Knowing the best strategy to recommend to families in every financial situation requires either an encyclopedic knowledge of tax, investment, and legal matters or a crystal ball. The former can take decades to accumulate, and the latter is even harder to come by.
But luckily for your earning prospects, when left to their own devices many of your clients are predisposed to make the least-optimal choice in response to even the most basic of financial questions.
That's too bad for them, but it makes your expertise that much more valuable. And if you're fortunate enough, you can flesh out a nice career just by preventing them from following their own misguided intuition.
Here are five common money mistakes many families make, and what you can do to protect them from their ignorance:
Saving money for college in their children's name
The problem: Well-intentioned parents and grandparents put money intended for college in UTMA/UGMA accounts in their children's name. Although the initial portion of annual earnings on investments held this way are taxed at the child's usually-lower rate, any money sheltered from the IRS could be offset by the ravenous treatment these accounts receive from a school's financial aid office. And the child can take control of the funds upon reaching adulthood (18 to 21, depending on the child's residence state).
What you can do: Get the money out of the accounts — preferably before the child's senior year in high school, when the financial aid application process begins. Although your clients can't transfer the money back into their own accounts, they can spend it on items benefiting the child that exceed a parent's normal financial obligations — including a car, a trip with an organization, or elementary and secondary tuition expenses.
Saving money for college in 529s
The problem: Okay, the world would be a better place if the biggest money mistake parents made was using 529s to save money for college. But in some cases, doing so means clients may be neglecting more pressing short-term and long-term financial needs. And if down the road they have to use money in 529 accounts to cover costs unrelated to college, the taxes and penalties on non-qualified withdrawals can eat up a third to half of the earnings (but not the original deposits).
What you can do: Lower- and middle-income parents who qualify might be better served by depositing money into Roth IRAs first, and then putting any extra funds into 529s. First off, families can usually borrow money to pay for college, however there's no such thing as a “retirement loan.” Almost as important is the idea that contributions to a Roth IRA can always be withdrawn with no taxes or penalties at any time, for any reason. That includes covering tomorrow's college costs or today's cash crunches. And 529s still might be the preferable alternative for high-income parents, or grandparents with no earned income.
Buying too little of the wrong kind of life insurance
The problem: You find clients paying premiums on a cash-value life insurance policy that's intended to support the insured's survivors. But it has a death benefit that won't replace more than a year or two of the insured's income. Or, in some cases, it's a less-expensive term policy, but it was purchased at the client's place of employment, and may not follow him if he leaves his current job.
What you can do: If the sole goal of the policy is to protect the clients' survivors, the parents may want to consider buying a term life insurance policy on their own that could provide a much greater death benefit for the same premium amount. They may also want to see if any cash value accumulated in the old policy can be converted to paid-up term coverage.
Making adult children co-owners of the parents' home
The problem: Some members of the greatest generation think that this maneuver will help them not only avoid probate, but also exempt the home from liability for nursing home expenses and eventual estate taxes. Instead, they could incur gift taxes upon adding the child's name to the deed, jeopardize favorable tax treatment if the house is sold, and even lose the home if unfortunate circumstances befall the adult child.
What you can do: Tell the clients, “Get thee to an attorney.” A qualified estate-planning lawyer can show them that although probate marks the end of their lives, the process isn't the end of the world. The attorney can also point out to clients that currently $2 million can pass to heirs free from estate taxes, and that they may be able to double that amount through shrewd use of the marital exemption. As to the question of nursing home expenses, you should let your clients know that long-term care funded by public assistance is care they would probably just as soon do without.
Dying to avoid capital gains taxes
The problem: Older clients have a substantial portion of their assets in one or two long-held common stocks or mutual funds. The investments don't fit with current financial goals, but the owners are hesitant to sell the securities because of the capital gains tax that would come due. They would prefer that their death give the heirs a stepped-up cost basis, and thereby reduce or eliminate any capital gains taxes when the investments are eventually sold.
What you can do: Calculate the actual amount of money due if some (or all) of the positions were to be sold right now. With federal long-term capital gains tax rates ranging from 5 to 15 percent now, and dropping to as low as 0 percent next year, clients might be surprised at how little these taxes would cost them. (Especially compared with the potential losses that could be incurred by an undiversified portfolio.) But even confronted with all this empirical evidence, don't be surprised if the elder clients still hang on to their shares. After all, the history they have with these types of investments may be both longer, and more rewarding than the relationships they have with some other members of the family.
Writer's BIO: Kevin McKinley CFP is a Vice President-Private Wealth Management at Robert W. Baird & Co., and the author of the book Make Your Kid a Millionaire (Simon & Schuster). You can reach him at [email protected]