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Legacy Planning
The following presents a more detailed look at a hypothetical case study.
At a recent meeting to review their Investment Portfolios, Bill and Sue Smith raised an issue that had been of concern for some time … the failing health of Bill’s 75 year old mother Millie. Both Bill and Sue were very concerned about the physical and emotional welfare of Millie, but had also come to a point where they understood there would be financial implications upon her death. Was there anything they could do now to prepare for the inevitable?
Our information gathering process fleshed out the details of Millie’s Net Worth as follows:
- Stock totaling $3,000,000, cost basis of $200,000, current yield of 1%
- Municipal Bonds totaling $4,000,000, cost basis of $3,000,000, current yield of 4%
- Millie’s primary residence totals $750,000, cost basis of $40,000, no mortgage.
Millie’s annual cash needs total $120,000 before tax and her Will and Revocable Trust documents had recently been updated to take full advantage of her unified credit exclusion. In addition, Millie’s Will calls for a $500,000 charitable contribution to her favorite charity upon her death.
During the course of discussions, we helped Millie determine her primary goals and objectives as follows:
- Maintain her standard of living
- Reduce estate taxes upon her demise
- Create an efficient asset transfer plan
- Reduce income taxes
- Provide $500,000 to Millie’s favorite charity
INVESTMENT ANALYSIS:
Millie’s macro asset allocation is a 40/60 split stocks to bonds, respectively, and her annual cash needs are comfortably met. While this allocation works nicely for Millie’s individual situation, a more significant exposure to growth offers potential benefits for the family as a whole.
CASH FLOW ANALYSIS:
Millie’s current annual cash flow exceeds her needs by approximately $130,000 per year. While this is a nice cushion from a cash flow perspective, this increases her estate tax problem with each passing year.
ESTATE PLAN ANALYSIS:
As it stands now, if Millie were to die today her heirs would receive $4.8M of her $7.75M estate. Roughly $3,000,000 (~38%) of her estate would be eroded due to estate taxes.
While Millie’s current estate documents include the use of a Revocable Trust, it was discovered that none of her investment accounts are registered in the Trust name. If not corrected, her investment accounts will be subjected to the probate process upon her death and will delay the asset transfer process. The non-financial benefits, such as seamless management of assets in the event of incapacitation, are lost if the Trust is not funded prior to death.
In addition, her estate plan lacks a Durable Power of Attorney, a Health Care Proxy and a Living Will which may prove useful in the future.
PLAN RECOMMENDATIONS:
In an effort to achieve Millie’s goals and objectives the following recommendations were made:
- Set up a private annuity between Millie and Bill
- Fund Millie’s revocable trust and execute the Durable Power of Attorney, Health Care Proxy and Living Will documents
- Establish and execute an annual gifting program
- Establish an annual charitable gifting program
- Establish & execute new investment policies
Set up a private annuity between Millie and Bill
The main planning technique used for this case is a $4.0M Private Annuity contract between Millie and Bill. For tax sensitivity purposes, the assets used in the Private Annuity transaction are the $4.0M of fixed income investments. This contract provides Millie with a fixed annual cash flow for her lifetime. The annuity payments are based on Millie’s actuarial life expectancy and would be approximately $500,000 per year. If Millie were to die prior to receiving all of her principal, no further payments would be made and the money left in Bill’s account is not included in Millie’s estate. If Millie lives beyond her actuarial life expectancy, the annual payments of $500,000 must continue until her death. Despite this potential shortcoming, it was agreed that due to Millie’s current health situation and her family’s historic lack of longevity, it was unlikely that Millie would survive to her actuarial life expectancy. Assuming she survives for three years after the plan is implemented, her estate would save over $1M in estate taxes as a result of the Private Annuity.
Fund Millie’s Revocable Trust and execute the Durable Power of Attorney, Health Care Proxy and Living Will documents
It is important to fund Millie’s Revocable Trust, execute a Durable Power of Attorney, a Health Care Proxy and a Living Will. Funding Millie’s Revocable Trust will insure her investment accounts will not be subjected to probate upon her death, provides confidentiality and ensures a built in mechanism for managing Millie’s Trust assets in the event she is unable to do so herself. The Durable Power of Attorney also provides for asset management continuity for those assets not held in the Revocable Trust. A current Health Care Proxy and Living Will allows Millie to make her own decisions regarding how and to what extent she wants her medical care administered in the future.
Establish and execute an annual gifting program
If Millie establishes an Annual Gifting Program and makes the maximum transfer to her son, daughter-in-law and 2 grandchildren, ($44,000 total per year), she will have sheltered close to $250,000 from estate tax (assuming a 4% growth rate) within the next 5 years. Since Millie wanted to help fund her grandchildren’s education, the annual gifts earmarked for them was directed to 529 Education Accounts for their benefit. This type of account allows for tax-free growth and tax-free distributions, assuming the funds are used for educational purposes.
Establish an annual charitable gifting program
Forming an annual charitable gifting program to fund the $500,000 bequest during Millie’s lifetime (rather than at death) will take advantage of the income tax benefit available for lifetime charitable gifts. Based on Millie’s expected income tax situation, the suggested annual charitable gift amount is $100,000. In order to maximize her annual charitable deduction, the contribution is done using a combination of low basis stock and cash, based on Millie’s Adjusted Gross Income. In the event of an untimely death, the annual charitable gifts will be coordinated with the amount specified in her Will so the charity will receive the full $500,000 (cumulative) regardless of when Millie passes.
Establish & execute new investment policies
Millie’s equity investment policy should be executed with tax sensitivity in mind. Although investment considerations should dictate investment policy, realizing capital gains should be avoided whenever possible. Any unrealized gains held by Millie at her death will receive a stepped-up cost basis and completely escape income taxation. The private annuity fund in Bill’s account should be managed on a “total return basis” which means investment policy considers both current yield and growth potential. Increasing the growth exposure offers the possibility of greater return potential over the long-term versus a straight municipal bond portfolio. In addition, it also provides some protection against Millie living beyond her actuarial life expectancy.
SUMMARY:
As a result of the foregoing and assuming Millie dies 3 years from now, the Smith Family’s overall wealth will be enhanced by approximately $1,250,000. In addition, the family has the peace of mind that Millie’s estate situation is in good shape and there will be no surprises when the inevitable occurs.
North American’s expertise and holistic approach to wealth management was the right fit for the Smith Family. By going through our LIFE process (Listening, Informing, Formulating, Executing) we had an opportunity to become close to the Smith Family, anticipate their needs and provide them with the objective guidance they desired. Equally important is that once the plan was implemented, it wasn’t forgotten about. As time marches on, we will be involved with monitoring the plan and any changes in the family’s objectives to make sure the appropriate plan design changes are made.
The above discussion and related recommendations are based on hypothetical facts and circumstances and the United State Internal Revenue Code, and applicable regulations, as of March 31, 2005. This is intended to illustrate possible tax savings and other favorable consequences that may be achieved through proper planning. Anyone considering employing these, or any other estate planning tactics, should do so only after consulting with an estate planning professional.