Knowing How Much of Your Estate to Give and When

The major issues in your estate plan are deciding who should receive your assets and how they should receive them (directly or through trusts, for example). Two other important issues that don’t receive as much attention are: How much wealth should you transfer sooner rather than later, and when should you give it? While these usually are considered as tax questions, there are many non-tax angles and developing optimum answers actually can increase the family’s after-tax wealth in the long term.

These questions are keys whether or not there is an estate tax. Some details may change, but the basic answers will remain the same regardless of the estate tax. As you know, there is no estate tax in effect in 2010. But in 2011 we’ll have an estate tax. Either the 2001 tax law will be revived, or Congress will enact a new one late in 2010.

To decide how much wealth to transfer to others and when, you should first develop a retirement plan. The retirement plan tells you how much money you need and want to retain. Wealth you own beyond that is extra or surplus. You don’t plan to spend it during your lifetime, so you plan for others (either your loved ones or charity or both) eventually to receive it. The time and manner of the transfers help determine how much after-tax wealth they receive.

Finding Your Core

To develop the retirement plan, determine how much money you need to retain to maintain your current lifestyle and reach your future goals. This will be your core capital that you must retain for the rest of your life.

We’ve discussed ways to compute this amount in past visits, and those discussions are in the Cash Watch section of the Archive on the web site. Naturally, you decide on the lifestyle you want and how much that costs in today’s dollars. There are a couple of directions you can go from there. You can continue with a detailed spending plan that includes inflation adjustments for each item and accounts for periodic large expenses such as new cars and home repairs. I constructed an Excel worksheet to help in this calculation that subscribers can download free from the members’ web site.

The other approach is a less detailed calculation and approaches the issue from the other direction. Decide on the safe spending rate for you. As we’ve discussed in past visits, this is the percentage of your nest egg that can be spent in the first year and increased for inflation each year with a low probability of running out of money during retirement. Most academic studies peg this rate between 4% and 5% for people just retiring. We’ve given examples of when a higher spending rate can be safer. As I said, the articles are in the Cash Watch section of the Archive.

For example, you may decide you can spend 4.5% of your nest egg the first year with a low probability of running out of money. Suppose you also calculated your first year’s spending at $100,000. That computes to a nest egg of $2,222,222. You’ll actually need a different amount. That simple calculation doesn’t account for annual inflation increases and also doesn’t factor in investment returns. There’s a lot of software available on the Web to help with the calculations. You should have your estate planner or a financial planner help test the calculations or do them for you.

Your investment strategy also influences the amount of your core capital needs. If you take risks with your investments, you’ll need more of a cushion in your calculations. If you follow a risk-managed, balanced investment strategy your wealth is likely to last longer and you should need less of a cushion in the level of your core capital. One way to achieve this result is to use my “hedge fund” mutual fund portfolio as a core investment position for most of your nest egg and invest the rest of your portfolio using one of my Managed Portfolios with perhaps some in the Invest with the Winners strategy.

After computing your core or essential capital needs, you should have a cushion. Establish an amount as a reserve or emergency fund. This covers unexpected expenses or investment losses, leaves you room for lifestyle changes, and allows increased lifetime charitable or family giving should the inclination strike you.

Add your essential capital needs and your reserve fund, and this is the amount of your current wealth you should retain and treat as your core capital. Any additional net worth is your excess or surplus capital. This is the portion of your estate you expect to be available to others.

The next question is when to distribute the additional capital and how to distribute it to minimize taxes. Of course, not everyone has excess capital or a significant amount of excess capital. Those that do have excess capital, should want to maximize the amount that is enjoyed by the next owners, and timing the transfer of that wealth is a major factor in maximizing it.

For example, if you decide not to transfer the excess capital any time soon, that capital can be invested more aggressively than the rest of your wealth. You can afford to take more risk, because you don’t have to worry about short-term fluctuations in value. Your living expenses are covered by your core capital. If you invest both wisely and aggressively, the objects of your affection will receive more wealth. Most people won’t make this distinction in investment strategies, because they don’t separately compute core capital and excess capital. They invest all their wealth the same way.

Timing the Transfers

Excess capital can be transferred to others at any time. You’ll want to consider the needs and maturity of the potential recipients, of course. This will influence both when you give and also whether you give directly or indirectly through trusts or other means. You’ll also want to consider the income tax brackets of loved ones compared to yours. If you are in a significantly higher bracket, it could make sense to transfer income-producing property to others soon.

Tax strategies and other factors need to be considered. This is where the existence of an estate or gift tax finally comes into play. Start with the basic strategies and build on them.

In these times of turbulent markets and tax laws, be sure your plan is flexible. Most people don’t want to be locked into an inflexible giving strategy, and that makes sense. That’s why you start with basic strategies. The basic strategies usually can be halted or reversed at any time.

Here are some strategies to consider.

? Life insurance. When you are young enough, life insurance premiums pack a big payoff for the next generation. The eventual life insurance benefits exceed the premiums paid by a nice multiple. Using excess capital to buy life insurance can be a wealth maximizing strategy whether the objects of your largess are loved ones or charities.

? Annual gifts. The annual gift tax exclusion allows you to give up to $13,000 each year (indexed for inflation) to every person you want. Married couples can give $26,000 annually each. If you have three children, each spouse can give each child $13,000 annually for a total of $39,000 transferred from each spouse each year. (You always can give less, of course.) You also can give to your children’s spouse and to the grandchildren.

? Lifetime gift tax credit. Each person has a lifetime gift tax credit that effectively excludes $1 million of gifts from taxes. Gifts that exceed the annual exclusion are taxed, except the first $1 million are protected from taxes by the lifetime credit. Any use of the lifetime credit reduces the estate tax credit, if one is in effect for your estate. Few people expect these rules to change regardless of what happens with the estate tax.

The annual exclusion and lifetime gift tax credit are incentives to transfer wealth now. You remove the property from your estate free of taxes today and also remove the future appreciation from your estate. You can give gifts directly or through trusts.

? Charitable gifts. Your children and grandchildren may not be the only objects of your affection. There are many ways to fulfill charitable inclinations. You can write checks, give appreciated property, or buy life insurance. You also can use more sophisticated strategies that reserve some income or wealth for you or your heirs, such as charitable gift annuities, charitable remainder trusts, and charitable lead trusts.

? Other strategies. Larger estates may need more sophisticated strategies. These could include various trusts, family limited partner-ships, and business transfer strategies. The less liquid the assets in your estate are, the more sophisticated strategies you are likely to need. Less liquid assets include small businesses, real estate, and collections.

May 2010. RW