LifeFocus.com T. Young info@lifefocus.com www.LifeFocus.com
Financial Windfall
March 28, 2010
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Table of Contents Congratulations: You've Won the Lottery and You're Suddenly Wealthy! ........................................................ 10 What is it? ................................................................................................................................................ 10 What should you do immediately after you win? ......................................................................................10 Claiming the prize .................................................................................................................................... 10 Collecting your winnings .......................................................................................................................... 10 Short- and long-term financial planning ................................................................................................... 12 Disclaimers ........................................................................................................................................................15 What is a disclaimer? ............................................................................................................................... 15 How are disclaimers governed? ...............................................................................................................15 What are the advantages of a disclaimer? ...............................................................................................16 What are the requirements? .....................................................................................................................17 Wealth Due to Inheritance ................................................................................................................................ 19 What is it? ................................................................................................................................................ 19 Evaluating your new financial position ..................................................................................................... 19 Short-term and long-term needs and goals ..............................................................................................21 Tax consequences of an inheritance ....................................................................................................... 21 Impact on investing .................................................................................................................................. 22 Impact on insurance .................................................................................................................................22 Impact on estate planning ........................................................................................................................ 23 Impact on education planning .................................................................................................................. 23 Giving all or part of your inheritance away ............................................................................................... 23 Choosing and Evaluating Financial Professionals ............................................................................................ 25 What is it? ................................................................................................................................................ 25 Choosing a financial planner ....................................................................................................................25 Choosing a securities broker ....................................................................................................................27 Choosing an attorney ............................................................................................................................... 28 Designing and Managing an Investment Portfolio .............................................................................................30
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What is designing and managing an investment portfolio? ......................................................................30 Designing an investment portfolio ............................................................................................................ 30 Managing an investment portfolio ............................................................................................................ 30 Charitable Gifting .............................................................................................................................................. 31 What constitutes a gift to charity? ............................................................................................................ 31 How do you decide whether to donate to charity? ................................................................................... 31 What are the tax benefits of donating to charity? .....................................................................................31 What options do you have for donating to charity? .................................................................................. 31 Lifetime (Noncharitable) Gifting .........................................................................................................................34 What is lifetime (noncharitable) gifting? ................................................................................................... 34 What are the nontax advantages of making lifetime gifts? .......................................................................34 What are the tax advantages of gifting? ...................................................................................................35 How can you make a gift? ........................................................................................................................37 To whom should you give? ...................................................................................................................... 38 When should you make a gift? .................................................................................................................40 What property should you give? ...............................................................................................................40 Are there any gifting traps you should avoid? .......................................................................................... 40 What else should you know about gifting? ...............................................................................................41 Gifting for Education Savings ............................................................................................................................42 What is it? ................................................................................................................................................ 42 Strengths ..................................................................................................................................................42 Tradeoffs .................................................................................................................................................. 43 What are the most favorable types of property to gift to your child? ........................................................ 43 Questions& Answers ................................................................................................................................44 Private Foundations .......................................................................................................................................... 45 What is a private foundation? ...................................................................................................................45 Why would you want to establish a private foundation? .......................................................................... 46 How do you establish a private foundation? ............................................................................................ 46 What are the pitfalls related to private foundations? ................................................................................ 48
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What are the sanctions imposed on private foundations? ....................................................................... 49 How do private foundations end? .............................................................................................................49 Introduction to Estate Planning ......................................................................................................................... 50 What is estate planning? ..........................................................................................................................50 Who needs estate planning? ....................................................................................................................50 How to do it .............................................................................................................................................. 51 How do you begin? .................................................................................................................................. 52 What other factors need to be considered? ............................................................................................. 52 What are your goals and objectives? ....................................................................................................... 54 What are estate planning strategies? .......................................................................................................55 Selecting a Trustee ........................................................................................................................................... 56 What is it? ................................................................................................................................................ 56 Selecting a trustee ................................................................................................................................... 56 What are the duties of a trustee? ............................................................................................................. 57 What are the powers of a trustee? ........................................................................................................... 58 What are the liabilities of a trustee? ......................................................................................................... 59 What is a trust protector? ......................................................................................................................... 59 Personal Liability Insurance .............................................................................................................................. 61 What is it? ................................................................................................................................................ 61 Determining your need for personal liability insurance ............................................................................ 61 Basic liability protection under a homeowners or automobile insurance policy ....................................... 61 Comprehensive personal liability insurance coverage under a personal umbrella liability policy ............ 62 What personal liability insurance does not cover ..................................................................................... 63 Questions & Answers ...............................................................................................................................63 Capital Gains Tax ............................................................................................................................................. 65 What is capital gains tax? ........................................................................................................................ 65 Capital gains tax on sale or exchange of capital assets .......................................................................... 65 If your capital gain in a given year pushes you into a higher tax bracket, which capital gain rate do you use? ......................................................................................................................................................... 65 What are the netting rules? ...................................................................................................................... 66
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How do you use the capital gains tax to lower your taxes? ..................................................................... 67 Capital gains taxation of dividends ...........................................................................................................67 Investment Tax Planning .................................................................................................................................. 68 Introduction .............................................................................................................................................. 68 How does investment tax planning work? ................................................................................................68 How are your investments taxed? ............................................................................................................68 What are before- and after-tax rates of return? ........................................................................................71 How do you comparison shop for investments? ...................................................................................... 71 Major Asset Classes ......................................................................................................................................... 73 Table of Federal Estate Tax Brackets and Exemption Limits ........................................................................... 74 The Best Property to Give to Charity ................................................................................................................ 75 A/B Trust Diagram: $7 Million Estate ................................................................................................................ 76 How a Charitable Lead Trust Works ................................................................................................................. 77 How a Charitable Remainder Trust Works ........................................................................................................78 Building an Investment Portfolio ........................................................................................................................79 Steps to Financial Planning Success ................................................................................................................ 80 Personal Liability Umbrella Insurance ...............................................................................................................81 How an Irrevocable Trust Protects Assets ........................................................................................................ 82 How a Domestic Self-Settled Trust Protects Assets ......................................................................................... 83 How an Offshore (Foreign) Trust Protects Assets ............................................................................................ 84 Sudden Wealth ................................................................................................................................................. 85 Evaluate your new financial position ........................................................................................................ 85 Impact on investing .................................................................................................................................. 85 Impact on insurance .................................................................................................................................86 Impact on estate planning ........................................................................................................................ 86 Giving it all away--or maybe just some of it ..............................................................................................86 Investment Planning: The Basics ......................................................................................................................88 Saving versus investing ........................................................................................................................... 88 Why invest? ..............................................................................................................................................88
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What is the best way to invest? ................................................................................................................88 Before you start ........................................................................................................................................89 Understand the impact of time ................................................................................................................. 89 Consider working with a financial professional ........................................................................................ 89 Review your progress .............................................................................................................................. 89 Creating an Investment Portfolio .......................................................................................................................90 A good investment portfolio will spread your risk ..................................................................................... 90 Asset allocation: How many eggs in which baskets? ...............................................................................90 More on diversification ............................................................................................................................. 90 Choose investments that match your tolerance for risk ........................................................................... 91 Investment professionals and advisors .................................................................................................... 91 Stockbrokers ............................................................................................................................................ 91 Professional money managers .................................................................................................................91 Financial planners .................................................................................................................................... 91 Life Insurance: Do You Need It? ....................................................................................................................... 93 Should you buy life insurance? ................................................................................................................ 93 If you need life insurance, don't delay ......................................................................................................93 Periodically review your coverage ............................................................................................................93 Life Insurance Basics ........................................................................................................................................ 94 The many uses of life insurance .............................................................................................................. 94 How much life insurance do you need? ................................................................................................... 94 How much life insurance can you afford? ................................................................................................ 94 What's in a life insurance contract? ......................................................................................................... 94 Types of life insurance policies ................................................................................................................ 95 Your beneficiaries .................................................................................................................................... 95 Where can you buy life insurance? .......................................................................................................... 96 Umbrella Liability Insurance .............................................................................................................................. 97 Why now? It's not even raining ................................................................................................................ 97 What's covered? ...................................................................................................................................... 97
