From the March 2009 issue of Wealth Manager Web • Subscribe!

Unintended Consequences

Today's tax law changes, volatile markets and low interest rates may unleash something that your client is not ready for--the law of unintended consequences. As many of us know from personal experience, unintended consequences are not always for the better. With that in mind, we will examine a few of the unintended consequences that you can help your clients avoid in 2009. Watch for them in connection with:

? Credit Shelter Trusts

? Trustee and/or Guardian appointments

? Required Minimum Distributions

? Life Insurance Policies

? Missed Opportunities

The Credit Shelter Trust (CST)

Credit Shelter Trusts have often been used very effectively to reduce the estate tax of a married couple. As we know, the primary advantage of the CST is to keep part of the estate of the first to die outside the taxable estate of the surviving spouse. Per EGTRRA, the estate tax exemption amount is increasing this year by $1.5 million for a total of $3.5 million. Thus, for a couple with a $7 million estate who both die in 2009, a CST can save approximately $1.5 million dollars in estate taxes ($3.5 million @ 45%).

Sounds awesome, and in the case above, it is. But a CST is not the perfect solution for everyone--specifically not for couples whose asset bases have taken a serious beating and who have an article in their will establishing a CST with instructions to fund it with the maximum allowable by federal law.

For example, let's look at Mr. and Mrs. Jones balance sheet.

Mr. Jones

Mrs. Jones




Investment Account





Mr. Jones' assets are $6 million, and those of Mrs. Jones are $2,750,000. Mr. Jones dies in 2009, so the CST will be funded with $3.5 million. Thus, Mrs. Jones has direct control only over $250,000 and her home. Is this enough to support her lifestyle for the rest of her life? The bulk of the liquid assets will be in the CST where she most likely may have access only to the income and/or principle subject to an ascertainable standard relating to her support, maintenance, health and education. Five or five power--the beneficiary's right to withdraw each year 5% or $5,000, if greater, from the trust--may add additional resources. If she is not the sole trustee and the trust language provides, she may have more access to the CST--but only at the discretion of an independent trustee.

Furthermore, let's say that the value of Mr. Jones' (individual) assets is less than the $3.5 million, and the home is owned as joint tenants in common. Then we look to Mr. Jones' 50% share of the home to complete the funding of the CST.

Unintended Consequence?

Any gain on the portion of the home that becomes part of the CST after death cannot be sheltered on sale with the Section 121 capital gains exemption, and upon the survivor's death there will be no step-up on the additional (if any) appreciation.

Moreover, there could be an opposite scenario, where, unintentionally the CST is not funded. For this example, take a couple whose most significant assets are a home owned
JTWROS and an IRA designating the wife as beneficiary. Because these assets pass directly by operation of law--not through the will--there may be no (or minimal) assets available to fund the CST. Another instance where a CST may be under-funded is when the state estate tax exemption amount is less than the federal exemption amount, and the will instructs that the CST be funded to the maximum allowable by state law

What this tells us is that it is imperative to review our clients' wills, their designated beneficiaries and titling of property, etc. to ensure that upon their demise their assets go to the people and places they intended. We need to make sure that their plans are flexible and adaptable to changing conditions.

Trustee and Guardian appointments: Still a go?

When deciding who should be a trustee or who should be named as a guardian for their children, people often look to family and friends. Unfortunately, this market has taken a toll on many people whose situations were thought to be rock solid. Therefore, the question has to be asked: Are they still the best solution for your needs?

Thus, now may be the time to have a discussion with your clients on the benefits of a corporate trustee and the impact this market may have on their choice of guardian.

Some of your clients may already have a relationship with a corporate trustee. You may want to review with your clients who is responsible for their trusts and whether these corporate trustees are still the best fit. As you know, several financial services companies are disappearing, changing names and ownership, or in a state of disarray; thus your clients may not be getting the focus they deserve and require.

Finally, is your client a trustee of a trust? With markets as volatile as they are now, does your client have the expertise and the fortitude to assess risk, position the trust portfolios
correctly and monitor their exposures? Can they do this alone?

Life Insurance: Not as much as you think?

