End of Year Review

As we are nearing year-end it makes a lot of sense to review your current Will, especially if any of the following occurred during 2017 –

  • A named beneficiary died
  • A possible beneficiary was born
  • A named beneficiary divorced
  • A named beneficiary is very sick or has a drug dependency
  • You are moving or moved to a different state
  • The value of your assets changed significantly

These are just a few events that should prompt a review of your Will and your Estate Plan.

The professionals at Garden State Trust Company will be happy to meet to review your Will and Estate Plan at no obligation to you.

http://www.gstrustco.com/boomers—beyond.html

Federal Estate Taxes

Dear Garden State Trust Company:

What is going to happen with federal estate taxes in 2018?

—Interested Observer

Dear Interested:

The IRS has announced that, under current law, the inflation-adjusted exemption from federal estate and gift tax will grow to $5.6 million in 2018. For a married couple, that means a total estate of $11.2 million may be kept in the family tax free. By the way, the Service also announced that the gift tax annual exclusion will grow to $15,000 in 2018, the first increase in several years.

Into this mix we add the tax reform legislation working through Congress this November. The initial draft calls for an immediate doubling of the exempt amount in 2018, and eventual repeal in 2024.

Interestingly, the doubling of the estate tax exemptions has less “revenue cost” than one might expect. According to the most recent IRS statistics, roughly half of taxable estates fall in the range of $5 million to $10 million, yet they pay only 11% of the total net estate tax. Estates larger than $50 million pay 42% of the total federal estate tax, though they represent less than 6% of taxable estates.

Do you have a question concerning wealth management or trusts? Send your inquiry to contact@gstrustco.com.

© 2017 M.A. Co. All rights reserved.

Vacation Homes

The last recession took a toll on the value of vacation homes. The National Association of Realtors reports that, from the end of 2007 through 2012, when primary homes were dropping in value by 14.8%, the value of vacation properties fell by 23%. The good news is that prices have come back strongly. The median price of a vacation home rose 28% in 2015 and another 4.2% in 2016, reaching $200,000.

The main reason for owning a vacation home is—or should be—for rest and relaxation. The vacation home also may serve as a “tryout” for a destination for retirement living. In some cases, it may become the home one retires to.

But vacation homes have investment and tax angles to consider as well.

Rental income from the property may help cover some of the expenses of maintenance and improvement. If the property is rented for 14 or fewer days, the income is tax free. Rentals for longer periods may be offset with income tax deductions for mortgage interest, property taxes, insurance premiums, utilities, and other expenses, but the biggest tax benefits are available only to owners who use the property for 14 or fewer days during the year.

When It’s Time To Sell

The $250,000 exclusion from capital gains ($500,000 for married couples filing jointly) for the sale of a principal residence does not apply to the sale of a vacation home. At one time, it was possible to get around this rule by selling one’s principal residence and moving into the vacation home, living in it as the principal residence for at least two years. At that point a new exclusion would become available. This strategy was curtailed, beginning in 2009. Now the exclusion is not available for the portion of your ownership attributable to vacation home use.

Example. You bought a $1 million vacation property in 2010. In 2017 you sold your primary residence to begin living in the vacation home. Now assume that you decide to sell that home in 2020, after living in it for three years, when it is worth $1.5 million. That period is 30% of your total ownership, so only 30% of your gain of $500,000 ($150,000) is excludable from income. The same dollar limit of $250,000 also applies.

Query: Did the adoption of this tax rule in 2009 contribute to the decline in the value of vacation homes around that time? No one can say with certainty.

Estate Planning

The issue of capital gains taxes evaporates if ownership of the vacation home continues until the death of the owner. At that moment the tax basis of the property steps up to fair market value, so there would be no capital gain on a sale soon after.

If there is an intention to keep the vacation home in the family, a Qualified Personal Residence Trust (QPRT) should be considered. One can think of this as a major gift scheduled for a future date. The home is placed in a special trust that lasts for a specific number of years. The homeowner retains the right to live in the home for the full duration of the trust, and the children (or other beneficiaries) receive the home when the trust terminates.

