Estate Planning for the Faint of Heart – No Trusts Required!

November 02, 2017
For those hesitant to create an estate plan, Wealth Planner Ali Hutchinson discusses tax-efficient options for transferring wealth to future generations or charity that require no long-term commitment, trusts or legal fees.

In every meeting, we speak with our clients about ways to maximize total family wealth. There are many facets to this process, including choosing the right companies and managers with whom to invest, entering and exiting investments at the right time, setting up an appropriate asset allocation and, of course, investing in a tax-efficient manner. As clients have undoubtedly heard us say, it takes a lifetime of 6% returns on investment to outpace income and estate tax rates approaching 50%. For this reason, a responsible wealth management discussion includes not only asset allocation but, perhaps more importantly, asset location. The more you can transfer to charity, children, grandchildren and others during life, especially into income tax-favored accounts, the less you will transfer to federal and state governments at your death.

Many of our clients raise objections to estate planning. Some are convinced that the current administration will do away with the estate tax, so complex planning is a waste of time and legal fees. Others feel their financial lives are overly complex and are hesitant to put additional structures in place. No matter your objection to estate planning, if you are interested in transferring wealth to the next generation in a tax-efficient way with no long-term commitment, trusts or legal fees, read on!

Objection 1: “I get it. I want to transfer assets to my children and grandchildren, but my financial life is already too complex. I understand the value of trusts, but it’s too much trouble to set them up and keep track of ongoing administration.”

We hear you! There are some very simple ways to transfer significant wealth to your family during life without complex planning structures, thereby increasing the overall wealth transferred to children and grandchildren and decreasing taxes paid.

As an example, meet Mr. and Mrs. Client, a married couple in their 60s. They have two children, Son and Daughter, both of whom are married. They have three young grandchildren, all of whom currently attend nursery school.

To the chagrin of their wealth planner, Mr. and Mrs. C do not have the time or patience for GRATs,1 SLATs2 or QPRTs.3 The documentation and annual interest payments required for an intrafamily loan4 make them cringe. Despite (or because of!) these feelings, they were savvy enough to call their relationship manager and set up some automatic payments to take advantage of the medical, educational and annual exclusions from gift tax. Here is a copy of their annual account statement for the first half of the year.

 

Date Description Amount
1/1/2017 Paid to Account XXX f/b/o Daughter - 2017 Gift $14,000
1/1/2017 Paid to Account XXX f/b/o Son-in-Law - 2017 Gift $14,000
1/1/2017 Paid to Account XXX f/b/o Son - 2017 Gift $14,000
1/1/2017 Paid to Account XXX f/b/o Daughter-in-Law - 2017 Gift $14,000
1/1/2017 Paid to 529 Plan f/b/o Grandson1 - 2017 Gift $14,000
1/1/2017 Paid to 529 Plan f/b/o Granddaughter - 2017 Gift $14,000
1/1/2017 Paid to 529 Plan f/b/o Grandson2 - 2017 Gift $14,000
1/1/2017 Paid to United Healthcare - Medical Insurance Premium for Daughter and Family $2,200
1/1/2017 Paid to Blue Cross - Medical Insurance Premium for Son and Family $2,000
1/1/2017 Paid to Aetna - Dental Insurance for Daughter and Family $150
1/1/2017 Paid to Aetna - Dental Insurance for Son and Family $100
2/1/2017 Paid to United Healthcare - Medical Insurance Premium for Daughter and Family $2,200
2/1/2017 Paid to Blue Cross - Medical Insurance Premium for Son and Family $2,000
2/1/2017 Paid to Aetna - Dental Insurance for Daughter and Family $150
2/1/2017 Paid to Aetna - Dental Insurance for Son and Family $100
3/1/2017 Paid to United Healthcare - Medical Insurance Premium for Daughter and Family $2,200
3/1/2017 Paid to Blue Cross - Medical Insurance Premium for Son and Family $2,000
3/1/2017 Paid to Aetna - Dental Insurance for Daughter and Family $150
3/1/2017 Paid to Aetna - Dental Insurance for Son and Family $100
4/1/2017 Paid to United Healthcare - Medical Insurance Premium for Daughter and Family $2,200
4/1/2017 Paid to Blue Cross - Medical Insurance Premium for Son and Family $2,000
4/1/2017 Paid to Aetna - Dental Insurance for Daughter and Family $150
4/1/2017 Paid to Aetna - Dental Insurance for Son and Family $100
5/1/2017 Paid to United Healthcare - Medical Insurance Premium for Daughter and Family $2,200
5/1/2017 Paid to Blue Cross - Medical Insurance Premium for Son and Family $2,000
5/1/2017 Paid to Aetna - Dental Insurance for Daughter and Family $150
5/1/2017 Paid to Aetna - Dental Insurance for Son and Family $100
5/1/2017 Paid to School - 1/2 Tuition for 2018 School Year Grandson1 $10,000
5/1/2017 Paid to School - 1/2 Tuition for 2018 School Year Granddaughter  $11,100
5/1/2017 Paid to School - 1/2 Tuition for 2018 School Year Grandson2  $9,000
6/1/2017 Paid to United Healthcare - Medical Insurance Premium for Daughter and Family $2,200
6/1/2017 Paid to Blue Cross - Medical Insurance Premium for Son and Family $2,000
6/1/2017 Paid to Aetna - Dental Insurance for Daughter and Family $150
6/1/2017

