Why do Financial Planning?

Benefits of Financial Planning:

Financial planning may give you peace of mind, maximize of current and future financial well being, prepare you for future emergencies, take care of estate planning, prepare for children’s education costs, avoid tax traps, minimize the effects of stock and real estate bubbles and crashes.


Retail do-it-yourself investors sometimes sell at the bottom in a panic and buy at the top in a panic and lose money. If those investors had been guided by a professional they might of at least been encouraged to get an index fund to get the market’s rate of return. Or possibly a professional advisor could find a mutual fund that could do better than an index fund.

Tax Planning:

Further, there are tax traps that cost investors money. For example: getting a capital gains distribution from a mutual fund that is going down in value, losing capital gains treatment for assets in IRA’s, buying allegedly tax-free Munis only to find that they have AMT tax, getting a big mortgage on their residence and then finding later that the interest deduction is not allowed for cash out refinances exceeding $100,000 over the original purchase mortgage, buying rental real estate with a negative cash flow and then being denied the tax deduction because AGI was too high, using borrowed money to fund a money losing business and then having the tax deduction denied due to basis rules, paying higher than expected tax on capital gains for commodities and collectibles.

Risk Management:

Risk management, which may involve buying insurance, is important. Example: a person with no disability insurance became handicapped about ten years before his intended retirement and could not work for three years. His after-tax opportunity cost of lost wages was $240,000, which forced him to sell his stocks and that triggered taxes of $35,000 which in turn created a need for more selling of stocks. This damaged a balanced investment portfolio which caused a need for additional investment changes to rebalance to a smaller net worth portfolio. He had only stocks in his taxable account and to remain balanced he would need to buy some stocks inside of his IRA, and when those go up he will not get capital gains tax treatment when he makes a qualified retirement distribution when retired.

Education Planning:

Paying for college is extremely expensive. Education Planning maybe able to help. It covers 529 Plans, tax credits for education expenses, investment planning for education costs, and tax deductions or tax favorable treatment related to education expenses. To do education planning correctly requires a good knowledge of income tax planning. To set up an asset allocation for a 529 Plan requires special effort since changes inside the 529 account are allowed only once a year. Investment allocations need to be balanced between a need for the higher returns from stocks on one hand contrasted on the other hand with the fact that a tax-free vehicle is best used for bonds, so it may be better to keep stocks out of a 529 Plan. Also the risk of a stock market crash hurting your child’s education budget are serious, so that is another reason to consider bonds for the allocation. Further complicating the allocation decision is that many 529 Plans have limited choices of expensive funds, so that implies it is best to use a state plan that has a cheap bond index fund and use the 529 Plan as a place to fulfill the “global” (big picture) bond allocation. This means when funds are spend from the 529 Plan that the client would need to re-allocate more of his other funds into bonds, assuming the goal was to maintain the same proportion of bonds. 529 Plans require documentation that college expenses are legitimate and busy immature students may not want to verify petty purchases, so it maybe best to limit 529 Plan spending to a few large easily documented expenses.

Regarding integrated financial planning, the 529 Plan future contributions should be examined to see how it effects estate planning. This is because contributions are subject to the annual $14,000 tax-free gift limit and it may be best for high net worth clients to refuse to give funds to a 529 Plan and instead give each year $14,000 of FLP units to their heirs. Anyone can gift funds for tuition without gift tax if they write the check payable directly to the college, instead of to a 529 Plan.

For those who own small businesses and who can employ their children in the business there are some tax advantaged ways to pay for college. However, these must be offered to all employees, so if too many non-family employees want to go to college then it might be unwise to offer this program.

Estate Planning

Estate planning is about transfer of assets after one’s death and the taxes and fees related to the transfer, including gift taxes, if gifts were used while one is alive.

Methods to transfer assets at death are by contract (Revocable Trusts or Irrevocable Trusts, insurance proceeds or Qualified Retirement Account beneficiary designation) or by a Will. Also, if none of the above applies then assets pass by court proceedings.

