In part one of this two-part blogging extravaganza, we took a pretty deep dive into some of the financial and legal hassles that America’s richest citizens have to deal with, and that can make it difficult for them to give away or hand down their wealth as they would like. In this post, however, I’d like to dig into “rich person problems” that you are a bit more likely to bump into yourself.
After all, if you’re reading a finance blog, you’re probably at least hoping to have a lot of money someday, even if you don’t just yet. So you should have some idea of the issues (and their potential solutions) that can affect people who, while pretty well-off, haven’t been building up a huge fortune over decades or had one handed down to them. While part 1 was about multi-millionaire problems, here we’ll get into more “upper middle-class” problems.
- Headache #2: dying with too much money (cont'd)
- Headache #3: getting too much money too fast
- Headache #4: the one for "normal" people
To start, let's revisit the topic of estate tax.
In addition to the federal government’s estate tax and its corresponding exclusion amount, a dozen or so states have their own as well. If you live in one of those states, you may very well end up owing their estate tax even if you’re nowhere near owing the federal one. And even if you don’t think you’re likely to end up owing estate tax at the state level... you may want to dig a bit and make sure.
“Psh, what?” you might say. “You think I don’t know how much money I have?”
No, I’m sure you do. But do you know how much money your estate will have after you die? Because here’s a fun plot twist: people sometimes get tipped into millionaire territory, without even realizing it, by their life insurance policy.
Another tough pill to swallow. After all, it’s not like you will ever use that money yourself. But as far as the IRS is concerned, the money promised by your insurance policy is in fact part of your estate. So in case you’re now worried about it, here’s a breakdown of all the different exclusion amounts for all the different estate taxes as of this writing:
By the way, let me be clear: I don’t view estate tax – or any of the other taxes I’ve discussed – as some kind of objective evil. Similarly, avoiding it isn’t necessarily a priority for everyone rich enough to pay it. You may be perfectly ok with this whole arrangement, and that’s ok. But your attitude depends on numerous variables: the amount of tax you’ll owe, the amount of estate you hope for your heirs to receive, and (probably) your political views as well, to name just a few.
With that disclaimer out of the way, let’s say that you’re one of those wealthy individuals who prefer that the government not get a piece of the pie before your kids do. What recourse do you have in that case?
The obvious answer is to reduce the size of your estate ahead of time – in other words, get rid of stuff! Sure, you could have a blowout garage sale or write fat birthday checks to your grandkids. But as you can probably guess, there are more efficient means available. And this is where trusts come in, another thing I touched on in my earlier post about estate planning.
There are two main kinds of trusts: revocable and irrevocable. I’m going to skip over revocable trusts for now, as they’re honestly kind of weird and not that relevant here. If you’re trying to reduce the size of your estate, what you really want is an irrevocable trust. An irrevocable trust is kind of like a safe where you stash part of your wealth – but you don’t have the key. You can put as much money into it as you want, but you can’t take anything back out.
Contributions to an irrevocable trust are legally treated the same as gifts to an individual, and are therefore part of the same old rigamarole we talked about in the last post – estate tax, gift tax, the lifetime exclusion amount, etc. So then you might wonder… how is this helpful? If you’ll have to pay gift tax anyway, why not just write huge checks to your kids or grandkids and get it over with?
And you’d be right: there is no major difference. Not in the short term anyway.
The long term, however, is a different matter. The key is to move assets out of your estate and into a trust while they still have time to appreciate in value. If you write big fat checks to your kids, they get the amount you write on the check and nothing else. But if you put that same amount into a trust, wrapped up in stocks or real estate, then your kids or other beneficiaries will also get the extra value it accumulates over time. And estate tax won’t take a chunk out of it, because it’s not part of your estate!
Basically, an irrevocable trust can be great if you have the foresight to set it up well in advance, and have appreciable assets to put in it that you know you won’t ever use yourself. But what if you’re in that awkward spot I mentioned earlier, where you don’t actually have that much cushion but could still end up with a taxable estate upon your death because of life insurance?
Good news – there’s one particular type of irrevocable trust that may still come in handy.
This latest bit of bureaucratic wizardry has to do with the fact that a trust, much like your estate, is legally considered an entity unto itself. That’s why tax law treats contributions to it as a “gift” to “someone,” and therefore subject to gift tax. The flip side to this, however, is that you can also have a trust “receive” money on your behalf. Like, for example, your life insurance payout.
You can easily set up what’s called an irrevocable life insurance trust, or ILIT, which legally takes over ownership of your life insurance policy. So instead of paying monthly premiums directly to your insurance provider, you make regular contributions to the trust and the trust pays the premiums. And similarly, the payout from the policy goes to the trust upon your death, then from there to whomever you’ve previously specified.
The upshot of all this is that, when you die and your policy pays out, that money ends up in the ILIT rather than your estate. So once again, your beneficiaries have that much more money at their disposal that estate tax can’t touch. The drawback is that, unlike other assets that you could put in an irrevocable trust, life insurance policies don’t exactly appreciate.
As with everything else, the best solution depends entirely on your situation.
Let’s say, for the sake of easy math, that you have a $1M life insurance policy and your home is worth $1M as well. If you live in Washington, where the lifetime exclusion amount is $2.2M, then chances are very good your estate will get taxed. So in the interest of leaving your kids as much of your stuff as possible, you decide to put some of that stuff in a trust.
