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Financial Planning > Tax Planning

Wealth Transfer: Money Matters, But So Does Tax Status

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For years, financial professionals have helped clients accumulate assets to fund retirement using a variety of investment vehicles, each with its own advantages. With the baby boomers knocking on retirement’s door, the industry has placed even greater emphasis on helping clients make the most of their assets, including the best ways to transfer wealth.

Economists believe the U.S. is on the verge of seeing one of the biggest transfers of wealth in history, and today’s financial professionals must be ready!

About a generation or so ago, virtually all assets came in the form of after-tax savings and investments, all with similar tax status. Heirs received a “step-up” in basis on these assets at the date of the decedents’ death and all future earnings were the tax responsibility of the heirs–virtually no strings attached to the deceased.

As a result, estate planners focused on meeting the client’s goals while keeping the estate tax as low as possible, primarily through creative use of trusts and life insurance. While this type of wealth transfer planning is still an important feature of estate planning, a new issue has appeared: Transferring assets of different tax status.

Because all of a client’s assets will be included in the estate for estate tax calculations, it is important to understand the consequences of each type of inherited asset. Today’s wealth transfer plans must also take into account whether the asset is in a tax-qualified plan funded with pre-tax dollars (TQ asset), a tax-free account funded with after-tax dollars (e.g., Roth IRA asset), or a traditional after-tax investment (non TQ asset).

During the distribution phase, the client will need to fund the difference between retirement spending and regular retirement income streams by making withdrawals from their assets. Which asset to take the money from greatly depends upon the client’s feelings about paying current income tax, as opposed to the desire to leave to heir’s assets having the most advantageous tax status. The IRS will always get its share; the issue becomes who pays the tax.

Assuming the client has money in all three categories of assets–TQ, Roth, and Non TQ–what is the most tax-efficient distribution method to fund retirement, while still allowing for a legacy? The answer varies based on each client and situation, but 2 key strategies can be employed: A client-focused strategy and a family-focused strategy.

The client-focused strategy

The first approach is based upon the client’s needs. To minimize current income taxation, the client should first make withdrawals from Roth IRA assets, then Non TQ and finally TQ. With this withdrawal strategy, it is likely the legacy after death will be composed of a higher percentage of TQ dollars, as opposed to Roth and Non TQ. The result: an heir will pay income tax on the TQ assets at the heirs’ rates.

The family-focused strategy

The family focused strategy is based upon the needs of the client’s heirs. If given a choice, heirs would choose to receive the highest percentage of their inheritance in the form of Roth assets, followed by Non TQ. The least desirable tax status to inherit is TQ, as it means the heir will pay more income tax.

This status mix allows the greatest flexibility with the lowest potential income tax liability. Under the family approach, the client must be willing to pay more in current income taxes in order to leave the heirs with less income tax to pay. The financial professional can advise the client on how to make balanced withdrawals from all tax status assets to most efficiently use the income tax brackets of the client, while taking into consideration the possible income tax brackets of the future heirs.

Both of these strategies have different goals. The “client” approach defers as much income tax as possible, while the “family” approach balances the tax between generations.

From a pure tax status viewpoint, the client wants to consume assets in the exact same preference order as the heirs would like to inherit assets. It is critical for the advisor to inform the client and allow the client’s desires to drive the strategy.

In any wealth transfer situation, there are always variables that can have an impact. Think of the planning process as a road map for the future; like nearly all travel plans, it will be subject to detours, construction delays, accidents and spur of the moment side trips. The role of the financial professional is to map out a plan for success consistent with the goals of the client, and then be available to assist the client as the future unfolds.

Phillip Hawkins, CLU, is vice president-securities products at State Farm Corporate headquarters in Bloomington, Ill. You can e-mail him at [email protected]


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