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What's not covered? ................................................................................................................................ 97 How big of an umbrella are we talking about? ......................................................................................... 98 Where can I buy an umbrella liability policy? ........................................................................................... 98 Estate Planning: An Introduction .......................................................................................................................99 Over 18 .................................................................................................................................................... 99 Young and single ..................................................................................................................................... 99 Unmarried couples ................................................................................................................................... 99 Married couples ........................................................................................................................................99 Married with children ................................................................................................................................ 100 Comfortable and looking forward to retirement ........................................................................................ 100 Wealthy and worried ................................................................................................................................ 100 Elderly or ill ...............................................................................................................................................100 Gift and Estate Taxes ....................................................................................................................................... 101 Federal gift tax and federal estate tax--background .................................................................................101 Federal gift tax ......................................................................................................................................... 101 Federal estate tax .................................................................................................................................... 101 Federal generation-skipping transfer tax ..................................................................................................102 State death taxes ..................................................................................................................................... 102 Charitable Giving .............................................................................................................................................. 103 A few words about estate taxes ............................................................................................................... 103 Make an outright bequest in your will .......................................................................................................103 Make a charity the beneficiary of an IRA or retirement plan .................................................................... 103 Use a charitable trust ............................................................................................................................... 103 Why use a charitable lead trust? ..............................................................................................................103 Why use a charitable remainder trust? .................................................................................................... 104 Asset Protection in Estate Planning .................................................................................................................. 105 Liability insurance is your first and best line of defense ........................................................................... 105 A Declaration of Homestead protects the family residence ..................................................................... 105 Dividing assets between spouses can limit exposure to potential liability ................................................105
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Business entities can provide two types of protection--shielding your personal assets from your business creditors and shielding business assets from your personal creditors ......................................105 Certain trusts can preserve trust assets from claims ............................................................................... 106 A word about fraudulent transfers ............................................................................................................ 106 Trust Basics ...................................................................................................................................................... 107 What is a trust? ........................................................................................................................................ 107 Why create a trust? .................................................................................................................................. 107 The duties of the trustee .......................................................................................................................... 108 Living (revocable) trust .............................................................................................................................108 Irrevocable trusts ......................................................................................................................................108 Testamentary trusts ................................................................................................................................. 109 How can I figure out my net worth? ...................................................................................................................110 Should I invest my extra cash or use it to pay off debt? ....................................................................................111 What will happen if I die without a will? .............................................................................................................112 How can I minimize taxes on my estate? ..........................................................................................................113 Do I need an attorney to prepare my will? ........................................................................................................ 114 I just made a gift. Do I have to file a gift tax return? ..........................................................................................115 What makes up my taxable estate? .................................................................................................................. 116 What is the applicable exclusion amount? ........................................................................................................ 117 How will estate taxes be paid if I leave no provision in my will? ....................................................................... 118 How often do I need to review my estate plan? ................................................................................................ 119 Is jewelry or art covered under my homeowners policy? .................................................................................. 120 How can I find insurance for my sailboat? ........................................................................................................ 121 My cleaning person is bonded and insured. Is that important? .........................................................................122 How do I insure my coin collection? ..................................................................................................................123 I'm going on a cruise. Do I need trip interruption insurance? ............................................................................124 I've just bought a pair of expensive skis. Will they be covered under my homeowners insurance? ................. 125 Are hunting rifles covered under my homeowners insurance? ......................................................................... 126 I'm planning on living in Europe for several months. Do I need special health insurance? .............................. 127 Should I invest in mutual funds or individual securities? ...................................................................................128
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What is a mutual fund prospectus and how do I read it? .................................................................................. 129 How can I gauge my risk tolerance? ................................................................................................................. 130 How do I construct an investment portfolio that's right for me? ........................................................................ 131 What is asset allocation and how does it work? ................................................................................................132 Should I work with a stockbroker to buy individual stocks? .............................................................................. 133 Who do I call if I have a complaint about my stockbroker? ............................................................................... 134 How much of my portfolio should I keep in stocks? .......................................................................................... 135 How long should I hang on to an investment? .................................................................................................. 136 How do I protect my assets in the event of a divorce? ......................................................................................137 Should I sign a prenuptial agreement to protect my assets when I remarry? ................................................... 138 What's the best way to handle a financial windfall? .......................................................................................... 139 When I play the lottery, I have to choose between a lump sum and annual payments. Does it matter? .......... 140 What is my tax bracket? ....................................................................................................................................141 What is the alternative minimum tax? ............................................................................................................... 142
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Congratulations: You've Won the Lottery and You're Suddenly Wealthy! What is it? Winning a lottery is usually an unexpected and happy event. But when you win a big jackpot, you may feel unprepared to deal with the financial issues that arise almost immediately. You may have to choose advisors; decide when, where, and how to collect your winnings; decide what to do with your winnings; and consider the tax and estate planning implications of your win.
What should you do immediately after you win? If you don't have a team of financial professionals in place, consider assembling a team of professionals before you claim your prize. Financial professionals can help you set up trusts to shelter your money from taxes and to insure that the money goes to your heirs when you die. They can also help you minimize the taxes you pay this year and in the upcoming years, and they can help develop an investment strategy based on your short- and long-term needs.
Claiming the prize In some states, you must list a beneficiary in the event you die, and you must decide whether you want the money to be paid out as a lump-sum payment or in yearly installments. (You don't get to decide this in all states.) Tip: In some states, you're generally allowed to claim the prize as either an individual or a club. If you want to share your wealth with family members, list them as members of your club. (Again, this is only an option in some states.) Is it better to claim the prize anonymously? In some states (but not all), you're allowed to claim your lottery prize anonymously. If this is an option in your state, you should seriously consider it. True, you won't be a local celebrity, you won't get your picture on television, and you won't get your name in the newspaper. On the other hand, your phone won't ring day and night with salesmen pitching the latest scheme, and you won't get letters from people around the country (and the world) asking for donations. You won't receive requests from every charity organization you've ever heard of (and many you haven't), and you won't get endless solicitations. Finally, you won't have people knocking on your door every day to introduce you to fail-safe investments in fast-food franchises, restaurants, vacation property, can't-lose commodities, and businesses that you didn't even know existed.
Collecting your winnings How is the money paid out? You may or may not get to choose how you collect your lottery winnings. It depends on the rules in your state. In most states, you don't have a choice about how you receive your winnings. In these states, payments of large jackpots are usually spread out over 25 years or more. In some states, you can choose after you win how to receive your winnings, but you need to be careful because you could end up owing taxes on money you haven't yet received. In many states, if you win a "small" amount (e.g., $250,000 or less), you'll receive the winnings as
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one lump-sum payment. If your winnings are larger, you may receive the money in equal installments (e.g., once a year for 25 years). Income tax consequences of payout The government gets its share of your winnings before you receive a dime. Your state and federal governments will immediately keep about one-third of your lottery winnings. Example(s): Franklin wins $6 million in the SuperLotto. When he purchased his ticket, he had to decide which payment option he preferred. Franklin chose the lump-sum option, so he gets a lump-sum payment of $3 million (50 percent of his winnings). Of course, the federal government and the state take a bite out of this money before Franklin touches it, so he ends up taking home $2 million. Franklin has to be careful with this $2 million. Even though the IRS withholds 25 percent of lottery payments over $5,000, this won't be sufficient to cover actual taxes due. Franklin's winnings of $3 million will be subject to federal income tax at a marginal rate of 35 percent. Franklin is going to owe much more in taxes when he files his federal income tax return than he has already paid, so he should talk to a tax professional now and put aside enough money to pay the additional income taxes he will owe. If you don't have a choice as to how you receive your lottery winnings, you will be subject to income tax only on the amount of money you receive each year. If you do have a choice and you elect to receive your winnings in installments rather than as a lump sum, you may still be subject to income tax on the entire lump-sum amount you could have received. This is known as constructive receipt. However, if you're a cash basis individual who becomes qualified for the prize after October 21, 1998, a special rule may apply to you. If the qualified prize (e.g., your lottery winnings) is payable over a period of at least 10 years, and your option to elect a single cash payment or installment payments is exercisable not later than 60 days after you become eligible for the prize, you may not have to include the total value of the prize in your gross income right away. Make sure that before you decide how you will receive your winnings, you see a tax expert to discuss your options. Can you split your lottery winnings among family members? It depends. In some states, you can purchase lottery tickets in several names. If a ticket purchased in the name of several people wins, all the people split the money. In other states, a ticket isn't purchased in anyone's name. It's a bearer instrument, meaning that whoever holds the ticket can claim the prize money. If you want to split the prize money, you have to create a lottery pool before you purchase tickets. Here's an example of how a lottery pool may work: • Several people pool their money to buy lottery tickets • You record the name of each person and the amount he or she contributes • You buy the lottery tickets • You make photocopies of the tickets, which you give to each person in the pool • If one of the tickets wins, the prize money is split among all contributors Example(s): Samantha creates a lottery pool among 15 coworkers. Samantha collects $100 from the coworkers, keeps careful records, and buys 100 lottery tickets. One of the tickets is worth $1 million. This means that Agnes, who bought 1 ticket, receives 1/100 of the total prize, or $10,000. But Paula, who bought 10 tickets, receives 10/100 (1/10) of the total prize, or $100,000. In some states, you can choose to receive your winnings as an individual or a club. If you have this choice, it's generally best to divide your winnings among several family members (assuming that you want to share). This will lower your potential estate tax liability. If, when you die, your estate is worth less than your remaining applicable exclusion amount, your estate will not owe any federal estate taxes. However, if your estate is worth more than this exemption amount, it may owe federal estate taxes. So, if you can split the winnings among family
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members, you may be able to reduce or eliminate potential federal estate taxes. Technical Note: Federal estate taxes are currently repealed for 2010 (that may change). They are scheduled to be reinstated in 2011 with an applicable exclusion amount of $1 million. When should you collect your winnings? You are subject to income tax on lottery winnings in the year you receive the prize money, not the year you win the lottery. So, if you buy a lottery ticket for a game played on November 15 of Year 1, and you receive the prize money on November 30 of Year 1, you will be subject to income tax on your lottery winnings in Year 1. In contrast, if you don't receive the prize money until January 7 of the next year (Year 2), you will then be subject to income tax on the winnings in Year 2. You can then invest the money in a short-term vehicle and collect enough interest on the money to pay some of the income taxes you will owe when you file your tax return for Year 2.
