Tower Topics ~ Summer 2001

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Inheritance: New challenges, new opportunities
Seeking advice, setting financial objectives are key

Jim and Susan are very happy with their lives. They have two great children, are doing well in their careers, and live in a nice house in a good neighborhood. Their savings account is modest but growing, and they have excellent retirement plans through their employment. Some day they expect to be very comfortable financially.

When that day comes, they know they will have new opportunities—opportunities to do things for their family and for the causes important to them, like Conception Abbey. They also know they will need to step-up to a new level of planning for their finances, but that time seems far off.

For many families, “some day” comes much sooner than they ever anticipated—and not simply because careers take off or investments skyrocket. Often it comes because of a substantial inheritance.

There has been much research and much written in recent years about the enormous amount of wealth poised to pass from one generation to the next. The explosion of wealth in the last decade—fueled y a relentless bull market that has increased more than five-fold—has made it even more difficult to get an accurate reading on just how much wealth is out there. Whether the actual amount is 5 trillion dollars or 15 trillion dollars, suffice it to say that a lot of wealth will change hands in the next several years.

You may be among the millions of Americans who have—or will shortly—come into a significant inheritance and have questions about how this new wealth will affect your life. Or, you may be in an older generation and concerned with helping those who will inherit from you to develop a new financial paradigm. This article is designed to address the way new wealth dictates new financial ground rules. Generally this means developing new perspectives on how you spend, how you save, how you invest, and how you give.

THE FIRST STEP: Get Good Advice

One of the first things you will want to do is consult advisors you trust. Good advice from qualified lawyers, accountants, investment advisors, and other financial professionals is invaluable as you formulate new approaches appropriate for your new level of wealth. Their advice will be critical in several key areas:

• Tax and investment planning. The influx of substantial assets may dramatically alter your income-tax outlook, quite likely pushing you into higher brackets. The degree to which major new assets affect your income-tax situation depends to a great extent on how those assets are used and invested.

Planning pointer: If your current level of cash flow is sufficient to meet expenses and support your desired lifestyle, there is little reason to select investments that will produce a lot of ordinary income—much of which will be lost to income tax at rates as high as 39.6%. Consider investing a substantial portion of your assets for capital appreciation or in tax-deferred vehicles.

On the other hand, capital appreciation in investments such as stock is taxed only when the asset is sold at a profit—and then generally at the maximum rate of 20%. Note: Inherited appreciated capital-gain assets receive a step-up in basis at death and thus avoid capital-gain tax on the later sale of the asset.

Similarly, tax-deferred investments, such as commercial variable annuities, produce no taxable income until you receive a distribution or make a withdrawal. Caution: Many tax-deferred investments (including retirement plans) carry substantial penalties if you make a withdrawal before age 591/2. And these assets are not stepped-up at death.

• Estate planning. The more assets you have, the more you will need to be concerned about federal estate and gift taxes. Currently you can make up to $675,000 of taxable gifts during your lifetime and at your death without incurring this “transfer tax.” (Note: The gift and estate taxes work together as a “unified” tax, ultimately taxing your cumulative lifetime and estate gifts at the highest applicable marginal rates.) This amount is scheduled to go up gradually until it reaches $1,000,000 in 2006.

Example: Bill Smith has an estate of $500,000 and has made no taxable gifts during his lifetime. Since he has less than $675,000, his entire estate is sheltered from the federal estate and gift taxes.

Bill’s mother dies and leaves him $1.2 million, making his total estate $1.7 million. If Bill disposes of that $1.7 million as either taxable gifts during his lifetime or taxable distributions through his estate, the estate will be subject to a marginal tax rate of 45%. Depending on when Bill makes taxable gifts or taxable distributions through his estate, the total tax could be as much as $425,250.

If you suddenly find yourself with an estate that exceeds the amount currently effectively sheltered from federal estate and gift tax, your plans will be tempered by new tax considerations. Be sure to factor in those tax considerations as you chart a new course.

• Establishing personal, family, and charitable financial objectives. Your advisors can be valuable resources for formulating new ways of thinking about your financial goals. An inheritance may change the focus from “What do I need from my money?” to “What can I do with my money?”

Your first priority, of course, is to ensure your own personal financial security, both presently and in the future.

The next priority for most people is to determine what they can and should do for their families—and when.

Most parents search for a balance between giving their children enough to give flight to their dreams without giving them so much that it destroys their initiative.

Once you have addressed these objectives, you can be intentional in addressing charitable objectives to perpetuate your values beyond your own lifetime. And, of course, good charitable plans work in harmony with your personal and family goals.