Paid to Aetna - Dental Insurance for Son and Family

$100

  Total Income, Gift and Estate Tax-Free Transfers to Descendants Jan 2017-June 2017 $154,800
  Total Income, Gift and Estate Tax-Free Transfers to Descendants 2017 $309,600
  Total Tax-Free Transfer to Descendants over 20 Years $6,192,000

Merely setting up automatic payments for annual exclusion gifts, medical care, dental care and tuition has allowed this family to transfer over $300,000 per year to descendants, free of transfer tax or use of the federal gift/estate tax exemption (which remains available to shelter nearly $11 million5 of assets in the survivor’s estate). Conservatively assuming that these clients live at least 20 more years, into their 80s, even without inflation adjustments, they are able to pass over $6 million to their heirs free of gift tax, estate tax or use of lifetime gift/estate tax exemption. And without a single trust agreement! Not even factored into this calculation is increased tuition or appreciation on the annual exclusion gifts, assuming the children invest the funds in a responsible manner (a plan for which is described more fully later in this article). Based solely on this strategy, Mr. and Mrs. Client have successfully diverted at least $3 million from the federal and state government to their family or family foundation over 20 years without even contacting an attorney.

Objection 2: “$28,000 a year is a lot to transfer outright to each child and in-law. I don’t want them to quit pursuing their advanced degrees/day jobs. I value hard work and education and want to transfer not only assets, but values.”

The largest portion of this program, of course, is the annual exclusion gifts Mr. and Mrs. C make each year. Under current tax rules, each individual may transfer $14,0006 to any individual free of gift tax or use of lifetime exemption. This means a married couple can transfer $28,0007 to each child and grandchild tax-free. In order to ensure that they transfer values as well as wealth, Mr. and Mrs. C had a family meeting with the children and in-laws in order to discuss their wishes for the annual exclusion gifts. Most importantly, they would like the children to save for education and retirement in a responsible manner.

The children and their spouses all work hard, but given their relatively new careers (they are in their early 30s) and young children, they do not currently have the cash flow to lock up liquidity in long-term tax-favored accounts. Prior to Mr. and Mrs. C setting up this annual giving program, the children were saving some, but not enough, for retirement. For example, Son was setting aside 6% of his salary and diverting it to a 401(k) account in order to take advantage of the maximum amount his company would match. He would love to set aside more; however, the balance of his after-tax salary is spent almost immediately on (deductible!) mortgage interest payments as well as diapers, childcare and family-sized barrels of animal crackers. Armed with the knowledge that they will receive $28,000 each, tax-free, every year, the children have the confidence to lock up some liquidity in tax-favored accounts and allow it to grow, income tax-free, for decades. Now, not only do they max out their 401(k) contributions ($18,000 each, annually), but each of them also fully funds an after-tax IRA ($5,500 every year). Finally, even though Mr. and Mrs. C are paying for private nursery school and contributing to separate 529 plans for the grandchildren, the children know they may want to have the ability to help their children with college or even graduate school tuition. Both live in New York, where a state income tax deduction is available for amounts contributed to a 529 college savings plan, up to $10,000 per married couple. Mr. and Mrs. C. live in New Jersey, where there is no such deduction. For this reason, the children and in-laws also contribute $5,000 each to a 529 plan for each of their children, for a total deduction of $10,000 against state income taxes. With this plan in place, each $28,000 annual exclusion is apportioned as follows:

  Child Spouse
Maximum After-Tax IRA Contribution $5,500 $5,500
Maximum Pre-Tax 401(k) Contribution $18,000 $18,0008
Maximum Decductible 529 Plan Contribution $5,000 $5,000
  $28,500 $28,500

This plan successfully transfers dollars that would otherwise be taxed in Mr. and Mrs. C’s estates to tax-deferred retirement and educational accounts. These are funds that will be available for children and grandchildren much later in life, and, without the annual exclusion gifts, would have gone unfunded due to present liquidity needs. The impact is incredibly meaningful once Son and Daughter reach retirement age, as their accounts have been growing tax-free for 30 years. This compounded accumulation allows them to continue the family tradition and transfer wealth to their grandchildren and more remote descendants and charity without the fear that they may not have enough in their own personal names to live comfortably.

Variations on this plan work for families with younger children or older grandchildren as well. We are realistic – a 16-year-old with a summer job is taking the money he earns scooping ice cream and spending it on first dates and video games. He is not opening a Roth IRA account. However, technically he should, since anyone with taxable income is eligible to begin funding these accounts, and tax-free compounding is an incredible tool for wealth preservation and growth. Especially assuming the ice cream parlor is not paying him more than $118,000 for his labor, this lucky 16-year-old is eligible to fund a Roth IRA, which grows income tax-free and does not require minimum distributions at any time. A parent or grandparent who is interested in tax-efficient wealth transfer can give IRA money to the 16-year-old, with the understanding that he will fund the account, invest it and not touch it until retirement.