Short- and long-term financial planning You'll need to develop a financial strategy based on the amount you've won, your needs, and your short- and long-term goals. Your overall strategy will depend on your needs. What are your needs? To figure out your needs, you need to examine your financial situation. Use the following questions to begin evaluating your financial needs. • Do you have credit card debt or other debt on which you're being charged a high rate of interest? • Do you have children you need to put through college? Do you need to bolster your retirement savings? • Do you own a home? • Are there charities that are important to you? • What other financial concerns or obligations do you have? Just how wealthy are you? Many lottery winners decide to quit their jobs, give money to their friends and family, and buy cars, only to realize later that they aren't really as wealthy as they thought they were. For example, even winning a $1 million jackpot doesn't necessarily mean that you're suddenly wealthy; if that jackpot is paid out over 20 years, your annual payment may be less than what you earn by working. To help you analyze your financial situation, choose the following category that best represents your winnings: • Below $300,000: You're probably not ready to retire yet. If your winnings are disbursed in a lump sum, you have to make most decisions right now. You also have to estimate what your life will be like 5, 10, or 20 years from now. However, if the money will be distributed over a period of years, you have more time to plan your financial strategy. • If money is tight, you can relax and pay down some debt. You will want to think about your tax position and your estate plans, perhaps create a living trust and a will, perhaps buy a home, and fully fund your IRAs, 401(k) plans, or other retirement savings accounts. Example(s): Mr. Arnold wins $150,000 in his state lottery. He has more than $6,000 in credit card debt on which he pays 18.99 percent interest. Mr. Arnold realizes that he needs to pay off this debt first.
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Example(s): Mr. Arnold also has a 401(k) plan at work, which he has never fully funded. From now on, he contributes the full amount he is permitted. Example(s): Mr. Arnold already owns a home, but since his three children are quickly approaching college age, he decides to pay off the mortgage more quickly in order to free up money when the children are in college. Example(s): He also allots more money for his children's education, sets up an emergency fund (equal to six months' worth of his salary), and plans a family vacation. With the help of a financial professional, he invests the rest of his winnings in several diversified mutual funds. Example(s): To an outsider, Mr. Arnold's lifestyle doesn't seem to have changed much, but Mr. Arnold feels more financially secure than ever before. • Between $300,000 and $1 million: You may have to make more complex plans. Depending on how the money is distributed (immediately or over a period of years), you may be able to retire (or partially retire), go back to school, or change careers. You also need to think about your tax position and estate plans. If you've acquired more than the applicable exclusion amount, you may not be able to pass it all on to your intended beneficiaries without having to pay federal estate taxes. However, if you reduce your estate by giving annual gifts, you may be able to avoid potential estate taxes when you die. Currently, you can give $13,000 federal gift tax free to as many people as you want. You may also be able to avoid probate if you make use of trust funds. Example(s): Mr. and Mrs. Marsh win $825,000 in their state lottery. Their most pressing need is to get their son and their daughter through college. Their daughter also needs expensive orthodontia. Mr. Marsh can give gifts in the amount of the annual gift tax exclusion each year to each child without paying gift tax. Mrs. Marsh can do the same thing. So the Marshes set up an educational trust fund for each child, into which they can put up to double the annual gift tax exclusion amount per year per child. Example(s): In addition, the Marshes meet with an estate lawyer to set up a will and a living trust. If they die, they want as much of their money as possible to pass to their children tax free, and they want to avoid the delays and costs of probate court. • More than $1 million: You have many options. This money may be distributed to you in equal amounts annually, so you can't spend it all at once. If so, you do have the security of knowing that you have a steady income stream for 20 years. You also have the luxury of time. You don't have to make any rash decisions. Even if you make mistakes in handling your money one year, you have time to rethink your strategy before the next distribution. You may be able to retire, travel, create charitable trusts, and much more. You'll probably want to set up an irrevocable trust funded by tax-exempt annual gifts in the amount of the annual gift tax exclusion for each of your children. You will need to work with a team of financial professionals to develop an estate plan and minimize your taxes. Insurance planning Although you may not have previously owned one, you should consider purchasing an umbrella liability policy now that you're a lottery winner. It's sad to report, but your chances of being sued may increase when you win a lottery. Although your homeowners policy contains some liability coverage, it may not be enough to adequately protect you. You should also consider purchasing additional life insurance to protect your heirs in the event that you die leaving a large estate. You can set up an irrevocable life insurance trust to hold the life insurance policy so that proceeds from the policy won't be includable in your estate for estate tax purposes when you die, but may be used to pay any estate taxes that may be owed on your estate. Finally, consider increasing your deductibles on your automobile insurance to decrease the cost of your premium if you now have enough cash on hand to pay the deductible in the event of a collision. Call your insurance agent or insurance company for more information. Income tax planning Once you win a lottery, you'll need to reconsider your income tax planning strategies. First, you'll need to know what your overall tax liability will be and how winning the lottery will affect you tax-wise not only this year but in
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the future. Depending on your tax bracket, you may need to pay estimated taxes if the tax on your lottery winnings has been under withheld (e.g., if you will be in a tax bracket higher than 25 percent). Don't forget about paying estimated state income taxes if necessary. You may also want to increase the amount you contribute to an IRA, Keogh plan, 401(k) plan, or other tax-advantaged account, or you may want to invest in tax-free or tax-deferred vehicles. Estate planning Due to your lottery winnings, your estate planning needs will become more complex. To protect your family's interests, consider setting up a living trust and specify that all lottery installments be trust accounting income. This will preserve your unlimited marital deduction and ensure that your spouse has income interest for the rest of his or her life in the event that you die. The trust should also specify how much of each lottery payment is considered principal and how much is income. This will avoid disputes between beneficiaries (often children), who receive the interest, and remainderpersons (often grandchildren), who receive the principal. You may also want to set up trusts for your children to pay for college and find ways to lessen the impact of potential estate taxation.
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Disclaimers What is a disclaimer? Refusal of a gift, bequest, or property transfer A disclaimer (also referred to as a renunciation or a waiver) is a valuable estate planning tool that allows you to redistribute transfers of property free of transfer taxes. A disclaimer is your refusal to accept a gift, bequest, or other form of property transfer (such as a power of appointment). Once disclaimed, the property is then distributed to the next recipient. You (the disclaimant) are regarded as never having received the property. As a result, no transfer of property is considered to have been made, and no federal generation-skipping transfer tax (GSTT) and/or federal gift and estate tax is imposed on the disclaimed portion for the disclaiming party. You have nine months to decide A disclaimer allows you to take a second look at a transaction up to nine months after the person who created the transfer dies. During this time, you can decide whether it is better to accept the transfer or pass it on to another party because that party should receive it or because, by doing so, the tax collector or other creditors are avoided. However, in order for the disclaimer to work you must not accept any of the benefits of the disclaimed property during the nine-month period. Example(s): Joe dies leaving most of his property to his wife, Nancy, and the rest to their children. Nancy is wealthy in her own right and does not need Joe's property. She disclaims the bequest. All of Joe's property then passes to their children. Nancy incurs no transfer taxes because she has made no transfer. Caution: A disclaimer may create a generation-skipping transfer, subject to the GSTT, if the disclaimed property passes to a skip person (e.g., a grandchild or grandnephew). Further, if you are insolvent or in bankruptcy, be careful about disclaiming transfers to keep property out of the reach of creditors. A disclaimer by an insolvent person is ineffective under most state and federal laws.
How are disclaimers governed? Disclaimers must be effective under state law Disclaimers are governed both by state law and by federal law for gift tax, estate tax, and GSTT purposes. For your disclaimer to be effective for your state's gift and/or state death tax purposes, it must meet the requirements of your state's laws. For your disclaimer to be effective (a so-called qualified disclaimer) for gift tax, estate tax, and GSTT purposes, it must meet the requirements of federal law. Technically, a qualified disclaimer (one used for federal purposes) need not meet the state law requirements, but practically speaking, because the disclaimed property must pass to some other person, it must shift property rights in accordance with state law. Thus, a disclaimer will not be recognized for estate tax or GSTT purposes if it fails to effectively pass property rights under the applicable state law. Therefore, to be fully effective for both state and federal purposes, your disclaimer should: • Comply with federal requirements (i.e., be a qualified disclaimer) • Comply with the applicable state law that effectively shifts property rights • Meet separate rules for state gift and/or state death taxes to be effective for state tax purposes Example(s): In her will, Ellen leaves property to Anne or to Anne's children if Anne dies first. Ellen dies. Anne does not want the property but wants to pass it on to her children. The law in Anne's
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state requires that a disclaimer be received within six months after the bequest. Federal law requires a disclaimer be received within nine months after the bequest. Anne disclaims the property eight months after the bequest. She would have made a valid disclaimer under federal law; however, it fails because the disclaimer did not meet the shorter period required for an effective disclaimer of property rights under state law. Tip: If you are disclaiming to avoid estate and GSTT taxes, check with an attorney to make sure your disclaimer is effective under your state's laws. Disclaimed intestate transfers pass according to state law If you disclaim property you received by intestacy because the transferor (the person giving you the property) left no will or other arrangements, the state's intestacy laws determine who the next recipient is. Example(s): Thomas dies intestate (leaving no will). The intestacy laws in Thomas's state divide the property among Thomas's wife, Amelia, and their two adult daughters, Katy and Casey. Katy and Casey don't need the property and feel that their mother should have it all. The daughters disclaim their right to receive their shares with the intent that the property pass to their mother. Instead, the property passes to the daughters' minor children under the state's intestacy laws. Tip: Be sure that the property will pass to the intended beneficiary before executing a disclaimer. Check with an attorney about the succession laws in your state, or look up the statute in a law library near you (the librarian will help you find the statute, and most succession statutes are fairly easy to understand).