THE POWER OF GIVING

Once you have formulated a solid plan for personal, family, and charitable objectives jointly, specific actions can flow from that plan.

Ultimately, your assets can go to only four different places:
• To support your personal expenses during your lifetime;
• To your family and other beneficiaries during life and at death;
• To charity;
• To the government as taxes.

Almost certainly the last “destination” is the least desirable to most people. Fortunately, there are numerous strategies to reduce the amount lost to taxes. These strategies can let you exercise control over the ultimate disposition of a much greater percentage of your assets.

It is somewhat ironic to realize that some of the best strategies for controlling the disposition of more of your assets involve giving some of them away—to family members and other individuals and to charity. Decisions we make about giving can preserve significant assets that otherwise would go to pay taxes.

Example: Mary Thomas is in the 39.6% federal income-tax bracket. She makes a gift of $10,000 to Conception Abbey. As a result, Mary pays $3,960 less federal tax this year. Her gift effectively allows her to control the ultimate use of additional assets equal to those tax savings.

It is not only charitable gifts that result in savings. Gifts to family members can preserve more assets within the family unit.

Example: Bob and Helen Jones are financially secure. In fact, they have more annual income than they can use, and much of it is lost to federal income tax at the rate of 39.6%.

Their children, Carol and Steve, are just starting out in their careers and have young families. Bob and Helen decide to give them some investments that generate $10,000 of income each year—income on which they would otherwise pay $3,960 in federal income tax. Result: Since both Carol and Steve are in the 28% tax bracket, they pay just $2,800 in tax. The family is ahead by $1,160.

Reducing Gift and Estate Taxes. As mentioned previously, you can currently give away either during life or at death up to $675,000 of taxable gifts without incurring gift and estate taxes. If you exceed that limit, however, the tax hits with a vengeance at rates that start at 37% and go up to 55%. With rates this high, you are wise to increase the amount of assets you control with a well-designed giving program.

Planning pointer: Consider gifts from a spouse with an estate worth more than $675,000 to a spouse with a smaller estate. This lets both spouses pass on the maximum amount tax-free and reduces the overall tax. (Note: Gifts between spouses generally are not taxable for gift-tax purposes.)

Lifetime gifts to other family members can also generate estate- and gift-tax savings. Each spouse can give up to $10,000 per recipient each year free of gift tax and remove significant assets from a potentially taxable estate.

Even if your gift exceeds the annual exclusion, it may still make sense.

• First, no actual tax is due until cumulative taxable gifts exceed $675,000 (or the then-current exempt amount). •In addition, if the assets you give away appreciate in value, all the growth along with any income they generate escapes taxation in your estate.
• Furthermore, if you do have to pay tax on a lifetime gift, the gift tax you pay will also be removed from your estate if you live three years beyond the gift.

Charitable Gifts Yield Major Savings. Charitable gifts generate dollar-for-dollar deductions for federal gift- and estate-tax purposes without any limitation on the total amount—and these deductions produce major tax savings.

Example: Ken Brown dies with an estate of $5 million. His will includes a provision for a gift of $1 million for Conception Abbey. The gift reduces the tax on Ken’s estate by $550,000.

Ken was able to control the ultimate disposition of an additional $550,000 through his charitable planning. This means the real “cost” of this gift to his heirs is not $1 million but rather $450,000 ($1,000,000 - $550,000 tax savings).

Choosing the Right Asset Can Increase Savings. As significant as these savings are, they could be even better, depending on the asset Ken directs to be used to fund his gift. Assume, for example, that Ken’s estate includes an IRA worth $1 million.

Distributions from an IRA are typically taxed as ordinary income to the person or entity receiving the distribution. Why? Neither the contributions to the account nor its earnings have ever been taxed. Consequently, if the IRA account passes to Ken’s children—even though they get some deduction for estate tax attributable to the IRA account—they could pay income tax of more than $200,000.

If Ken specifically directs the IRA account to Conception Abbey to fulfill his plans to make a $1 million gift, the children will be relieved of the income-tax burden. And, because we are tax-exempt, we will not have to pay income tax on the IRA proceeds. Considering the income- and estate-tax savings, the cost to the children of Ken’s $1 million gift could be less than $250,000.

LET US BE ON YOUR TEAM

As you go about the important work of setting and carrying out your goals, we would welcome the opportunity to discuss charitable strategies in more detail with you and your advisors. Please feel free to call on us if we can be of assistance. To help you in your planning process, we would like to send you a complimentary copy of our booklet, New Perspectives in Estate Planning. Simply return the enclosed card or call our office.

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