 


Two Roads to Retirement: Parents Help vs. You’re on Your Own


This chart shows four different savings scenarios involving either an IRA or 401(k). In Scenario 1, which is a full max/parent-help scenario, the IRA starts at age 16 (i.e., when the child has income from part‐time jobs), and is at $3.9 million at age 65. In Scenario 2, which is a full max/parent-help scenario, the 401(k) starts at 22 – when the child graduates college/gets her first “real” job, and is at $9.6 million at age 65. In Scenario 3, which is a half max/no-help scenario, the child does her best and opens an IRA at 26 saving half of the maximum, and the account is at $1.2 million by age 65. in Scenario 4, which is a half max/no-help scenario,  the child does her best and opens a 401(k) at 32 saving half of the maximum, and the account is at $2.8 million by age 65.

Full Max/Parent-Help Scenario: In this scenario, the child is able to max out both types of retirement accounts every year with help from her parents. The IRA starts at age 16 (i.e., when she has income from part-time jobs). The 401(k) starts at 22 – when the child graduates college/gets her first “real” job. This results in a total amount in tax-sheltered accounts by age 70 of $14.5 million.


This chart shows the full max/parent-help scenario vs. the half max/no-help scenario. With the full max/parent‐help scenario, the child is able to max out both types of retirement accounts every year with help from her parents. This results in a total amount in tax‐sheltered accounts by age 70 of $14.5 million. In the half max/no‐help scenario, the child does her best and opens her retirement accounts once she has more of a cushion – 10 years after the child who starts at the earliest possible age (26 for IRA and 32 for 401(k)). Every year after opening it, she contributes half the maximum amount. This results in a total amount in tax‐sheltered accounts by age 70 of $4.2 million.

Half Max/No-Help Scenario: Here, the child does her best and opens her retirement accounts once she has more of a cushion – 10 years after the child who starts at the earliest possible age (26 for IRA and 32 for 401(k)). Every year after opening it, shecontributes half the maximum amount. This results in a total amount in tax-sheltered accounts by age 70 of $4.2 million.

In the end, the “no-help” child is still doing a fairly good job in saving half of the maximum starting relatively early. The true comparison is the child who does not put anything away for retirement – in this example, resulting in $0 in tax-protected retirement funds at age 70, vs. $14.5 million in the
“parent-help” example.

This hypothetical example is for illustrative purposes only. It assumes an annual rate of return of 7%. The assumed rate of return is not guaranteed. Your actual results will differ from the values being illustrated.


Objection 3: “I’m convinced the current administration will do away with the ‘death tax’ – why waste time and money setting up trusts and family companies when I will just be able to give money outright to my descendants next year?”

Given the current uncertainty over the estate, gift and generation-skipping transfer tax, many are hesitant to set up complicated planning structures or to make large, irrevocable gifts to trusts. This is completely understandable. However, helping the next generation save for education, retirement and healthcare, in a tax-efficient way, are generally causes most families can get behind, and the transfers described above do not require trusts, family corporations or even a lawyer to set up the plan. Finally, while we have heard talk of eliminating the “death tax,” the income tax is still very much in the picture, and these strategies maximize income tax-free, or deferred compounding. Simply calling your Brown Brothers Harriman relationship manager and setting a few automatic payments may result in significant tax savings over the long term – without the headache of complicated administration, tax returns or legal fees.

Withdrawals of taxable amounts are subject to ordinary income tax to the extent of gain, and a 10% federal income tax penalty may apply prior to age 59.5.

1 Grantor retained annuity trusts. For more information on GRATs, see “Giving Your All, Then Giving Some More: Creative Ways to Enhance Your Wealth Plan.”
2
Spousal lifetime access trusts. For more information on SLATs, see our third quarter 2016 InvestorView article, “Spousal Access Trusts: Efficient Tax Planning Without Completely Letting Go.”
3
Qualified personal residence trusts. For more information on QPRTs, please reach out to your BBH relationship manager or wealth planner for our white paper on this subject.
4
For more information on intrafamily loans, see “Giving Your All, Then Giving Some More: Creative Ways to Enhance Your Wealth Plan.”
5 $11.2 million in 2018 under current tax rules.
6 $15,000 in 2018 under current tax rules.
7 $30,000 in 2018 under current tax rules.
8 Under current law, the maximum contribution in 2018 would be $18,500. Recently, lawmakers have suggested cutting contribution maximums from $18,500 to $2,400. In the event this occurs, it may be possible to save the balance in a Roth 401(k), which would decrease the pre-tax benefit but would still allow for significant income tax-free compounding over the long term. BBH is closely monitoring the tax reform process and will keep you apprised of related planning opportunities.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2021. All rights reserved. PB-04747-2021-07-29

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