Many of our clients own universal and/or variable life
insurance policies. As you may recall, these types of policies include an investment component and thus are affected by market conditions.
Unfortunately, the market conditions of late have been abysmal, meaning some of your clients may end up with very unexpected surprises regarding their life insurance--specifically, greater premiums than expected, a lesser face value than expected or in some instances a lapsed policy. I say this because many initial insurance projections or illustrations showed the cash value build-up used to pay premiums (i.e. "vanishing premiums). But if the policy did not perform as well as projected--surprise! Therefore, you may want to suggest to these clients that they get an updated in-force illustration to ensure that what they expect to occur will occur.

Furthermore, there remains some uncertainty regarding the health and continued viability of various insurance organizations. At this point, it is anyone's guess as to whether the current market crisis will cause any insurance company to fail, but unfortunately, we learned over this past year to "never say never." Therefore, it may be a good time to check whether there are any significant rating downgrades on your clients' insurance carriers. You might also want to become familiar with your state's regulations for handling the liquidation of insolvent insurers and to what extent death benefits and cash values are covered

RMD Waivers

The Worker, Retiree and Employer Recovery Act of 2008 (WRERA) suspended required minimum distributions (RMDs) for 2009. Two areas where we see some confusion are when the required beginning date (RBD) is in 2009 and for beneficiaries of inherited retirement plans.

If your client turned 70 1/2 in 2008, their RBD is April 1, 2009, but this is not considered a 2009 distribution. It is a 2008 distribution because the RMD is based on the value of the account on Dec. 31, 2007. The penalty for not taking a distribution is 50% of the RMD--an unintended consequence that can easily be avoided. On the other hand, some people do not realize that the RMD waiver applies to them and take a distribution when they don't have to, instead of allowing their assets to continue to grow tax-deferred.

Furthermore, clients who do not need the RMD to support their lifestyle, may mistakenly think that they can take only a cash distribution from their IRA. Thus, to meet the RMD, they are forced to sell some portfolio holdings at a very inopportune time. They should be aware that they may be able to take an "in-kind" distribution and hold on to the stock if they believe it has growth potential and is in line with their overall plan.

Missing Out on Opportunities

"A cat who sits on a hot stove will never sit on a hot stove again. But he won't sit on a cold stove, either." This is a famous quote by Mark Twain that I feel really sums up clients' attitudes today. Who can blame them; this past year was one of unimaginable events and declines. Unfortunately, though there are ways for our clients to take advantage of this depressed market, many clients are frozen in a state of inactivity. They are too fearful to implement any strategy.

This is a shame for those clients that have wealth transfer concerns. I say it's a shame because of the perfect storm of low interest rates and depressed values that make some wealth transfer strategies really powerful. Take GRATs for example: The 7520 rate is the lowest in history (2% for Feb. 2009), and markets are down approximately 40%, just imagine the wealth transfer that could happen even if the market comes only halfway back. For your clients with estate tax issues, wouldn't it be great to see the recovery on their child's balance sheet instead of their own?

If GRATs are too complicated for your client, annual exclusion gifting can do the trick. For 2009 the annual exclusion amount has increased only $1,000 from last year--but it's really more valuable than that. I say this because $13,000 of stock today is not the same as $13,000 of stock was. Here's what I mean: Let's say early last year you were only able to gift 100 shares of stock A, but since the share value had decreased significantly you can now transfer 200 shares. Thus, one could say that when assets values are depressed, the annual gift tax exclusion can be more valuable. Obviously, this only makes sense if the stock appreciates in value in the hands of the giftee.

Income-tax planning is another area where clients could take advantage of depressed markets and low rates. As of this writing, tax rates are still at all-time lows--does this lend itself to opportunity that should not be missed? For many clients diversifying out of a concentrated (low basis) position, when markets are down is emotionally difficult. But postponing a sale requires a strong belief in relative out performance. Compared to a 15% rate today:

o selling at a 20% capital gains rate next year requires an additional 4.1% return

o selling at a 28% capital gains rate next year requires an additional 13.5% return

The chart below shows that the basis of a stock is essential for analyzing the implications of diversification; the lower the tax basis of a concentrated position, the higher the incremental return required to compensate for higher tax rates.

In these challenging times many clients are desperate for good advice. Confusion breeds contempt--let's try and ease our clients' pain.

Susan L. Hirshman CFA, CPA, CFP, ( is a managing director and wealth advisor at JPMorgan Private Wealth Management in New York.

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