But what exactly should you put in there? Obviously, you could set up an ILIT to catch that $1M life insurance payout and keep your estate under the lifetime exclusion amount. But in this particular case, I’d say a plain irrevocable trust would be a much better option.
This is because, unlike your life insurance payout, your house will appreciate. Suppose that you can reasonably expect it to reach $4M over the next twenty years. So, because you’re such a good plan-ahead-er, you put your house in an irrevocable trust (and yes, you can still live in it btw). It does indeed reach $4M by the time you eventually pass to the great beyond, and – boom! Not only did you keep estate tax at bay, you made an additional $3M for your heirs and/or beneficiaries.
This one is kind of common knowledge, but… only kind of. So it’s worth a closer look.
While everyone fantasizes about winning the lottery, most people are also vaguely aware that the taxes on such winnings would be monumental. Since a lottery win is incredibly unlikely, of course, they probably don’t consider the specifics of what taxes would apply and when. Or, for that matter, what other stressors might accompany such a sudden jackpot.
Although very very very few people win the lottery, there are many people who at some point may sell their homes, businesses or other assets after decades of investing in them and growing their value. So when they finally do sell, they may find themselves with a lottery-level windfall of cash. Depending on their particular situation, this may make for a bigger mess than they bargained for.
Take Bob and Evelyn, for example, a fictitious couple loosely based on some clients of mine who sold their fictitious business for $30 million. Their fictitious buyer is a real big dog who paid it all in cash; unusual, sure, but by no means impossible. For their part, Bob and Evelyn are pretty humble, level-headed folks. All they really want to do with this huge sum is fund their own retirement, send the grandkids to college and maybe buy a nice summer bungalow on the Oregon coast. But that would only make a dent in their new fortune.
Eventually, they conclude that they’d like to donate most of it… but are unsure how to go about it. They figure you can’t just send a $15 million check in the mail, and while philanthropy buzzwords like trust, endowment and foundation occur to them, they’re unsure what these mean. In addition, they definitely want their kids to be involved in these decisions as well, but that adds another layer of complication.
On top of all this puzzlement, the couple have a ticking clock to deal with. Even though they may only ever spend, say, $3M of it, the IRS will still tax them on the full boat. Anywhere from 20-37% (43.4% under the new proposed tax law), in fact, depending on how much of the sale is classified as “capital gains” versus “income.” Is there anything they can do about that? If there is, they’d better figure it out fast, as tax day waits for no man.
It’s all quite a pickle, but the good news is that Bob and Evelyn have an ace up their sleeve. Namely, me.
(*flicks down shades, tosses hair, flashes toothy grin as beach-rock theme plays*).
(*wife visibly rolls eyes*)
Apologies; got a bit carried away there. Anyway…
There are about a thousand different ways Bob and Evelyn could navigate this highly unique scenario, each with its own balance (or imbalance) of pros and cons. But I, being the rockstar advisor I am, recommend they consider a little-known type of account called a donor-advised fund – assuming they’re absolutely sure they want to give all that money away.
A donor-advised fund is sort of like escrow, but for charity; it serves as the holding place between a donor and their future charitable beneficiaries, even if you don’t yet know who they will be. Contributions to a donor-advised fund count as charitable donations, so you get a corresponding deduction on that year’s taxes. They aren’t subject to capital gains taxes, and aren’t counted as part of your estate, so you won’t owe estate tax on them either.
Bob and Evelyn think that sounds great, so they move quickly to put a chunk of their new fortune into a donor-advised fund. As a result, they get a (huge) deduction on this year’s taxes that neatly counteracts the (also huge) income tax they would have had to pay on it. And they avoid the various other taxes that could have gotten at it as well, ultimately saving millions upon millions of dollars for charity that would have otherwise gone to the government.
Of course, the big catch with a donor-advised fund is that now they have to give the money away. No takesies-backsies. But they get to do so on their terms, on their timeline, and with their whole family involved in the process. They can even set things up so the family continues their charitable legacy long after they are gone. Big money means big decisions, and fortunately the couple just bought themselves time to make a decision they’re truly confident in.
Although I’ve fictionalized a number of important details in this anecdote, it still stands as a great example of why I love being a financial advisor. The point isn’t to help clients finagle their way into being able to afford another yacht; rather, it’s to help them think through and identify their goals in various areas of life, and then figure out how to get their money to support those goals.
And that challenge is by no means unique to rich people, which brings me to my final point.
I’ve outlined some of the unique complications that people face when their net worth gets into the millions – but as I’m sure you’re aware, you needn’t be in that elite club to have your own money headaches. Yes, “big money means big decisions,” but that actually applies just as much to your local electrician as it does a corporate CEO. What constitutes “big money” just looks different for both of them.
In both cases, however, the cliche is true (annoying as it may be when you’re fed up and just want to throw in the towel): “an optimist sees the opportunity in every difficulty.” Being a financial optimist, and therefore a financial opportunist, has nothing to do with your net worth and everything to do with your creativity, persistence, willingness to learn, etc.
I find that pretty encouraging, myself – hopefully you do too. :)