The home transferred to a QPRT must be a personal residence, but it does not have to be a primary residence. Vacation homes and associated property, for example, are eligible for this estate planning strategy. And the trust may include other structures on the property if they are suitable for a personal residence, taking into account the neighborhood and the size of the house.

A gift tax return will be required when the home is placed in the QPRT.

However, the value of the gift will be discounted to reflect the delay until the gift takes effect. The discount can be very substantial, and it is a function of the current market interest rates as well as how many years will elapse before the gift takes effect.

For the strategy to succeed, the owner must survive to the end of the trust term. But if the owner dies during the trust term, the estate is in no worse position than if the QPRT had not been undertaken.

© 2017 M.A. Co. All rights reserved.

IRAs for Charity

Charitable giving in the U.S. rose 2.7% last year, reaching an all-time record of $390.05 billion. That’s also a record in inflation-adjusted dollars, reports the Giving USA Foundation in its annual report on philanthropy. Individuals, foundations, and corporations contributed to the robust growth in philanthropy, while bequests were projected to have declined by 9.0%. Some 72% of charitable gifts come from individuals—an average of $2,240 per U.S. household.

Religious organizations are the largest beneficiaries of charitable giving, receiving 32% of the total gifts. Education comes in a distant second, at 15%, followed by human services with 12%.

The charitable IRA rollover

One reason for the growth in giving may be the growth in assets. As the stock markets touch new highs, people can afford to be more generous. Another factor might be that as top marginal tax rates have increased, the value of charitable deductions for top taxpayers has grown as well.

A popular charitable giving tax break has been made permanent, one that has been dubbed the “charitable IRA rollover.” Those who are over age 70½ may want to consider the gift of a direct distribution from their IRAs. Up to $100,000 may be transferred to charity in this manner. Couples may transfer up to $200,000 if each partner has an IRA. In contrast to normal IRA distributions, amounts transferred directly to charity won’t be included in ordinary income (and so no charitable deduction is appropriate).

The definition of who is permitted to take advantage of this tax strategy dovetails perfectly with those who are required to take required minimum distributions (RMDs) from their IRAs. So some taxpayers simply opt to direct their required minimum IRA distributions to charity, because the distribution requirement will be satisfied, even though the amounts distributed aren’t included in taxable income.

Extra tax advantages

In some sense, the income tax exclusion for a transfer to charity from an IRA might not seem like such a big deal. After all, one always has been allowed to follow an IRA withdrawal by a charitable contribution and claim an income tax deduction. However, the full benefit of that deduction is not available to all taxpayers.

  • Nonitemizers. There are a great many taxpayers who do not itemize their deductions, even in the upper tax brackets.
  • Big donors. Percentage limits on the charitable deduction mean that some donors can’t take a full charitable deduction in the year that they make a gift.
  • Social Security recipients. An increase in taxable income may cause an increase in the tax on Social Security benefits for some taxpayers. The direct gift from an IRA avoids this problem.

Accordingly, if you are 70 ½, you should consider a charitable gift from your IRA if:

  • You do not itemize tax deductions;
  • Your charitable deductions have been maximized; or
  • You do not need the additional income made necessary by your required minimum distribution.

As welcome as this tax planning opportunity is, every taxpayer’s situation is unique. See your tax advisor before taking any action.

© 2017 M.A. Co. All rights reserved.

The IRS Opens a Facebook Page. Yours.

Two law professors at Washington State University have warned that the IRS has turned to data mining of social media in their enforcement efforts [Houser and Sanders, “The Use of Big Data Analytics by the IRS: Efficient Solutions or the End of Privacy as We Know It?”, 19 Vand. J. Ent. & Tech. L. 817 (2017), http://www.jetlaw.org/wp-content/uploads/2017/04/Houser-Sanders_Final.pdf]. The demise of the Taxpayer Compliance Measurement Program left a data gap that needs to be filled, and social media may provide part of the solution.