What are the advantages of a disclaimer? A disclaimer can be useful in a number of situations, including the following: Keeps property out of an already large estate If you have a large estate that may already be subject to a heavy estate tax burden, when someone leaves you property, your potential estate tax problem may be compounded. A disclaimer will keep the property out of your estate and avoid the potential increase in estate tax. Shifts income-producing property to someone in a lower income tax bracket If you are in a high income tax bracket when income-producing property is left to you, and the next recipient is your child, you may want to disclaim the property in favor of your child if your child is in a lower income tax bracket. However, beware of making disclaimers in favor of children who are subject to the kiddie tax rules. CurrentlyCurrently, unearned income above $1,900 may be taxed at your income tax rate. The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn't exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn't exceed one-half of their support. Makes a tax-free gift to the next recipient If you want to make a tax-free gift to the next recipient, you can disclaim the property in his or her favor. Qualifies a trust interest for the charitable deduction If you make a gift that is not properly structured as a partial-interest gift, the noncharitable beneficiaries can disclaim their interest in order to qualify the gift for the charitable deduction and potentially reduce the estate taxes. Technical Note: A partial-interest gift is a transfer of property to both charitable and noncharitable
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beneficiaries (e.g., a trust paying income to charity, with the principal going to noncharitable beneficiaries). To qualify for the charitable deduction, the partial-interest gift must be properly structured as some form of charitable trust, such as a charitable lead trust, charitable remainder annuity trust, pooled income fund, or charitable remainder unitrust. Qualifies a transfer for the unlimited marital deduction Disclaimers by other beneficiaries in favor of a surviving spouse can be used to qualify transfers for the unlimited marital deduction and potentially reduce the estate taxes. Takes full advantage of a spouse's applicable exclusion amount You can disclaim property that passes to you from your spouse in order to take full advantage of your spouse's applicable exclusion amount (formerly known as the unified credit). Example(s): George dies in 2009, leaving his entire estate (valued at $3.5 million) to his wife, Louise. George's entire estate passes free of estate taxes because it fully qualifies for the unlimited marital deduction. George's estate uses none of the applicable exclusion amount. Louise, who already owns property outright that is valued at $3.5 million, does not need George's $3.5 million estate, but wants it to pass directly to their son, Sam. Say that Louise does not disclaim George's estate and dies later in 2009. Louise's estate is valued at $7 million (Louise's $3.5 million + George's $3.5 million). The applicable exclusion amount in 2009 allows Louise to pass $3.5 million of her estate tax free. Assuming no other variables, Louise's estate pays estate taxes on $3.5 million ($7 million - $3.5 million). Now, say that Louise disclaims George's estate. The applicable exclusion amount in 2009 allows George to pass $3.5 million of his estate tax free. George's estate pays no estate taxes. Louise dies later in 2009, and her estate is valued at $3.5 million. The applicable exclusion amount allows Louise to pass $3.5 million of her estate tax free. Louise's estate pays no estate taxes. Together, George's estate and Louise's estate pay no estate taxes. By disclaiming George's estate, Louise allows George's estate to use all of his applicable exclusion amount, and together they save estate taxes on $3.5 million. Eliminates nonqualified heirs Nonqualified heirs may disclaim in favor of qualified heirs their interests in an estate that qualifies for special use valuation. Fully utilizes the federal generation-skipping transfer tax exemption You can disclaim a transfer in favor of a skip person in order to take advantage of the federal GSTT exemption, which is equal to the applicable exclusion amount in effect for the calendar year in which the transfer is made. Corrects errors Most of us do not have a crystal ball that tells what the future will be. A disclaimer is a great tool for changing the focus of transfers due to changes in circumstances. It allows beneficiaries to fix a will or trust that does not meet their needs or the decedent's desires. Avoids receiving flawed property You may be the recipient of property you don't want (e.g., property with environmental problems or Uncle Joe's hunting lodge). A disclaimer allows you to avoid a transfer that would prove burdensome.
What are the requirements? There are five requirements that must be satisfied in order for a disclaimer to be effective:
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The refusal must be irrevocable and unqualified A disclaimer must be irrevocable and unconditional. You cannot retain the ability to change your mind or retain any right to direct beneficial enjoyment of the disclaimed property. Tip: To avoid any problems with the IRS on this point, be sure to state specifically that the disclaimer is irrevocable and not subject to any qualifications or conditions. The refusal must be in writing and signed A disclaimer must be written, must specifically identify the interest in the property being disclaimed, and must be signed by the disclaimant or disclaimant's representative. A disclaimer should be drafted or reviewed by an attorney. Caution: Be sure to also satisfy any state law requirements regarding execution of a disclaimer (i.e., does it need to be acknowledged, witnessed, or recorded?). Remember, if the disclaimer fails under state law, it fails under federal law. The disclaimer must be received within nine months The written disclaimer must be received by the transferor, or the transferor's legal representative, no later than nine months (or earlier, depending on state law) after the later of (1) the date on which the transfer is made or (2) the day on which you (the disclaimant) attain age 21. Caution: The disclaimer period in your state may be different. Check with the appropriate state agency or call an attorney. Further, when the nine-month period begins to run depends on the type of transfer being disclaimed. Generally, the period begins to run when the transfer is complete (for lifetime transfers), or when the transferor dies (for transfers made at death). However, the creation of a joint tenancy, a power of appointment, and remainder interests present special problems. Consult an attorney to be sure when the nine-month period will expire. Tip: The nine-month period coincides with the federal estate tax filing deadline. Unlike the tax deadline, however, the disclaimer period cannot be extended. You must disclaim prior to accepting the interest You can disclaim the whole transfer or an interest in (part of) the transfer. However, if you disclaim an interest, you must disclaim the entire interest. You must not have accepted any part of the interest disclaimed or any of its benefits. Example(s): George died. His will directs that a trust be created. The trust provides that George's wife, Lilly, receive income from the trust for her life, and then the principal goes to their children, Judy and Jack. The day after George dies, Lilly wins the lottery and no longer needs the income from the trust. Before Lilly receives any of the trust income, she disclaims her interest in favor of their children. Caution: The IRS rules regarding disclaimers of partial interests are complex. Use special care when disclaiming partial interests, especially where a trust is involved. You (the disclaimant) must not give any direction on the interest you disclaimed The property disclaimed must pass to a surviving spouse or a person other than you (the disclaimant) without any direction on your part. Any express or implied agreement where the property passes to someone you designate will disqualify the disclaimer.
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Wealth Due to Inheritance What is it? Introduction If you're the beneficiary of a large inheritance, you may find yourself suddenly wealthy. Even if you expected the inheritance, you may be surprised by the size of the bequest or the diverse assets you've inherited. You'll need to evaluate your new financial position, learn to manage your sizable assets, and consider the tax consequences of your inheritance, among other issues. Issues that arise in connection with an inheritance If you've recently received a bequest, consider the possibility that the will may be contested if your inheritance was large in comparison with that received by other beneficiaries. Or, you may decide to contest the will if you feel slighted. If you're the spouse of the decedent, you may elect to take against the will. Taking against the will means that you're exercising your right under probate law (governed by the statutes of your state) to take a share of your spouse's estate, rather than what your spouse left you in the will, because this is more beneficial to you. Another possibility is that you may disclaim the bequest if you're in a high income or estate tax bracket, or don't need or want the bequest. Tip: If you've inherited assets from your spouse or a family member, you may be in charge of settling the estate, claiming survivor's benefits, and dealing with other financial and emotional issues at a time when you're grieving. For more information on these issues, see Loss of a Spouse/Family Member. Caution: Some states allow no-contest clauses to be included in wills. If a will has such a clause and someone contests the will and loses, he or she gets nothing.
