Perhaps the hardest words an advisor has to speak are these: “I don't know.”
Sure, they have the advantage of making an advisor look confident and ethical enough to speak the truth, but they also leave the speaker feeling inadequate.
Experience is the best road to building a mental library that keeps the “dunnos” at bay. What follows is a few volumes I've added to my own in the course of my 16 years in the securities industry. Here's hoping they help a few of you look wiser in clients' eyes as you advise them on managing and transferring wealth.
Problem: A single grandparent wants to provide her grandchildren with a meaningful financial legacy, but her current financial situation doesn't allow her to give anything beyond a few thousand dollars per year.
Solution #1: Advise her to make her grandchildren the beneficiaries of her IRA accounts. She will still have access to the money whenever she needs it. When she dies, any remaining amounts will go directly to her grandchildren. If the children are savvy, they will stretch the required minimum payments over their long life expectancies, keeping the majority of the money sheltered from taxes. But if they need to get at the money, it is readily available (although with a bit of a tax bite).
Solution #2: The grandparent can purchase a cash-value life insurance policy, again with the grandchildren as beneficiaries. If she needs money in an emergency, she can borrow from the policy. When she dies, the money goes to the grandchildren — with no income taxes.
Problem: An advisor is serving two generations of a family — a senior couple and their middle-aged children. The older couple is in the lowest tax bracket. The Baby-Boomer children are in their prime earning years, and their income is being taxed at the highest rate. The elder parents have a substantial amount of money in tax-deferred annuities and IRAs that they don't need. If the elderly parents die, the annuities and IRAs will go to the adult children — and withdrawals may then be taxed at the maximum rate.
Solution: Start withdrawing the annuity and retirement money immediately, with an eye on the senior couple's effective tax bracket. Between the standard deduction, the personal exemption and the huge difference between the lowest and highest tax rates, you should be able to get tens of thousands of dollars out of the tax-advantaged accounts each year and still keep it taxed at 15 percent. This could save the second generation close to $100,000 in taxes on a mid-six-figure tax-deferred portfolio.
Problem: Your clients are a business-owning couple in their 60s. They are retiring, selling the company and dispersing some of the sales proceeds to their children and grandchildren. But their descendants have a wide range of financial stability and expertise, and are scattered around the country.
Solution #1: Offer to develop financial plans for each family subset, which they can then either implement through you or on their own.
Solution #2: Hold private investment seminars for the family members online or over the telephone. Better yet, if the kids and grandkids are going to be in your town for a particular holiday or event, offer to host an afternoon “family money meeting” at a local hotel.
Problem: Your clients are a middle-aged, middle-income couple. One set of their parents has decided to leave them several million dollars in assets, including a large IRA. The “good problem to have” in this situation is the substantial estate and income tax bill that will be due after both parents die. You've approached the parents with strategies to avoid the government's grab, but they aren't interested.
Solution: Have the adult children purchase a second-to-die life insurance policy on the lives of the parents. If the older couple is in average health, the premiums should be low enough to make a sizable potential payoff on the initial outlay. And if the estate ends up owing few or no taxes, the younger couple gets to keep the tax-free proceeds of the life insurance as a bonus.
Problem: Your client is selling a large piece of real estate and will be on the hook for a substantial capital gains tax.
Solution: Consider using a “private annuity trust” as part of the transaction. The client establishes the trust, places the property in the trust and nominates someone other than himself (such as a non-dependant child) to serve as trustee. The trustee then sells the property to the prospective buyer for cash. The proceeds are kept in the trust and reinvested. Your client can then begin to receive fixed installment payments from the trust for the rest of his life — although he can delay taking payments until he turns 70. The payment amount will be based on IRS life expectancy tables.