The professors warn of the dangers of abuse of secret data collection systems. Taxpayers may have an expectation of privacy when they are online, but this is an error. Anything that may be seen by the public may be seen by the IRS. The Service then pairs this information with its own databases in a process of data analytics. “For the IRS, data analytics is not trying to predict the future behavior of taxpayers, but predicting data that it does not have; that is, predicting whether tax returns are compliant with the tax law.” Given the data breaches that the IRS itself has experienced, as well as questionable IRS targeting practices of recent years, the concerns raised by the professors seem warranted.

Don’t publish anything on social media that would make you uncomfortable if you saw it on the front page of The New York Times.

© 2017 M.A. Co. All rights reserved.

Who Owns Mutual Funds?

There are an estimated 94 million mutual fund investors in the U.S., reports the Investment Company Institute in its 2017 Investment Company Fact Book. Those investors represent 54.9 million households, or roughly 43.6% of all U.S. households. That level of mutual fund ownership has held steady during this century.

43.6% of U.S. households own mutual funds

Year% households
19805.70%
198514.70%
199025.10%
199528.70%
200045.70%
200544.40%
201045.30%
201543.00%
201643.60%

Source: 2017 Investment Company Fact Book

The explosive growth in mutual fund ownership after 1980 may be attributable to the advent of 401(k) plans. Indeed, for 67% of households their first mutual fund purchase was through an employer-sponsored retirement plan. Some 37% of those who own mutual funds own them only inside such plans. Mutual funds owned in IRAs, which first became widely available in 1981, may also account for this spectacular growth.

As one might expect, as household income rises, the odds of finding mutual fund investors rises also. Some 80% of U.S. households with income over $100,000 are mutual fund owners. Still, mutual funds are certainly not just for the very affluent. 17% of mutual fund-owning households reported income of less than $50,000. The median income of households owning mutual funds was $94,300.

Why invest in mutual funds? According to the survey, which permitted multiple answers to the question, 92% are saving for retirement, 46% hold mutual funds to reduce taxable income, 46% are saving for emergencies, and 22% use mutual funds to save for education. For 64% of these savers, more than half of their financial assets are mutual funds.

U.S. mutual funds grew to $16.3 trillion in 2016. Domestic and international equity funds compose 52% of the total industry assets, bond funds 22%, money market funds 17%, and hybrid funds 8%.

© 2017 M.A. Co. All rights reserved.

Could “Stretch IRAs” Be Killed?

Under current law, when an heir inherits a Roth IRA or an IRA from someone who has not yet begun receiving minimum distributions, he or she must make a choice. The money must be distributed either within five years or over the heir’s lifetime. For lifelong distributions, the heir will need to withdraw a minimum amount each year based upon IRS life expectancy tables. This strategy is referred to by estate planners as a “stretch IRA.”

For a young heir, such as a child or grandchild, stretching payments over a lifetime, maximizing the period of tax deferral or tax freedom, can make an enormous difference in the total value of this financial resource. That’s because in the early years the required minimum distributions are likely to be less than the growth in the value of the account, which allows for additional tax-free or tax-deferred accumulations.

Writing in Trust & Estates magazine (June 2017), James Lange explores the alternatives for a 46-year-old heir who inherits a $1 million traditional IRA. Assuming a 7% rate of return, if the child takes only the minimum distributions for life the account will peak at about $2.7 million at age 76, and it will be worth $2.5 million at age 82. On the other hand, if the account is fully distributed within five years and subjected to ordinary income taxes, and the proceeds are placed in a taxable portfolio, the same pattern of withdrawals will exhaust the account at age 82.

Too Good to Last?

Lange’s article is titled “The Latest Developments in the Death of the Stretch IRA.” There hasn’t been much press attention to the issue, but last year the Senate Finance Committee voted unanimously for the Retirement Enhancement and Savings Act of 2016. One critical “enhancement” was the elimination of the vast majority of stretch IRAs in the future.