Evaluating your new financial position Introduction It's important to determine how wealthy you are once you receive your inheritance. Before you spend or give away any money or assets, decide to move, or leave your job, you should do a cash flow analysis and determine your net worth as a first step toward planning your financial strategy. Your strategy will partly depend on whether you have immediate access to, and total control over, the assets, or if they're being held in trust for you. In addition, you need to know what types of assets you've inherited (e.g., cash, property, or a portfolio of stocks). Inheriting assets through a trust vs. inheriting assets outright When you inherit money and assets through a trust, you'll receive distributions according to the terms of the trust. This means that you won't have total control over your inheritance as you would if you inherited the assets outright. With a trust, a trustee will be in charge of the trust. A trustee is the person who manages the trust for the benefit of the beneficiary or beneficiaries. The initial trustee was named by the individual who set up the trust. The trustee will likely be your parent or other family member, a close family friend or advisor, an attorney, or a bank representative. The trust document may spell out how the trust assets will be managed and how and when trust income and assets will be paid to you, and it will outline the duties of the trustee. Know the terms of the trust If you're the beneficiary of a trust, the following should be done to ensure that your interests are protected: • Read the trust document carefully. You have the right to see the document, so if you can't get a copy,
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hire an attorney to get it. Go over the document yourself or with the help of a legal or financial professional, making sure you understand the language of the trust and how its income and principal will be distributed to you. You may be the beneficiary of an irrevocable trust (can't be changed), or you may be the beneficiary of a revocable trust (can be changed). In addition, determine whether certain practices are allowed or prohibited. For example, one common trust provision prohibits a beneficiary from borrowing against the trust. Another can prevent the beneficiary from paying creditors with assets of the trust. An additional provision usually prohibits creditors from attaching a beneficiary's share of the trust. • Determine if the trust income is sufficient to meet your needs. Is the trust heavily invested in long-term growth stocks or nonrental real estate? Or, is the trust invested in things that provide income to you now, such as rental real estate or money market funds? From your agent (e.g., attorney, accountant) or trustee, get the income statements used to calculate how much income will be distributed to you. • Get to know your trust officers (if any) and find out how much the trustee fees are. Then, compare the fee with the average in your state or county (you might ask your local bank for this information). You may be able to negotiate the fee if it is too high, especially if the estate is large. Working with a trustee In some trusts, the trustee must distribute all of the income to the beneficiary every year. This type of trust may be simple to administer and relatively conflict free. You may want to work with the trustee or other professionals to ensure that the annual trust distribution is adequate to meet your needs. In other trusts, the trustee may decide when to distribute trust income and how much to distribute. If this is the case, open communication with the trustee is important. You'll need to set up a sound budget or financial plan and carefully prepare your request for a trust distribution if it is out of the ordinary. It's in your best interests to find a way to work with the trustee. In most states, trustees are difficult to replace, and although they're not supposed to lose money on investments, they're not usually penalized if the trust performs poorly. If you decide to sue the trustee for mismanaging the trust, his or her legal fees may be paid for from the trust. Caution: No matter how trust funds are distributed, pay close attention to how the trustee handles the trust investments. Have your lawyer, accountant, or financial advisor look over the trustee's investment strategy. If your advisor determines that the trustee's investment strategy doesn't meet your needs or, worse, is unsound, discuss this strategy with the trustee or possibly ask the trustee to change his or her strategy. Inheriting a lump sum of cash When you inherit a large lump sum of cash, you'll be responsible for managing the money yourself (or hiring professionals to do so). Even if you're used to handling your own finances, becoming suddenly wealthy can turn even the most cautious individual into a spendthrift, at least in the short run. Carefully watch your spending. Although you may want to quit your job, move, gift assets to family members or to charity, or buy a car, a house, or luxury items, this may not be in your best interest. You must consider your future needs, as well, if you want your wealth to last. It's a good idea to wait a few months or a year after inheriting money to formulate a financial plan. You'll want to consider your current lifestyle, consider your future goals, formulate a financial strategy to meet those goals, and determine how taxes may reduce your estate. Inheriting stock You may inherit stock either through a trust or outright. The major question to consider is whether you should sell the stock. This depends on your overall investment strategy and what type of stock you've acquired. If you acquire stock in a company, for example, and you now own a controlling interest, you'll need to look at how actively you want to be involved in the company or how much you know about the company. If you inherit stock and find that it doesn't fit your portfolio, you may consider selling it, depending on the market conditions.
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Inheriting real estate If you inherit real estate, such as a house or land, you'll probably have to decide whether to keep it or sell it. If you keep it, will you live there or rent it out? Do you hope that the house will appreciate in value, or are you keeping it for sentimental reasons? If you decide to sell or rent the house, you'll need to consider the tax consequences, as well. For more information, see Personal Residence and Vacation Home Tax Planning. Tip: It's possible that you may inherit real estate or other assets together with others, and sales may require the other owners' assent or court action to sever the property.
Short-term and long-term needs and goals Once you've done a cash flow analysis and determined what type of assets you've inherited, you need to evaluate your short-term and long-term needs and goals. For example, in the short term, you may want to pay off consumer debt such as high-interest loans or credit cards. Your long-term planning needs and goals may be more complex. You may want to fund your child's college education, put more money into a retirement account, invest, plan to minimize taxes, or travel. Use the following questions to begin evaluating your financial needs and goals, then seek advice on implementing your own financial strategy: • Do you have outstanding consumer debt that you would like to pay off? • Do you have children you need to put through college? • Do you need to bolster your retirement savings? • Do you want to buy a home? • Are there charities that are important to you and whom you wish to benefit? • Would you like to give money to your friends and family? • Do you need more income currently? • Do you need to find ways to minimize income and estate taxes?
Tax consequences of an inheritance Income tax considerations In general, you won't directly owe income tax on assets you inherit. However, a large inheritance may mean that your income tax liability will eventually increase. Any income that is generated by those assets may be subject to income tax, and if the inherited assets produce a substantial amount of income, your tax bracket may increase. Once you increase your wealth, you should look at ways to minimize your overall tax liability, such as shifting income, giving money to individuals or charity, utilizing other income tax reduction strategies, and investing for growth rather than income. You may also need to re-evaluate your income tax withholding or begin paying estimated tax. For more information, see Tax Planning for Income. Estate tax considerations If you're wealthy, you'll need to consider not only your current income tax obligations but also the amount of potential federal estate taxes and state death taxes that your beneficiaries may have to pay upon your death. If your estate will be worth more than the applicable exclusion amount ($3.5 million in 2009), consider looking at ways to minimize potential estate taxes. Four common ways to minimize potential estate taxes are to (1) set up a marital trust, (2) set up an irrevocable life insurance trust, (3) set up a charitable trust, or (4) make gifts to
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individuals and/or to charities. For more information, see Federal Gift and Estate Taxes (the Unified Transfer Tax System) and State Death Taxes. Tip: The estate tax applicable exclusion amount is $3.5 million in 2009. The estate tax is scheduled to be repealed in 2010. (Also, in 2010, the current rule allowing a basis step-up at death will be replaced with carryover cost basis.) The estate tax is scheduled to be reinstated in 2011, with the applicable exclusion amount decreasing to $1 million.
Impact on investing Inheriting an estate can completely change your investment strategy. You will need to figure out what to do with your new assets. In doing so, you'll need to ask yourself several questions: • Is your cash flow OK? Do you have enough money to pay your bills and your taxes? If not, consider investments that can increase your cash flow. • Have you considered how investing may increase or decrease your taxes? • Do you have enough liquidity? If you need money in a hurry, do you have assets you could quickly sell? If not, you may want to consider short-term, rather than long-term, investments. • Are your investments growing enough to keep up with or beat inflation? Will you have enough money to meet your retirement needs and other long-term goals? • How risky are your investments? Often, the more risk you take, the higher your return in the long run. However, consider your tolerance for risk. Are you willing to risk losing part or all of the inheritance you've invested? • How diversified are your investments? Don't put all your eggs in one basket. If you diversity your investments, you decrease your risk. For example, suppose you inherit an assortment of high-tech stocks. If the computer industry has a bad year, all of your stocks may decline in value. But if you diversify by selling some high-tech stocks and investing some of that money in utilities, some in international stocks, and some in blue chip stocks, you have decreased the likelihood that all of your stocks will perform poorly at the same time. Once you've considered these questions, you can formulate a new investment strategy. However, if you've just inherited money, remember that there's no rush. If you want to let your head clear, put your funds in an accessible interest-bearing account such as a savings account, money market account, or a short-term certificate of deposit until you can make a wise decision with the help of advisors.
Impact on insurance When you inherit wealth, you'll need to re-evaluate your insurance coverage. Now, you may be able to self-insure against risk and potentially reduce your property/casualty, disability, and medical insurance coverage. (However, you might actually consider increasing your coverages to protect all that you've inherited.) You may want to keep your insurance policies in force, however, to protect yourself by sharing risk with the insurance company. In addition, your additional wealth results in your having more at risk in the event of a lawsuit, and you may want to purchase an umbrella liability policy that will protect you against actual loss, large judgments, and the cost of legal representation. If you purchase expensive items such as jewelry or artwork, you may need more property/casualty insurance to protect yourself in the event these items are stolen. You may also need to recalculate the amount of life insurance you need. You may need more life insurance to cover your estate tax liability, so your beneficiaries receive more of your estate after taxes. For more information, see Tax Planning with Life Insurance.
