For those who have amassed a sizable estate, a major estate planning priority is figuring out how to transfer that wealth to the next generation. This is known as “wealth transfer,” and it entails the strategic gifting and distribution of a person’s assets during and after his or her lifetime.
In the past, estate taxes played a central role in wealth transfer strategies. But now that the gift and estate tax exclusion is so high—$5.45 million for individuals and $10.9 million for married couples in 2016—estate tax considerations aren’t as constraining. “Today, affluent individuals are able to be more thoughtful in their wealth transfer decisions,” says John Pettee, a Schwab Wealth Strategist based in Phoenix.
John says there are two main wealth transfer strategies: giving during your lifetime and bequeathing assets upon death. “In most cases, clients choose to employ both strategies,” he says, but he adds that there are no one-size-fits-all solutions when it comes to wealth transfer. “It’s my job to understand clients’ goals and educate them on the strategies that could help them achieve those goals.”
Here we’ll look at some potential benefits and drawbacks of transferring wealth during and after your lifetime, as well as some of the common strategies.
Giving during your lifetime
In general, clients with surplus wealth typically find lifetime giving attractive, John says. The tricky part is figuring out how much surplus you have.
The first step is to meet with your Schwab Financial Consultant to estimate how much of your assets you’ll need during your lifetime. “Once you’ve done that, we can estimate how much of a surplus you will have and identify which transfer methods are most appropriate for your needs,” he says. Keep in mind that assets being gifted will have their income tax cost basis carried over to the beneficiary, so thoughtful consideration is required.
There are numerous benefits of giving during your lifetime. For one, you get peace of mind from knowing that the assets (and any subsequent appreciation) are out of your estate, thereby reducing your estate’s tax liability.
“Giving during your lifetime also allows you to enjoy the benefits of your generosity,” says John. “Many clients appreciate being able to witness the impact of their gifts.”
There are, however, some drawbacks to lifetime giving. John explains, “One big concern many people have is that giving during their lifetimes will set a precedent—that their heirs will expect and depend upon regular gifts. The key to overcoming this issue is to be up front with your heirs about your giving plans.”
Some clients also worry that giving regular gifts might undermine their heirs’ motivation to build their own wealth. “Many affluent clients built their wealth themselves and value the struggle and hard work it took to get them where they are,” says John. “In most cases, they want to ensure that their gifts don’t undercut their heirs’ work ethic.”
John encourages clients to weigh the benefits against the drawbacks when deciding whether lifetime gifting is right for them. “I have worked with several clients who, because of their unique circumstances, decided that lifetime giving didn’t make sense. In the end, you have to do what’s right for your heirs and your estate,” he says.
For clients interested in transferring wealth during their lifetimes, below are a few strategies to consider.
Annual gifts: Under annual exclusion rules, you can give away up to $14,000 per person per year ($28,000 for married couples) without incurring gift taxes. This exclusion includes annual contributions to 529 college savings accounts and similar savings vehicles.
Irrevocable trust: With this trust, you can specify the terms and conditions of how and when the funds are to be used. This approach typically is attractive to individuals who need to transfer a large sum of money but want to have some say in how the assets are used. Keep in mind, however, that “irrevocable” means you forfeit all rights to and control over the money in the trust once it’s established.
Custodial account: The Uniform Transfer to Minors Act (UTMA) allows for the transfer of assets to minors through a custodial account. There are a few potential drawbacks to this account, however. For example, the minor will have full control over the account once she or he reaches the age of majority (typically 18 or 21, though it varies by state). Additionally, there are some tax and other financial ramifications associated with these types of accounts, so be sure you review your options with an attorney before making any decisions.
Grantor retained annuity trust (GRAT): For high net-worth individuals, a GRAT could facilitate the transfer of significant assets that are expected to appreciate, while reducing or eliminating associated gift taxes. A GRAT removes property from your estate while paying income for a number of years. The assets within the trust act as an annuity, paying out interest or a percentage of the assets to the grantor each year. When the trust expires, the beneficiary receives the remaining trust value. If the grantor dies before the trust expires, however, the account becomes part of the deceased’s taxable estate.
Bequeathing assets upon death
“When planning for the transfer of wealth upon your passing,” John says, “you can gain important insight by considering how the gifts will be used and what their overall impact will be. This way you can determine whether adjustments are necessary in the final disposition of your estate.”
The next step is to have a conversation with your heirs about any irrevocable trust structures that will continue for their benefit. There are a number of strategies to transfer wealth to your heirs while circumventing the long, arduous and costly probate process. John points to three types of strategies that can help clients meet their wealth transfer goals.
Stretch IRA: This is a strategy to extend the life of an inherited individual retirement account (IRA) by naming beneficiaries from multiple generations. The younger the beneficiary, the smaller the required minimum distributions—and the longer the account lasts, assuming none of the beneficiaries need to withdraw more than the minimum amount each year. The success of this strategy depends on your heirs’ willingness to follow through on it, however, so make sure you communicate your wishes and the benefits up front.
Irrevocable trust that owns life insurance: This strategy is useful for individuals who are subject to estate taxes but lack ample liquidity to take care of that burden. This situation typically happens when a large estate is “cash poor,” meaning it comprises mostly low-liquidity assets like real estate or assets with income tax liabilities like traditional IRAs. By establishing an irrevocable life insurance trust, you can create pools of liquidity outside of your estate.
Support trust or discretionary trust: A support trust can provide annual income for the beneficiary while avoiding large lump sum distributions. Usually, a named trustee decides when a beneficiary will receive distributions and can help when greater asset protection for the beneficiaries is desired.
How Schwab can help
Establishing a wealth transfer strategy often requires the help of an attorney. While Schwab does not provide tax planning or legal advice, your Schwab Consultant, in conjunction with a Schwab Wealth Strategist, can help you prepare for your meetings with your attorney—saving you time and money.
Planning for incapacity
Even the best laid plans could go awry without the proper protections in place. Planning for incapacity ensures that should anything happen to you, someone you trust will be in charge of your finances and able to carry out your wealth management plans on your behalf.
Here are two ways to help protect your wealth.
Durable power of attorney for finances: This legal document gives someone you trust the authority to make financial decisions on your behalf. This type of power of attorney is usually comprehensive—whoever you choose will typically be able to handle all of your financial affairs for you if you become incapacitated.
Revocable living trust: With this trust, you maintain control of the assets in the trust unless you become incapacitated, at which point the successor trustee will have absolute control over the assets in the trust.
In many cases, it might make sense to establish both a durable power of attorney and a revocable living trust. The former can control assets that may have been left out of the trust inadvertently or intentionally.