Under the bill, nearly everyone will have to abide by the five-year rule for inherited IRAs and lump sum death benefits from qualified retirement plans. There are exceptions for surviving spouses and disabled dependents, for whom lifelong distributions would be permitted. If a beneficiary is a minor, the five-year distribution rule would not kick in until he or she reaches the age of majority. There are also exceptions for charities, charitable remainder trusts, and beneficiaries who were born within 10 years of the account owner.

Nothing Can Be Simple

The bill also carves out the first $450,000 in IRA assets from the application of the five-year rule. Therefore, a new wrinkle will be added to estate planning.

In estates in which combined IRA balances are less than $450,000, no change of plans will be needed (assuming that the exclusion isn’t changed in final legislation). Estates with larger IRAs may need to be reviewed and new plans devised, if the new rules are adopted.

Prospects

Lange makes much of the fact that, given the unanimous vote, the elimination of the stretch IRA has bipartisan support. On the other hand, the bill died last year, and it has not be reintroduced as of this writing. Will there be tax reform this year? One of the difficulties of developing a consensus for a tax reform bill is the need to “pay for” tax cuts with other tax increases, so as to stem the revenue loss. The stretch IRA is a low-hanging fruit that looks ripe for harvest by eliminating it. The Joint Committee on Taxation scored the provision as raising $3.8 billion over the next ten years. But if tax reform bogs down, and gets pushed into 2018 (at this moment, the most likely outcome), the stretch IRA remains safe for another year or so.

©2017 M.A. Co. All rights reserved.

Emotional Investing

We like to think that since the advent of modern portfolio management practices, investing in stocks and bonds has become a cerebral, analytical process with no room for emotion. The truth is that most investors, even institutional investors, are buffeted by emotional turbulence from time to time, and that truth is reflected in the volatility of the financial markets.

But if a little emotionalism when it comes to investments is unavoidable, too much emotion can be hazardous to your wealth. Here are four symptoms of problem emotions, financial behavior that is inconsistent with sound investment practice.

Fear of loss. Investors are generally motivated by fear or by greed. Behavioral scientists have learned that, for many people, the pain of loss is larger than the sense of satisfaction from a gain of the same size. Similarly, some investors will accept larger risks in order to avoid a loss than they will in seeking a gain.

Taken to an extreme, fear of loss leads to investment paralysis. An excessively risk-averse investor may park funds in ultra-safe, low-yielding bank deposits or short-term Treasury securities until a decision is made, accepting long periods of low returns. Or winning investments may be sold off too quickly in an attempt to lock in gains, while losing investments manage to stay in the portfolio indefinitely.

Following the herd. It’s difficult to be a contrarian, to find value that everyone else has overlooked. Many people find it easier to go with the crowd, to own the current hot stock or hot mutual fund. At least that way, if the investment does poorly, one has plenty of fellow sufferers with whom to commiserate.

But when “crowd” is defined as one’s family and friends, the crowd’s investment goals may be very different from one’s own.

Hair-trigger reflexes. Markets move on news. In many cases, the first market response is an overreaction, either to the up side or to the down. Sometimes “news” is only new to the general public, and it’s already been reflected in the share price through trading by those with greater knowledge. The true importance of any news event can only be discerned over the longer-term.

Generally, it’s better to watch the market react to news than to be a part of the reaction. Remember that market dips may present the best buying opportunities but they’re also the toughest times, emotionally, for making a commitment to an investment.

Betting only on winners. Some 85% of the new money going into domestic equity mutual funds goes to funds with MorningStar ratings of four or five stars, according to one estimate. This may be one reason that the government requires this disclosure for investment products: Past performance is no guarantee of future results. The disclosure is required because it is true. High returns are usually accompanied by high risks; ultimately, those risks may undermine performance.

Abnormal returns, whether they are high or low, tend to return to the average in the long run. Investing on the basis of the very highest recent returns runs a significant risk of getting in at the top of the price cycle, with a strong chance for disappointment.