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Impact on estate planning Re-evaluating your estate plan When you increase your wealth, it's probably time to re-evaluate your estate plan. Estate planning involves conserving your money and putting it to work so that it best fulfills your goals. It also means minimizing your exposure to potential taxes and creating financial security for your family and other intended beneficiaries. For more information, see Introduction to Estate Planning. Passing along your assets If you have a will, it is the document that determines how your assets will be distributed after your death. You'll want to make sure that your current will reflects your wishes. If your inheritance makes it necessary to significantly change your will, you should meet with your attorney. You may want to make a new will and destroy the old one instead of adding codicils. Some things you should consider are whom your estate will be distributed to, whether the beneficiary(ies) of your estate are capable of managing the inheritance on their own, and how you can best shield your estate from estate taxes. If you have minor children, you may want to protect them from asset mismanagement by nominating an appropriate guardian or setting up a trust for them. Using trusts to ensure proper management of your estate and minimize taxes If you feel that your beneficiaries will be unable to manage their inheritance, you may want to set up trusts for them. You can also use trusts for tax planning purposes. For example, setting up an irrevocable life insurance trust may minimize federal and state estate taxes on the proceeds. For more information, see Trusts.
Impact on education planning You may want to use part of your inheritance to pay off your student loans or to pay for the education of someone else (e.g., a child or grandchild). Before you do so, consider the following points: • Pay off outstanding consumer debt first if the interest rate on your consumer debt is higher than it is on your student loans (interest rates on student loans are often relatively low). • Paying part of the cost of someone else's education may impact his or her ability to get financial aid. For more information, see Gifting for Education Savings. • You can make gifts to pay for tuition expenses without having to pay federal gift tax if you pay the school directly. For more information, see Implementing Other Creative Solutions to Cover Higher Education Costs and Make Tax-Free Gifts of Tuition.
Giving all or part of your inheritance away Giving money or property to individuals Once you claim your inheritance, you may want to give gifts of cash or property to your children, friends, or other family members. Or, they may come to you asking for a loan or a cash gift. It's a good idea to wait until you've come up with a financial plan before giving or lending money to anyone, even family members. If you decide to loan money, make sure that the loan agreement is in writing to protect your legal rights to seek repayment and to avoid hurt feelings down the road, even if this is uncomfortable. If you end up forgiving the debt, you may owe gift tax on the transaction. The gift tax may also affect you if you decide to give someone a gift of money or property or a loan with a below-market interest rate. The general rule is that you can give a certain amount each calendar year to an unlimited number of individuals without incurring gift tax liability. If you're married, you and your spouse can make a split gift, doubling the annual gift tax exclusion amount per recipient per year without incurring gift tax liability, as long as you and your spouse are U.S. citizens, sign and file a gift tax return (IRS Form 709), and your spouse consents to splitting the gift. Giving gifts to individuals can also be a useful estate planning strategy. For
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more information, see Federal Gift and Estate Taxes (the Unified Transfer Tax System) and Lifetime (Noncharitable) Gifting. Giving money or property to charity If you make a gift to charity during your lifetime, you may be able to deduct the amount of the charitable gift on your income tax return. Income tax deductions for gifts to charities are limited to 50 percent of your contribution base (generally equal to adjusted gross income) and may be further limited if the gift you make consists of certain appreciated property or if the gift is given to certain charities and private foundations. However, excess deductions can usually be carried over for five years, subject to the same limitations. For estate planning purposes, you may want to make a charitable bequest that can reduce the amount of estate tax your estate may owe. Or you may want to make gifts to a charitable remainder trust. Such gifts may provide you with a tax deduction, while at the same time providing an income stream for you, your family, or a charity (with the remainder interest being held by the charity). For more information, see Charitable Gifting.
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Choosing and Evaluating Financial Professionals What is it? Although you may personally handle many of your financial affairs, sometimes you may need the services of a financial professional. Financial professionals include financial planners, attorneys, securities brokers, and other specialists. Selecting the right financial professional means evaluating the services they can offer and their credentials, and finding someone whom you can rely on to give you good advice and/or service when you don't have the time or expertise to completely handle your financial affairs.
Choosing a financial planner What a financial planner does A financial planner is a professional advisor who can help you set financial goals and who can write and implement an objective and comprehensive plan to manage all aspects of your financial picture, including investing, retirement planning, estate planning, and protection planning. A financial planner can give you information and advice on a wide range of other topics as well. These are too numerous to mention but include managing your cash, obtaining credit, buying a home, and paying for a college education. If the planner doesn't have the specialized knowledge required to handle certain areas, such as tax planning or estate laws, he or she can coordinate a team of experts who can help you. Although he or she can help you with a single issue, a financial planner, unlike other financial advisors, looks at your finances as an interrelated whole and helps you plan accordingly. What credentials to look for When choosing a financial planner, you should be aware that some financial professionals who use this title are not truly qualified to give comprehensive financial planning advice. They may be trained in only one area, or they may be primarily salespeople marketing themselves as planners. Although some states heavily regulate planners, others do not. Because anyone can call himself or herself a financial planner without being educated or licensed in the area, you should choose a financial planner carefully. Make sure you understand what services the planner will provide you and what his or her qualifications are. In general, a financial planner will have one or more of the following credentials: • CERTIFIED FINANCIAL PLANNER™ professional (CFP®)--CFP® professionals must have a college undergraduate degree, have three years of related experience, and have completed a course of study registered with and approved by the Certified Financial Planner Board of Standards, Inc. (CFP Board). They must pass a two-day 10-hour exam that covers all aspects of financial planning. In addition, they must adhere to a professional code of ethics and fulfill 30 hours of continuing education every two years. Many also belong to the Financial Planning Association, a professional organization. If a planner says that he or she is a CFP® licensee, ask to see the planner's CFP Board license or call (888) CFP-MARK to check. • Chartered Financial Consultant® (ChFC®) and Chartered Life Underwriter® (CLU®)--Some financial planners are members of the Society of Financial Service Professionals, a professional association for life insurance agents. To receive either designation, planners must have at least three years of experience and complete a course of study through the American College in Bryn Mawr, Pennsylvania. Certification is rigorous and prestigious, and planners earning these designations must adhere to certain ethical standards. • Accredited Personal Financial Specialist (PFS)--The PFS designation is granted to CPAs who are members of the American Institute of Certified Public Accountants, and who earn a minimum of 80 hours of personal financial planning education, successfully pass a PFP-related exam, and have at least two years of full-time business or teaching experience.
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• Registered Financial Consultant (RFC®)--This designation is awarded by the International Association of Registered Financial Consultants (IARFC) to advisors who have a college or graduate degree in financial services, or who have earned an IARFC-approved designation or professional degree. The RFC® also must have a minimum of four years experience as a full-time practitioner or educator in the field of financial planning or financial services. He or she must also meet licensing requirements, and they must complete continuing education courses, and adhere to a code of ethics. Many financial planners are also specialists in certain fields or can refer you to the type of specialist you need. Although you may need the help of a specialist in their area of expertise, you should not rely on them to provide general financial planning advice unless they are also qualified financial planners. Specialists include the following: • Accountants--Accountants prepare financial statements and tax returns and give tax advice, something many financial planners may not do. Accountants are often Certified Public Accountants (CPAs) or Public Accountants (PAs). Accountants may also be Personal Financial Specialists (PFSs). • Estate planners--Estate planners help you plan your estate and give advice on transferring and managing your assets before and after your death. If the estate planner is an attorney, he or she can give legal advice and prepare necessary legal documents. An estate planner may be an Accredited Estate Planner (AEP). • Insurance agents--Insurance agents sell various insurance products, something financial planners can't do unless they are insurance agents licensed in the state in which they practice. Insurance agents often hold the Chartered Life Underwriter® (CLU®) designation. • Investment advisors--Investment advisors give you advice about investments and help you plan a strategy to manage your investment funds. They are not primarily salespeople. In fact, they cannot sell securities without a license. They must be registered with either the Securities and Exchange Commission or a state securities agency. Financial planners may or may not be licensed to sell securities, but they are often Registered Investment Advisors (RIAs). • Securities brokers--Securities brokers (stockbrokers) are primarily salespeople who buy and sell stocks, bonds, and mutual funds. They must be licensed by the state and be registered with a company that is a member of the Financial Industry Regulatory Authority (FINRA). How to find a financial planner Ask friends, relatives, business associates, your attorney, or other professionals who share your financial values to recommend a financial planner. If you can't get a personal recommendation, call the Financial Planning Association. Check your local telephone directory, or check their website at www.fpanet.org. How a financial planner is compensated You may pay your financial planner a fee to develop a financial plan--either an hourly rate or a flat fee--with no asset management or commissions required. If the planner is managing your assets, then his or her fee may be equivalent to a small percentage of your assets and/or income. Or your financial planner may earn his or her living by receiving commissions from products he or she sells to you. Some planners use a combination fee-and-commission structure whereby you pay a fee for development of a financial plan and the planner also receives a commission from selling you products. You should ask the planner you are considering about his or her fee structure and ask for an estimate of what it might cost to use his or her services. Tip: When calculating how much it will cost to use the services of a financial planner, consider fees, commissions, and related expenses such as transaction fees and management fees related to the products they recommend. Interviewing and evaluating a financial planner It's a good idea to interview more than one financial planner. Personality styles, financial planning philosophies, qualifications, and fee structures may vary widely. When interviewing a financial planner, start by asking the
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following questions: • What are your qualifications and professional credentials? How long have you been in practice, and in what areas do you specialize? How many clients do you have? Are you a member of any professional associations? • How would you describe your financial planning philosophy? How will you help me assess my goals? Will you give me a written plan? Sell me investment and/or insurance products? • How are you compensated? Can you estimate how much using your services will cost me? • Have you ever been disciplined or had any professional licenses or designations revoked or suspended? • Do you foresee any conflicts of interest from working with me? Are you affiliated with any company whose products and services you might recommend to me? Do you plan on referring me to other professionals, or can you handle all my planning needs? If so, can you provide me with a list of names of these individuals? • How do you keep yourself abreast of new developments in the field of financial planning? Before deciding to work with a planner, thoroughly check out his or her credentials and licenses. To do so, ask the planner to provide you with a list of credentials and licenses he or she holds, and find out what organizations he or she is regulated by. Your planner should provide you with written disclosure documents that contain this and other information. CFP® professionals and other planners who follow ethical guidelines are required to give these disclosures to you. Then call the organizations listed and check out the information the planner gave you. Evaluate the answers the planners have given you, and choose the qualified professional who can best give you the advice and services you need. Make sure that you feel comfortable with his or her financial planning philosophy and that you trust him or her to manage your finances.
