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.

Someone to Trust

How could someone who earned $650 million over 17 years be broke? That’s the question the actor Johnny Depp recently put to a team of forensic accountants and his new business manager, according to a Vanity Fair article (“How Did Johnny Depp Find Himself in a Financial Crisis?,” August 2017). The team determined that Depp’s business managers of 17 years were guilty of mismanagement, breach of fiduciary duty, and disbursing funds without Depp’s knowledge, and the team filed a lawsuit seeking $25 million.

The business managers, who never had been sued before, fired back with a lawsuit of their own. A partial list of why Depp went broke, according to them, was that Depp owned:

  • 14 residences, including a chateau in France;
  • a 156-foot yacht, which was expensive to maintain;
  • 12 storage facilities filled with memorabilia, such as collectible guitars and art;
  • $30,000 worth of exotic wines flown to him monthly; and
  • he employed 40 full-time employees, costing $300,000 per month.

As an example of his extravagant lifestyle, Depp spent $5 million for a memorial service for his idol, journalist Hunter S. Thompson. A 153-foot cannon was built at Thompson’s home to blast his ashes into the air.

The business managers seek damages of $560,000 and a statement by a court declaring that “Depp caused his own financial waste.” The trial is expected in January.

Adding guidance to an inheritance

Although Johnny Depp may be an extreme example of financial management failure, it is stories such as these that cause some wealthy parents to wonder about the financial capacity of their own heirs. Even responsible adults have been known to have moments of weakness when faced with a large inheritance.

That’s why so many are turning to trust-based inheritances. When the trust is administered by a professional trustee, such as us, the beneficiaries get financial management according to the terms of the trust, along with investment management of the trust assets. There’s no guarantee that a trust will last for a lifetime, but it does improve the odds for lifetime financial security.

By the way, Depp paid 10% of his income to his business managers and his lawyer, some $65 million over 17 years. Our fee for trusteeship is well below that percentage. Ask us for details.

©2017 M.A. Co. All rights reserved.

Debts and Death

Dear Garden State Trust Company:

What happens to my debts when I die?

—STILL PAYING THE MORTGAGE

 

Dear Still:

According to a study by the credit bureau Experion, released in December 2016, some 73% of consumers have debts when they die, including mortgage debt.  Some 68% have credit card debt; 37% have mortgage debt; 25% have car loans; 12% have personal loans, and 6% are still paying off student loans.  The average total debt at death for these consumers was $61,554.

That does not mean all these people died virtually bankrupt.  The study does not include an assessment of how large the estates were. Most likely, most estates were large enough to retire the debts.

At your death, your debts pass to your estate, just as your assets do. Your executor will be responsible for paying off those debts. All debts and taxes must be paid before any inheritance is distributed to your heirs.  

If there are not enough cash or life insurance proceeds in the estate to meet the debt and tax obligations, some assets may have to be sold to raise the money. This could include the family home.  If there is a mortgage on the house, the heirs may be able to take over the responsibility for paying the mortgage, to avoid a forced sale.

If you should die without any assets at all, your debts die with you.  But try not to let that happen.

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

© 2017 M.A. Co.  All rights reserved.

The Trouble with Powers of Attorney

Reportedly the incidence of Alzheimer’s disease among those 85 and older is about 47%.  This population needs help with financial management.  Perhaps the most common tool to permit a family member to assist with handling an elderly person’s assets is the power of attorney.  Unfortunately, the power of attorney can also be an avenue that leads to financial abuse of the elderly.  Attorneys Martin Shenkman and Jonathan Blattmachr outlined steps that may be taken to head off such problems without compromising flexible financial management for the elderly person (“Powers of Attorney for Our Aging Client Base,” published in the July 2015 issue of Trusts & Estates magazine).  Among their recommendations:

  • Joint agents.  Checks and balances for the power of attorney may be created if more than one person must sign off on the exercise of the power. Although this may limit quick decisions in the event of an emergency, the tradeoff for greater security may be worthwhile.
  • Care managers.  An independent care manager may be hired to evaluate the elder periodically to report to the elder’s health care agent.  The care manager can determine whether the appropriate care is actually being provided to the elderly person.
  • No more gifts.  In the usual case, one who holds a power of attorney cannot make gifts of the elderly person’s property.  However, the power of attorney may be drafted to specifically allow for such gifts, if that is desired.  In the days when the federal estate tax kicked in at much lower levels, some estate planners routinely advised that gifting powers be included in a power of attorney, so as to begin putting an estate plan into effect and to control death taxes.  The authors make a persuasive case that, given today high federal estate tax exemption, such gifting powers should no longer be routinely included in powers of attorney.  The income tax benefits of holding property until death are far greater than the potential estate tax savings for all but the largest estates. What’s more, gifting powers have been a specific source of elder abuse.
  • Living trusts.  It is becoming more and more common for elderly clients to outlive their spouses, siblings, and friends. That creates a dilemma if there are no children nearby.  The authors suggest, “The use of a funded revocable trust that names an institutional co-trustee or successor trustee can provide a viable solution for clients fitting this profile.”

We are that “institutional co-trustee or successor trustee.”  It’s always nice to receive recognition of the value of our services from experts in estate planning.  We’d be very pleased to tell you more about how our services may benefit you and your family over the generations.  Please arrange for an appointment with one of our officers at your convenience.

© M.A. Co. All rights reserved.

 

Tax Reform Stalls

There has been surprisingly little progress on tax reform, given the high hopes that so many had last January.  On May 17 Republicans and Democrats from the Senate Finance Committee met with Treasury Secretary Steven Mnuchin and National Economic Council Director Gary Cohn.  The key takeaway seemed to be that the Senators want to pursue tax legislation on a bipartisan basis.  That means committee hearings and, most likely, a very protracted process.  Many already have suggested that tax reform can’t happen until 2018.  However, enacting major tax reform in an election year would be unusual, because so much attention must be invested in campaigning.

President Trump’s tax proposals rolled out at the end of April, included the elimination of the federal estate tax, so that remains a possibility.  In a statement accompanying the presentation of the one-page proposal, economics adviser Gary Cohn said: “The threat of being hit by the death tax leads small business owners and farmers in this country to waste countless hours and resources on complicated estate planning to make sure their children aren’t hit with a huge tax when they die. No one wants their children to have to sell the family business to pay an unfair tax.”

Cohn clarified that the repeal of the estate tax would be immediate, not phased in over a period of years.  Democrats are likely to resist changing or eliminating the federal estate tax.

We are no closer to knowing the fate of the federal gift tax or the generation-skipping transfer tax, however.  It has been argued by some observers that the gift tax must be retained so as to protect income tax revenues.  No indication as of May on the fate of basis step-up, or the possibility of taxing unrealized gains at death.

What’s the hold-up?

One of the major stumbling blocks to getting to tax reform is the issue of “revenue neutrality,” the idea that all tax cuts must be offset by tax increases elsewhere in the Tax Code so that net federal tax collections remain unchanged.  That was the model for the Tax Reform Act of 1986; it was not the approach used for the Economic Recovery Tax Act of 1981, which helped to break a long period of stagflation.  In fact, ERTA turned into a bipartisan stampede once the ball got rolling.

The cause of tax reform may have been set back when Senate Majority Leader Mitch McConnell (R-Ky.) announced in May that only a revenue-neutral tax bill could pass the Senate.  He did not identify any “pay-fors” to offset tax breaks expected to foster better economic growth.  The proposal put forth by President Trump, even though it lacks critical details, has been judged to “lose” as much as $7 trillion over its first ten years.  

What happens when the stock market bulls realize that corporate tax reform is not in the cards this year?  Wait and see.

© 2017 M.A. Co.  All rights reserved.