THE ALTERNATIVE APPROACH

To avoid impulsive decisions that may be tainted with emotion, one needs an investment plan. The best way to moderate the impact of stock and bond volatility in difficult markets is to own some of each. Assets do not move up down in lockstep. When stocks rise, bonds may fall. Or at other times, bonds also may rise when stocks do. The movements of each asset class can be mathematically correlated to the movements of the other classes. Portfolio optimization involves the application of these relationships to the investor’s holdings.

Expected returns need to be linked to the investor’s time horizon. Longer time horizons give the investor more time to recover from bad years, more chances to be in the market for good years.

©2017 M.A. Co. All rights reserved.

Continuing Low Interest Rates

Dear Garden State Trust Company:

I am so tired of these low interest rates. Can we expect another uptick sometime soon? Earlier this year there was talk of one more bump before the end of the year as I recall.

—CAUTIOUS SAVER

 

Dear Cautious:

I am afraid that you may have to get used to disappointment. Your memory is correct; many observers expected another interest rate increase in the second half of this year. New developments have made that unlikely, but not impossible.

The economy has been doing better, and inflation has lagged. In fact, inflation is down all around the world, raising the real possibility that the linkage between growing economies and rising prices has been broken. In July the U.S. consumer price inflation was just 1.7%, below the Fed’s target, even as the economy grew at an annualized 3% in the second quarter of the year.

A more immediate concern is recovery from hurricane damage. It will take some months to assess fully the situation and get rebuilding under way. An interest rate hike during that time would be most unwelcome, and seems unlikely.

Finally, there is the practical problem of staffing the seven-member Federal Reserve Board. There are three vacancies at the moment, Vice Chairman Stanley Fischer announced that he is stepping down early, in mid-October, and Fed Chairwoman Yellen’s term of office expires in early February. “Don’t rock the boat” may be the easier decision for the Fed to make while awaiting the appointment of new members.

Do you have a question concerning wealth management or trusts? Send your inquiry to contact@gstrustco.com.

© 2017 M.A. Co. All rights reserved.

Saving a Flawed Estate Plan

Given the unrelenting pace of change in the tax laws and in the economy, coupled with the ordinary changes in personal and family circumstances, any estate plan is bound to go out of date sooner or later. Sometimes planning failures may be remedied post mortem, sometimes not. Here’s a happy example.

Oskar Brecher died in 2016 with an estate of some $8 million. His last will and testament had been drafted in 1989. The federal estate tax had seen many important changes since then.

Brecher’s will left his surviving spouse the minimum amount needed to reduce federal estate taxes to zero, with the balance passing to a credit shelter trust, a routine approach to estate tax minimization at the time that his will was drafted. This was long before the major estate tax reforms of 2001, after which many states decoupled their death taxes from the federal template. Brecher died a resident of New York, which in 2016 had an estate tax exemption of $4,187,500, significantly lower than the $5,450,000 federal estate exempt amount.

Application of Brecher’s formula would result in a credit shelter trust of $5,450,000. A trust that large and not protected by the marital deduction would trigger a New York estate tax of $505,455, leaving $2,044,545 for the surviving spouse. The estate’s heirs petitioned to have Brecher’s will reformed, so as to reduce both federal and state death taxes to zero. In that case the credit shelter trust would be only $4,187,500, and the surviving spouse would receive $3,812,500.

The trust beneficiaries did not oppose the reformation, and the Surrogate’s Court granted the petition. Said the Court: “… reformation as a general rule is only sparingly allowed…however, the courts have been more liberal in their regard to petitions seeking reformation when that relief is needed to avert tax problems caused by a defective attempt to draft a will provision in accordance with the then tax law or instead caused by a change in law, subsequent to execution of the will, that renders a tax-driven will provision counterproductive. The central question in such a case is whether the clear wording of the subject instrument subverts rather than serves the testator’s intent.”

Moral of the story. This estate had a sympathetic judge. The better course is to have a professional review of your estate planning documents after major tax law changes. Relying upon a 37-year-old will is expecting too much from an initial estate planning consultation.

©2017 M.A. Co. All rights reserved.