Expert Dan Mythen, CEP, offers considerations for Legacy Plan Assets in today’s investment environment

What are the considerations in choosing an asset to pass on to heirs in today’s environment?
High net worth clients that plan to leave a legacy should consider how assets perform in terms of taxes, liquidity, market risk, leverage, and guaranteed values.  Below, I discuss the pros and cons of stocks, Funds/ETFs, Municipal Bonds, Partnership, REITs, LLC shares, Annuities, and Life insurance.  I will not address qualified plan assets or IRAs as they are generally not allowed to be owned within an irrevocable trust.  I have also left out real estate as a standalone asset but it might be part of an LLC, REIT or Partnership share.

First off, let’s assume that the client has done some advanced estate planning and that the assets we discuss below may be gifted into an irrevocable trust.  This trust structure currently avoids state and federal estate tax at the time of the grantor’s death along with asset protection.

Liquidity within the trust may or may not be important.  The trust might also have the capability to make distributions or loans to the beneficiaries for certain circumstances.  Liquidity may also come into play, such as in a trust, where the grantor would be the husband and the non-grantor wife could receive distributions for health, education, maintenance, and support for her ascertainable standard of living while the husband/grantor is still alive.  This is sometimes known as a spousal lifetime access trust or S.L.A.T.

Several high net worth clients have enjoyed recent record gains in their stock positions.  Is this a favorable asset to pass on wealth?
As most advisors are aware, stocks enjoy a stepped-up cost basis upon passing to the next generation so there is no capital gains tax upon sale of that asset when sold by the beneficiary.  Many high net worth clients have low-cost basis highly appreciated concentrated stock positions that may have been stock awards from their employers.  (See case study comparison at the bottom of the article)

  • Taxes – Enjoys stepped up cost basis at death
  • Liquidity – Very good unless no market exists to sell
  • Market Risk – Variable
  • Leverage – Generally accepted as collateral for securities based lending
  • Guaranteed Values – None

Would Mutual Funds or ETFs work well as a legacy asset?
They provide professional management and diversification.  The same “Tax Drag” on capital gains and income apply to funds and ETFs.  Some ETFs, Mutual Funds, and Managed Accounts intend to be “tax-managed” so as to not generate a large 1099 of reportable income to the trust.

  • Taxes – Enjoys stepped up cost basis at death, may have high annual income and capital gains
  • Liquidity – Very good unless restricted
  • Market Risk – Variable. Diversified as they typically manage a basket of stocks or/and bonds
  • Leverage – Generally accepted as collateral for securities based lending
  • Guaranteed Values – None except possibly index option protection strategies

What about Partnership, REITs or LLC shares?
These may be popular assets to gift into an irrevocable trust.  If it is a family-owned business (entity), the shares may be highly illiquid and might qualify for a discount against gifting limits for lack of marketability (liquidity), and entity controlling shares.

  • Taxes – Enjoys stepped up cost basis at death if able to be sold. Qualified distributions treated currently at the same rate as capital gains which is 20%
  • Liquidity – Poor unless entity is sold and shares become liquid. REIT has more liquidity
  • Market Risk – Variable, dependent on performance of entity or real estate
  • Leverage – Difficult to get loan on a non-traded share
  • Guaranteed Values – None

How do taxes effect the decision on which type of asset is placed within a trust?
Currently, all income from trust assets is at the highest rate of 39.6% income tax after only $12,500 of income.  So owning assets that generate a lot of current income would probably not be the best choice.   Assets may also be exposed to capital gains tax of 20% after $12,500 of income if sold before transferred to the next generation.

If I want to avoid taxes, what about owning Municipal Bonds?
Municipal bonds have always been a popular planning asset for clients wanting to avoid income taxes.  As we have been in extended low-interest rate environment, the current yields on all bonds are historically quite low.  A 20 year AA-rated municipal bond has an average yield of about 3.5% today. Widely traded bonds are liquid if there may be a need for the trust to disperse cash during the life of the grantor/client.   Any gain would be subject to capital gains tax.  There may also be more interest rate risk in owning bonds in today’s environment.  A common rule of thumb is for every 1% rise in interest rates, a 20-year bond loses about 15% in market value if sold.  Is this an acceptable risk for a low yield/return?