Taxes and fees are: Probate fees charged by the court for assets passing by probate. In California this can be $48,000 for a $1,000,000 asset like a house, even if the asset has been “hollowed out” with a cash-out refinance and has no equity. IRD tax is “Income in Respect of the Decedent” which is income on the income earned in final year of life. Finally estate tax is a tax based on net worth, not on assets. So an estate may pay state and federal estate tax, a court probate fee and IRD state and federal income tax. Also expensive real estate city and county transfer taxes may apply if the deceased person’s home is sold.

Using a Revocable Living Trust is a way to make assets transfer by contract and thus avoid probate, saving probate fees, time and privacy. It does not save on estate tax or income tax. When someone dies the revocable trust splits into an A Trust and a B trust with the deceased exemption amount in one trust and the excess in the other trust. That way the exemption amount (scheduled to be $1,000,000 in 2011, but subject to legislative change) is preserved free of tax to be sent downstream to the children. However, while the surviving spouse is alive, the spouse gets to draw on the income generated by the exemption trust.

Doing Charitable Gifting is a way to reduce estate tax and income tax. This would need integrated financial planning to determine how much tax would be saved and whether one would be able to afford to give the gifts.

Qualified Retirement Accounts such as 401k, 403b, IRA, etc. pass by contract based on the beneficiary designation statement, which can not be overruled by court order or by a Will. This is why it is vital to do a full financial plan and examine estate planning issues. As a rule of thumb it is far more flexible and more reliable for estate planning purposes to have assets in an IRA than in an employer sponsored retirement plan like a 401k because of the benefits of “stretch IRA” and the freedom and control that an IRA gives to the owner to have a sophisticated beneficiary designation.

Everyone can give $13,000 annually without gift tax, so to avoid inheritance tax parents should give this amount away to their children. However this should be used carefully because it is best to use it to give shares in FLP’s to reduce estate tax, rather than to fund a 529 Plan. Regarding integrated financial planning, 529 Plan future contributions should be examined to see how they effect estate planning. This is because contributions are subject to the annual $13,000 tax-free gift limit and it may be best for high net worth clients to refuse to give funds to a 529 Plan and instead give each year $13,000 of FLP units to their heirs. Anyone can gift funds for tuition without gift tax if they write the check payable directly to the college, instead of to a 529 Plan.

One way to reduce net worth so as to reduce estate tax is to buy lots of expensive cash value life insurance with the heirs named as beneficiaries. The problem is that an incidents of ownership of a life policy may cause the policy proceeds to be deemed by the IRS to be part of the estate. So the solution maybe to create an irrevocable life insurance trust (ILIT) and fund it with an annual gift and to annually issue a “Crummey letter” (named after a Mr. Crummey) inviting the beneficiary to feel free to withdraw funds from it in order to qualify as a completed gift, which is vital to removing the asset from the estate. The problem is that Whole Life insurance policies (not cheap Term Life insurance) is very expensive and the insured may not be able to get it if his health is poor. Another problem is that this uses up the $13,000 annual gift exemption, which maybe better spent on gifting of FLP shares.

Another technique is for the parents to sell distressed assets to their kids at fire sale prices, thus reducing the parent’s estate while they are alive. The sale must be at fair market value which should be verified with an appraisal. The need for an appraisal is determined by an estate planning attorney. Another technique is for the parents to liquidate assets and loan the proceeds to the children at today’s low 0.8% AFR short term rate using an interest-only loan and then the children invest in stocks and hope to make a long run return of roughly 8 to 10%. This is estimate is based on the past performance of broad market indexes and is not guaranteed for the future. To prevent the children from being spoiled the assets should be controlled by a Trustee.

California residents need to be careful about gifting or bequeathing a house to heirs because if not done correctly the heir will loose the low Proposition 13 property tax base rate. If the house is the only asset and it is to shared by two grown children where one will keep it and the other will sell his half interest then the parents should ask their attorney about strategies such as bequeath it to only one child after first getting a cash-out refinance and then bequeath the cash to the other child. That way each child would get the same amount of net worth. If an inherited house is titled in the names of two siblings and one sells or quit claims his share then that negates the Proposition 13 low tax base benefit and it may trigger expensive real estate city and county transfer taxes.

Donald Martin is a NAPFA-Registered Fee-Only financial planner and investment advisor.