Part of the payment will be a tax-free return of basis, part will be taxed as capital gains and the final portion will be taxed as income (representing the interest earned on the unpaid balance in the trust). If the client survives the payment schedule, any balance remaining in the trust can be held for (or distributed to) the beneficiaries. If he doesn't live long enough to see the last payment, the checks stop, and the remaining money goes to the beneficiaries. Either way, whatever is left in the trust passes to the descendants with no state or gift taxes.
Problem: A high-net-worth client needs to sell highly appreciated stock to pay for a child's impending college education. The capital gains tax, however, will knock a good chunk off the net proceeds.
Solution: Give the shares to the child and have her sell them. If her income is below roughly $30,000, the capital gains will be taxed at just 5 percent, instead of the 15 percent the parent or grandparent would have paid. This is especially effective when the student won't qualify for any financial aid and doesn't have to worry about the gifted stock reducing a potential scholarship or grant. Keep in mind, however, that this is an irrevocable gift, and the child is free to do what she wishes with the stock sale proceeds.
Problem: Your clients are a couple with markedly different investment goals and risk tolerances. They are hamstrung from taking action because they can't agree on an investment strategy that feels mutually acceptable.
Solution: Create a separate financial plan for each person. If a wife wants to keep things conservative, place her IRA money in a balanced portfolio, while the husband can tilt his retirement account toward tech stocks and emerging markets. Ironically, a yin-and-yang investment strategy may provide more return and less volatility than if you were to choose one spouse's strategy over the other's.
Problem: Your middle-income client calls you up and says, “I've come into some money. Should I invest it with you, or pay off my mortgage?” You would love to put the money to work, but you want to give her the best, unbiased advice you can.
Solution: She needs to answer one question, and you need to answer another. Her dilemma is to decide if the emotional satisfaction of owning a home debt-free is worth giving up any potential financial advantage you might provide. If she says, “Yes,” tell her pay off the mortgage and begin setting aside the money that would have otherwise gone for her monthly payment.
Your side of the decision is a little more complex. The simple answer is if you can guarantee a return on investment that is greater than her mortgage rate, then she should put the money with you (the key word there is “guarantee”). But that's before taxes come into play.
If she can deduct the interest on say, a $100,000, 6 percent mortgage, and is in the 25 percent federal tax bracket, you only need to earn a 4.5 percent after-tax return to match the payoff proposition.
A common stock portfolio would need to make about 5.3 percent per year in qualified dividends and long-term gains to tip the decision in your favor. Again, history says this would be likely, but not certain.
Problem: You have a prospect/client with a seven-figure (or higher) bond portfolio. He always has money coming due, and you are one of several advisors on his “shopping list” as he searches for the best yield possible. You win a few orders, but lose out on more to the other firms and their barely-better interest rates.
Solution: If your back office has the platform to support it, open up a fee-based account for him, charging a quarter percent or so on the assets under management.
You should then be able to buy bonds for him on an “agency” basis, with no extra commission eating into his yield. The little extra interest rate he gets will satisfy his thirst to get a “street-beating” bond every time, and he will be more likely to place the whole bond portfolio under your watch. And he will benefit from your knowledge of his entire investment holdings. You will get a predictable income stream that may end up exceeding what you would have earned competing against a horde of advisors. And you won't have to waste time searching through the entire bond universe every time he calls.
Problem: After years of accumulating money in a growth mutual fund, your client is sending her child to college. She wants to use the proceeds from the fund to pay for his tuition and monthly expenses. But the fund has a large buildup of unrealized capital gains, and selling it all would bring a hefty tax bill. Gifting the fund to the child is out of the question, as it would severely reduce his financial aid. Plus, she thinks the child should become more financially-disciplined before she would agree to hand over several thousand dollars to him. And one more thing: she is worried about selling too soon and missing any market run-ups.
Solution: Reverse the “dollar cost averaging” investment process, and sell a set amount of the fund each month, beginning when the student starts school. To determine how much, have the client and her son develop a budget, and then send that amount automatically to his checking account each month. You can even turn off the “money faucet” during the summer months, and restart it again in the fall.
Kevin Mckinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future.