  • Taxes – Enjoys stepped up cost basis at death
  • Liquidity – Very good unless restricted
  • Market Risk – Variable with interest rates or creditor default
  • Leverage – Generally accepted as collateral
  • Guaranteed Values – Depends on Municipalities ability to service debt /pay interest on bond

Okay, then what about Annuities?
Annuities are great vehicles for accumulating tax-deferred wealth that is meant to be spent during one’s lifetime.  They are generally poor wealth transfer vehicles and rarely if ever owned by an irrevocable trust.

  • Taxes – No stepped up cost basis upon death. Income from annuities is taxable at ordinary income rates unless annuitized.
  • Liquidity – Good unless restricted
  • Market Risk – Variable or Fixed dependent on underlying investment. Diversification in subaccounts
  • Leverage – Might be accepted as loan collateral
  • Guaranteed Values – Possibly

What about Life Insurance?
Life insurance has always been a popular vehicle for wealth transfer.  It provides liquidity shortly after the time of death which can meet monetary demands or help the family business continue without financial stress.  It helps avoid a “fire sale” of other assets.  As mentioned above, if held within an irrevocable trust it escapes all income and estate tax.

  • Taxes – Death benefit is always income tax-free and if in an irrevocable trust, is also estate tax-free. Withdrawals from policy cash values are generally tax-free.
  • Liquidity – Generally cash values as withdrawal of basis or/and loans.
  • Market Risk – Variable or guaranteed values available.
  • Leverage – Very high for death benefit in early years and reducing as time goes on.
  • Guaranteed Values – Guarantees on cash value but more importantly guaranteed death benefits now available up to age 120.

Example of comparing two assets for efficient wealth transfer:

Bob and Linda

  • Married, Good Health.
  • Both age 60 with two adult kids.
  • Current annual income over $470,070.
  • They are at the highest current income and capital gain tax rates apply.  39.6% income and 20% capital gain.  (At 35% bracket and below, capital gain tax would be 15%.)
  • Net Worth over $10 million.
  • $1 million position in Apple.  Assume a zero cost basis.
  • 5/30/17 price of Apple was $153. 5 year high is $156.

Option A:
They sell their Apple position and pay a 20% capital gain tax to net $800,000.  They then gift that amount to the Bob and Linda irrevocable trust.  The trust purchases a survivor universal life policy with a guaranteed death benefit of $3,387,926.

  • Taxes – $200,000 at highest capital gain rate of 20%. Death benefit is entirely tax-free
  • Liquidity – Little as this policy design favors a higher death benefit versus a liquid cash value
  • Market Risk – Guaranteed by the carrier
  • Leverage – 4.23 to 1 return leverage on inception. (3,387,926/800,000) May be acceptable loan collateral
  • Guaranteed Values – Guaranteed death benefit to age 120

Option B:
Gift the $1 million Apple position to the revocable trust.

  • Taxes – Annual dividends taxed at 20% No estate or capital gain taxes if held to death of grantors
  • Liquidity – Very good
  • Market Risk – Variable / Non-Diversified
  • Leverage – Typically accepted as loan collateral
  • Guaranteed Values – None

To equal the guaranteed amount provided by the insurance from day one, the Apple stock price must go from the current price of $153 to $518.  Is that realistic?  Option “A” retains another $200,000 of gifting ability.  If trust liquidity is not a goal, the insurance looks to be the better option.  With a single policy on Bob and Linda in similar trusts, there would be more liquidity at the first death.  A combination of both asset types may be appropriate.

As tax laws, life situations, market conditions, and family dynamics are ever-changing, it makes sense to tailor an efficient wealth transfer strategy that provides the right balance of flexibility, tax protection and asset protection.  The assets earmarked for wealth transfer should be analyzed based upon tax treatment, need for liquidity, potential market risk, leverage and available guarantees.

About the Author:
Dan Mythen has been securities licensed since 1984 and has spent the first half of his career wholesaling equity and bond funds through top financial advisers.  He brought to market the first Washington-only municipal bond mutual fund while at MFS.  The latter half of Dan’s career has been concentrated on planning options for efficient wealth transfer of assets for high net worth and ultra high net worth clients.  Dan has been associated with Mercury Financial Group for the past four years and is available for consultation with advisors and their high net worth and ultra high net worth clients.  Dan makes his home in Redmond Washington with his teenage son Kellan and enjoys fishing, hiking, flying his pet drone and yoga.

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Mercury Financial Group does not provide tax or legal advice. All clients are urged to seek counsel on such matters.