Choosing a securities broker What a securities broker does and how to find one A securities broker is a salesperson who works for a securities firm (a brokerage house). He or she earns a living by buying and selling your securities (e.g., stocks and bonds) and receiving a portion of the commission generated. Although a broker will try to match your investments to your financial goals, you may not want to rely on a broker to give you financial planning or investment advice. Even though a broker can give you factual information related to your investment (such as price quotations, history of the security, and risks involved), his or her main job is to execute trades that make money. Consequently, you should have some knowledge of what you want to buy when you consult a broker or work with an investment counselor or planner before you hire a broker. You can find a broker through your telephone directory, but it's wiser to ask for a recommendation from your financial planner, attorney, or someone who shares your financial values. How a securities broker is compensated A broker normally makes money by collecting commissions. Commissions are set by the individual brokerage house, and on large orders, they may be negotiable. Usually you pay a commission both on purchase and on sale that is a percentage of the price plus a flat amount. For example, if you are purchasing shares worth $500, your commission may be 2.5 percent of the price plus $7.50. You may pay an equal amount when you sell the stock. Some brokers don't receive commissions; instead, they receive a flat percentage of your assets annually for managing your accounts. Tip: To save money on commissions, you should try to minimize the number of trades you make. You might also consider using a discount broker who trades off the exchange or buying no-load mutual funds from a company that specializes in selling shares directly to the public without the help of, or cost of, a broker.
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Interviewing and evaluating a securities broker Before using the services of a broker, you'll want to ask him or her several questions, including these suggested by the federal Securities and Exchange Commission (SEC), the agency that regulates the securities industry: • Are you registered with our state securities regulator? Have you ever been disciplined by the SEC, a state regulator, or other organization (e.g., the National Association of Securities Dealers or one of the stock exchanges)? • What training and experience do you have? How long have you been in the business? • What is your investment philosophy? • Describe your typical client. Can you provide me with some names and telephone numbers of your long-term clients? • How do you get paid? By commission? Amount of assets you manage? Another method? Do I have any choices on how to pay you? • What criteria will I use to decide when to sell? • Will you educate me about investment types I don't understand? • Will you call me for permission to trade, or do you expect to have discretion over the account? You might also want to ask whether the firm has an in-house research department and whether you can open a margin account at the brokerage and, if so, what the related requirements are. After you've collected information on the broker, choose one who seems to be knowledgeable and ethical. Make sure your broker will work in your best interests, not only his or her own. Check on his or her credentials and history by calling the Securities and Exchange Commission at (800) 732-0330 or the Financial Industry Regulatory Authority at (800) 289-9999 and your state's securities office.
Choosing an attorney What an attorney does and how to find one You may want to hire an attorney if you need expert advice/and or representation concerning a legal problem. You may want to consult a lawyer before performing a legal transaction (e.g., planning your estate, buying or selling property, or divorcing your spouse) or after you are involved in a legal matter (e.g., you are sued or arrested). If you need help with routine matters such as preparing a contract or closing on a house, you may want to hire a general practitioner. However, many attorneys specialize, and you'll want to hire one who can help you with your particular problem. For instance, lawyers may specialize in family law, criminal law, tax law, real estate, bankruptcy, personal injury, or immigration, among many other areas. To find an attorney, consult the following sources: • Ask someone you know for a recommendation, including friends, relatives, associates who share your values, or other advisors. • Check your telephone directory (usually under "attorneys"). • Call the local bar association referral number or another type of lawyer-referral service. They will refer you to one or more attorneys in your area. There may or may not be a charge for this service or for the initial consultation. Be aware, however, that referral services do not recommend attorneys. You'll have to check out their credentials yourself. • Consult the Martindale-Hubbell Law Directory available at your local library. This directory lists most lawyers in the United States by age, specialty, school attended, etc.
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How an attorney is compensated Lawyers are usually paid by the hour. Other lawyers charge a contingent fee if the client is likely to collect a settlement in a civil case for damages. The contingent fee is usually a portion of the total settlement (one-third, for instance). If your lawyer is compensated with a contingent fee, you will usually also have to pay his or her expenses even if you lose your case. Sometimes you'll pay a lawyer a flat fee. No matter how you compensate your attorney, make sure you have some idea of what your total bill will likely be before hiring the attorney. If he or she is working on an hourly basis, determine what services you will be charged for and how frequently you will be billed. Most attorneys will charge you for out-of-pocket-expenses (e.g., copies, postage, court fees, long-distance telephone calls). You may also have to pay a retainer, which is an up-front fee that works like a down payment on the legal services that you require. Make sure that you ask to receive an itemized bill, and check it carefully. Interviewing and evaluating an attorney When choosing an attorney, it's wise to interview him or her briefly by phone and then set up a face-to-face interview. It's a good idea to interview at least two attorneys in order to have a basis for comparison. Here are some questions you should ask: • How long have you been in practice? • How much experience do you have in the area in which I need help? • In what states are you admitted to the bar? • How much do you charge, and what services do you provide for that fee? Will I be charged for expenses? Phone calls? For speaking to your secretary? How often will I be billed? Must I pay a retainer? • How large is your firm? Will other attorneys or employees be involved in my case? • How long will it take to resolve my legal issue? Once these questions have been answered to your satisfaction (it's a good idea to take notes), evaluate your impressions. Do you think you will work well with this attorney? Did any of his or her answers leave you feeling uncomfortable? Are his or her credentials and fee structure satisfactory? Remember, just because you've interviewed an attorney doesn't mean you have to hire him or her. Weigh your options carefully. Once you've hired an attorney, remember to get a letter spelling out exactly what you've hired him or her to do and the fee arrangement you both have agreed upon.
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Designing and Managing an Investment Portfolio What is designing and managing an investment portfolio? Designing and managing an investment portfolio refers to a step-by-step process that helps you to pursue your investment objectives.
Designing an investment portfolio Designing an investment portfolio involves creating a policy to fit your needs based on various factors (investment goals, risk tolerance, and time horizon), choosing investments that match your policy, and implementing the design. You can start out by asking yourself some basic investment questions. For example, why are you investing? Perhaps you would like to buy a house, or maybe you want to retire early. Next, ask yourself how comfortable you are with investing. Are you a cautious investor, or are you willing to take risks? Then, take into account your time frame for investing. Are you saving for your toddler's college education or to retire in a few years? Finally, determine what types of investments will best help you work toward your goals. In other words, what is the proper asset allocation for your particular situation? Your answers to these questions can be a starting point for constructing an investment policy and mapping out a portfolio design. For more information on this topic, see Designing an Investment Portfolio.
Managing an investment portfolio Once you have settled on a policy that reflects your attitudes about investing and a portfolio design that will help you pursue your goals, the next step is managing your investments. This is the subsequent selection of investments (the actual buying and selling) in keeping with the overall portfolio design. Managing a portfolio is one of the most important steps in the investment process. Properly managing an investment portfolio requires knowing not only what investments to purchase, but also when to buy and when to sell them. In addition, managing a portfolio requires constant monitoring of performance, along with rebalancing and making adjustments as needed. Aside from the most savvy of investors, this part of the investment process is usually best left to a professional, such as a financial planner or advisor. For more information on this topic, see Managing an Investment Portfolio.
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Charitable Gifting What constitutes a gift to charity? A gift to charity is simply a gratuitous transfer of property to a charitable organization. The key is that your gift must be some kind of property--your time or personal services do not count. There are several different types of property that can be donated to charity, and a gift is limited only by your imagination. Are you the type who wants to donate cash, stock, or your lunch box collection from a 1960s sitcom?
How do you decide whether to donate to charity? The decision to donate to charity is a personal one. Although the IRS does not require that you have any charitable motivation when you donate to charity--you can do it strictly for the tax benefits--most people who decide to donate to charity have a charitable intent. There are an infinite number of charities from which to choose. Most people have a particular charity in mind when they decide to make a contribution.
