529 Plan.
For those who own small businesses and who can employ
their children in the business there are some tax advantaged ways to
pay for college. However, these must be offered to all employees, so if
too many non-family employees want to go to college then it might be
unwise to offer this program.
Estate Planning
Estate planning
is about transfer of assets after one's
death and the taxes and fees related to the transfer, including gift
taxes, if
gifts were used while one is alive.
Methods to transfer assets at death are by
contract
(Revocable Trusts or Irrevocable Trusts, insurance proceeds or
Qualified
Retirement Account beneficiary designation) or by a Will. Also, if none
of the
above applies then assets pass by court proceedings.
Taxes
and fees
are: Probate fees charged by the court for assets passing by probate.
In California
this can be $48,000 for a $1,000,000 asset like a house, even if the
asset has
been “hollowed out” with a cash-out refinance and has no equity. IRD
tax is “Income
in Respect of the Decedent” which is income on the income earned in
final year
of life. Finally estate tax is a tax based on net worth, not on assets.
So an
estate may pay state and federal estate tax, a court probate fee and
IRD state
and federal income tax. Also expensive
real estate
city and county transfer taxes may apply if the deceased person’s home
is sold.
Using
a
Revocable Living Trust is a way to make assets transfer by contract and
thus
avoid probate, saving probate fees, time and privacy. It does not save
on
estate tax or income tax. When someone dies the revocable trust splits
into an
A Trust and a B trust with the deceased exemption amount in one trust
and the
excess in the other trust. That way the exemption amount (scheduled to
be
$1,000,000 in 2011, but subject to legislative change) is
preserved free
of tax to be sent downstream to the children. However, while the
surviving
spouse is alive, the spouse gets to draw on the income generated by the
exemption trust.
Doing
Charitable Gifting is a way to reduce estate tax and income tax. This
would need integrated financial planning to determine how much tax
would be saved and whether one would be able to afford to give the
gifts.
Qualified
Retirement Accounts such as 401k, 403b, IRA, etc. pass by contract
based on the
beneficiary designation statement, which can not be overruled by court
order or
by a Will. This is why it is vital to do a full financial plan and
examine estate
planning issues. As a rule of thumb it is far more flexible and more
reliable
for estate planning purposes to have assets in an IRA than in an
employer
sponsored retirement plan like a 401k because of the benefits of “stretch IRA” and the freedom and control
that an IRA gives to the owner to have a sophisticated beneficiary
designation.
Everyone can give
$13,000 annually without gift tax, so to avoid inheritance tax parents
should give
this amount away to their children. However this should be used
carefully
because it is best to use it to give shares in FLP’s to reduce estate
tax,
rather than to fund a 529 Plan. Regarding integrated financial
planning, 529
Plan future contributions should be examined to see how they effect
estate
planning. This is because contributions are subject to the annual
$13,000
tax-free gift limit and it may be best for high net worth clients to
refuse to
give funds to a 529 Plan and instead give each year $13,000 of FLP
units to
their heirs. Anyone can gift funds for tuition without gift tax if they
write
the check payable directly to the college, instead of to a 529 Plan.
One way to
reduce net worth so as to reduce estate tax is
to buy
lots of expensive cash value life insurance with the heirs named as
beneficiaries. The problem is that an incidents of ownership of a life
policy
may cause the policy proceeds to be deemed by the IRS to be part of the estate. So the solution maybe
to create an
irrevocable life insurance trust (ILIT) and fund it with an annual gift
and to
annually issue a “Crummey letter” (named after a Mr. Crummey) inviting
the beneficiary
to feel free to withdraw funds from it in order to qualify as a
completed gift,
which is vital to removing the asset from the estate. The problem is
that Whole Life insurance policies (not cheap Term Life insurance) is
very expensive and the
insured may
not be able to get it if his health is poor. Another problem is that
this uses
up the $13,000 annual gift exemption, which maybe better spent on
gifting of
FLP shares.
Another technique is for the parents to
sell distressed assets to their kids at fire sale prices, thus reducing
the
parent’s estate while they are alive. The sale must be at fair market
value
which should be verified with an appraisal. The need for an appraisal
is determined
by an estate planning attorney. Another technique is for the parents to
liquidate
assets and loan the proceeds to the children at today’s low 0.8% AFR
short term rate
using
an interest-only loan and then the children invest in stocks and hope
to make a
long run return of roughly 8 to 10%. This is estimate is based on the
past
performance of broad market indexes and is not guaranteed for the
future. To
prevent the children from being spoiled the assets should be controlled
by a
Trustee.
California residents need to be careful about gifting or
bequeathing
a house to heirs because if not done correctly the heir will loose the
low
Proposition 13 property tax base rate. If the house is the only asset
and it
is to
shared by two grown children where one will keep it and the other will
sell his
half interest then the parents should ask their attorney about
strategies such
as bequeath it to only one child after first getting a cash-out
refinance and
then bequeath the cash to the other child. That way each child would
get the same
amount of net worth. If an inherited house is titled in the names of
two
siblings and one sells or quit claims his share then that negates
the Proposition
13 low tax base benefit and it may trigger expensive real estate city
and
county transfer taxes.
