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Wealth Planning News
Vol. V, No. 1
The Colors of Money
There are three basic colors of money you can give to those you love. One goal should be to leave the best color of money possible, and to take steps to change the color of money left to descendants where that change would be beneficial to them.
Green money is money your loved ones receive free of any tax. Taxes that hit money you leave to a loved one are death taxes and IRD taxes. IRD stands for income in respect of a decedent and is income tax on things like unrecognized gain on installment notes, and taxes or gain in deferred annuities, and taxes on all retirement funds such as IRA accounts.
If you have an estate not subject to death taxes, and you own no unpaid installment notes from the sale of appreciated assets, no deferred annuities, and no IRAs or other retirement funds, the color of your money going to loved ones is green.
Yellow money is money subject to either income tax or death taxes in the hands of your loved ones. If you have an estate worth more than the estate tax exemption that applies at death, the part above your exemption amount is subject to the estate tax. It is yellow money because your loved ones will pay a tax on it. That tax can easily take 40 percent of yellow money.
Even if you have an estate not subject to death taxes, you may still have some yellow money. This would be the money you hold in an IRA or retirement account, or the growth in value of any annuity investment you made, or the deferred capital gain represented by a promissory note taken when you sold assets on the installment basis. As the payments on the note come to your loved ones they pay capital gains taxes on the deferred gain. As the annuity pays to your loved ones, which it must do no later than five years after you die, the growth of that annuity over what you paid for it will be taxed to your loved ones as ordinary income. As IRA or retirement funds come to your loved ones after you die, those funds are all subject to income taxes when paid to your loved ones. These income taxes that must be paid make the type of assets described in this section yellow money.
One of the really bad things about items subject to income taxes when they pass to your descendants is that the income received is added to other income of your loved ones. The effect is to push the loved ones into higher income tax brackets than otherwise, and to consume an even larger percentage of the funds in the form of income taxes that your loved ones have to pay.
As you may have guessed by now, you can leave loved ones things that are subject to death taxes and also subject to income taxes. Imagine an estate above the exemption, and imagine that the value above the exemption is a large rollover IRA also subject to income taxes. That IRA is red money.
There is a credit for some of the estate taxes paid, but still the combined death taxes and IRD taxes on certain assets can consume over 60 percent of such assets.
In This Issue
The Colors of Money
Changing the Colors of Money: A Capital Transfer
Change the Colors of Money
The way to change the color of money from red to yellow, or even to green, or to make the shade of yellow less bright and closer to green, is to make a capital transfer.
Imagine you have two pockets. One of them is named Taxed, and the other is named Not Taxed. Your goal is to take money out of the Taxed pocket and put it into the Not Taxed pocket. The way to do it varies in each case, but here is a general idea of how to do it.
Assume you have enough or more than enough to live on with current income. Usually that is part of the cause of having a large estate or large amounts of retirement funds. You should consider making gifts to loved ones via a trust that would protect the gifted assets and their growth from creditors and predators of your loved ones. You can use your annual gift tax exemptions for these gifts, and maximize the number of available exemptions in ways beyond the scope of this newsletter.
But what funds should you gift? Most people want to make gifts out of savings or other capital they can gift with no taxes. But if you have large amounts in an IRA it might make sense to make excess withdrawals, pay some income taxes on the withdrawals at rates far lower than the rates your children might later pay, and shift all appreciation on the remaining funds to your loved ones free of any taxes to them. The decision of what funds to use for gifts comes down to an individual analysis. You may be surprised to learn that the net cost of early withdrawals can be far less than the later taxes that your loved ones would otherwise pay.
One of the traditional ways to spend the funds gifted to the gifting trust is to use the funds to buy life insurance on your life or the life of you and your spouse. But what if you are too old or your health is too poor to qualify for any reasonable insurance rates, which is often the case? You may want to consider using the funds to buy insurance on the lives of your children, who are younger and presumably in better health, for the ultimate benefit of your grandchildren and their descendants.
The choices of how to make capital transfers and how to invest transferred capital require detailed analysis of your situation. But you may be pleasantly surprised by the results possible for your loved ones. Life insurance often ends up being the choice of investment for descendants. You now have a better understanding of why all those wealthy people buy investment life insurance, often investment grade insurance on their descendants, that far exceeds any amount most people normally consider as necessary.
We discuss the uses of life insurance in other newsletters. Ask us if you have any interest in that topic.