What are the tax benefits of donating to charity? Through tax legislation, Congress has attempted to encourage charitable giving because it is good social policy. Most every charity depends on individual contributions to remain financially solvent, especially in this era of fewer direct government dollars. As a result, charitable giving has become interconnected with the tax laws, which have grown more and more complex. Congress has sweetened the pot for taxpayers who donate to qualified charities. First, you generally receive an income tax deduction in the year you make the gift. Second, you do not have to worry about gift tax because federal gift tax does not apply to charitable gifts. Third, charitable gifts serve to reduce your taxable estate, thus reducing your potential estate tax liability. For more information, see Charitable Deduction. It is this last area--estate tax--where charitable giving may produce the greatest tax benefits. Over the next 30 years, an estimated $8 trillion of assets will pass from one generation to the next, resulting in the assessment of significant estate taxes. One solution to minimize these estate taxes is charitable giving.
What options do you have for donating to charity? An outright gift In the typical situation, your gift will be for the charity's benefit only, and the charity will take possession of the gift immediately. This type of gift is called an outright gift. This arrangement satisfies the general rule that a gift to charity must be paid to the charity in the form of money or property before the end of the tax year to be deductible for income tax purposes. Split interest gift in trust Another option is for your gift to be split between a charity and a noncharitable beneficiary. Here, one party (usually the noncharitable beneficiary) receives the use of the donated property for a specific period of time, which means he or she is paid a certain sum every year out of the donated property. Then, after this time period is up, the remaining property passes to the charity. Such gifts can be used to provide for a dependent child or a surviving spouse. In this arrangement, the charity's right to enjoyment and possession of the gift is delayed because the noncharitable beneficiary has the first interest in the donated property. Ordinarily, this delay would mean no tax deductibility for your gift. However, Congress has voiced its approval of such arrangements as long as the gift is set up as one of a number of special trusts expressly created for this purpose. If your split interest gift is set up as one of these trusts, you receive federal income, gift, and estate tax deductions.
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CRAT (charitable remainder annuity trust) A CRAT is a split interest gift between a noncharitable beneficiary and a charitable beneficiary. The noncharitable beneficiary has the first interest, and the charity has the remainder interest or second-in-line interest. The trust pays out a fixed amount of income every year (an annuity) to the noncharitable beneficiary for the term of the trust, and the remaining assets pass to the charity at the end of the term. CRUT (charitable remainder unitrust) A CRUT is a split interest gift between a noncharitable beneficiary and a charitable beneficiary. As with a CRAT, the noncharitable beneficiary has the first interest, and the charity has the remainder interest. However, instead of paying out a fixed amount each year, a CRUT pays the noncharitable beneficiary a fluctuating amount each year, depending on the value of the trust assets for that year. This amount is calculated as a percentage of the assets in the trust on a specified date each year. At the end of the trust term, the remaining assets pass to the charity. Tip: There are several varieties of CRUTs ( NI-CRUT, NIMCRUT, or Flip CRUT), each with slightly different rules regarding how the noncharitable beneficiary is paid. Pooled income fund A pooled income fund is a split interest gift between a noncharitable beneficiary and a charitable beneficiary. Like the CRAT and CRUT, the noncharitable beneficiary has the first interest and the charity has the remainder interest. A pooled income fund is managed by the charity (much like a mutual fund) and is made up of donations from several donors. The charity pays the noncharitable beneficiary a fluctuating amount each year, depending on the value of the fund in that year. These income distributions are made to the noncharitable beneficiary for his or her lifetime, after which the portion of the fund assets attributable to the noncharitable beneficiary is severed from the fund and used by the charity for its charitable purposes. Charitable lead trust A charitable lead trust is a split interest gift between a noncharitable beneficiary and a charitable beneficiary. Here, the charity has the first or lead interest and the noncharitable beneficiary has the remainder interest. The charity is paid a certain amount every year for the term of the trust, and then the remaining assets pass to the noncharitable beneficiary at the end of the trust term. Bargain sale A bargain sale in the context of charitable giving is a sale to charity at a bargain price (i.e., a price below the fair market value of the item sold, fair market value being the price a willing buyer would pay a willing seller in an arm's length transaction). The difference between the sale price and the actual fair market value of the asset equals your donation to charity. A bargain sale involves two separate transactions for tax purposes: a sale and a charitable gift. The IRS treats each event as a separate transaction. Consequently, each is reported separately on your income tax return. Private foundation Donors with sufficient resources may want to create a private foundation. A private foundation is a separate legal entity (often named for the donor) than can endure for many generations after the original donor's death. The donor creates the foundation, then transfers assets (typically appreciated assets) to the foundation, which in turn makes grants to public charities. The donor and his or her descendants retain complete control over which charities receive grants. Community foundation A type of organization related to a private foundation is called a community foundation. A community foundation concentrates its activities within a defined geographic area and is typically controlled by a representative group of community members, which may include the donor. In practice, a community foundation is a public charity,
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though it appears to share some of the characteristics of a private foundation. Donor-advised fund Similar in some respects to a private foundation, a donor-advised fund (DAF) offers an easier way for a donor to make significant charitable gifts over a long period of time. A DAF actually refers to an account that is held within a charitable organization. The charitable organization is a separate legal entity, but the donor's account is not--it is merely a component of the charitable organization that holds the account. Once the donor has transferred assets to the account, the charitable organization becomes the legal owner of the assets and has ultimate control over them. The donor can only advise--not direct--the charitable organization on how the donor's contributions will be distributed to other charities.
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Lifetime (Noncharitable) Gifting What is lifetime (noncharitable) gifting? Gifting can be a powerful estate planning tool, allowing you to transfer your wealth to others during your lifetime. Lifetime gifts have many advantages over gifts you might leave in your will (these are called bequests, legacies, or devises). You might find making lifetime gifts desirable for nontax reasons (e.g., personal gratification), or perhaps you'll make lifetime gifts for tax purposes (e.g., taking advantage of the annual gift tax exclusion), or your estate planning objectives may be the outcome of both nontax and tax factors. You'll want to figure your own personal desires and the tax implications of making lifetime gifts to fully clarify your estate planning objectives. When you have selected what property to give, the process of completing the transfer may be fairly simple (e.g., giving cash) or more complex (e.g., transferring ownership of a business). Make sure that you follow through and properly transfer ownership (e.g., change name on titles). Tip: You may need the help of a professional to complete certain property transfers--an attorney for transfers of real estate and business ownership interests, a trust officer for transfers of property to a trust, or an insurance professional for gifts of life insurance. Technical Note: Lifetime gifts are also referred to as inter vivos gifts.
What are the nontax advantages of making lifetime gifts? You see the recipient enjoy your generosity Lifetime giving allows you the immediate satisfaction of seeing the recipient (the donee) enjoy your generosity. For many people, this is the most important reason for gifting. You give your children financial independence Most parents want to see their children enjoy the best possible life. Lifetime gifts to your children allow you to help them achieve financial security and a more worry-free life. You are relieved of property management worries Giving away your property can relieve you of the responsibility of managing that property, allowing you to enjoy a more worry-free life. This may be especially important if you are an older person. You control the distribution of your property Giving away your property while you are living allows you to decide who receives what property. If you die without a will, the intestacy laws in your state will determine how your property is distributed and you will have no say. You express how you want your property distributed after your death by executing a will. However, since you won't be around to see what actually happens (e.g., someone may disclaim your gift), you won't be able to react to any change in circumstances. Lifetime giving allows you to adjust your gifts to changing circumstances and, at the same time, provides the most control over how your estate is distributed. You keep the property out of probate Lifetime gifts can reduce probate and administration costs because property you give away during life generally is not included in your probate estate at death. Additionally, removing property from your probate estate keeps it from being vulnerable to estate creditors or unhappy heirs.
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You keep the gift private Lifetime gifts are not open to public scrutiny, unless, of course, you wish to make them so. In contrast, a will becomes a public document, available to anyone who wishes to see it. Lifetime giving assures your privacy.
What are the tax advantages of gifting? You may enjoy significant income tax and estate tax savings with a properly structured gifting program. To understand the tax advantages of making lifetime gifts, you must understand what constitutes a gift and how it is taxed. Generally, a gift is not taxable income to the donee (the recipient). However, any income earned by the gift property, or any capital gain on its subsequent sale, is generally taxable to the donee. You, the donor, may be responsible for paying state and/or federal transfer taxes imposed on gifts you make. There are four transfer taxes that may affect your gift giving: (1) state gift tax, (2) state generation-skipping transfer tax, (3) federal gift tax, and (4) federal generation-skipping transfer tax (GSTT). Caution: The tax objectives of gifting are largely independent of each other, but they can also be inconsistent with one another (e.g., shifting income or capital gains may not be consistent with removing certain assets so you can qualify for special tax treatment). Be sure that the steps you take are consistent to accomplish your tax-saving goals. Eliminate future appreciation from your estate One of the most common reasons for gifting is to remove an appreciating asset from your estate. An appreciating asset is one that is increasing in value over time. Removing the asset today keeps any appreciated value out of your estate later. The amount that may be subject to gift tax will likely be less today than it will be in the future. Example(s): Darcy purchased some real estate for $150,000. Five years later, the property is worth $300,000, and she expects that it will double in value during the next five years. Darcy wants to give the property to her daughter, Ellen. If Darcy wants to save estate taxes, she should make the gift now instead of later. Now, only the $300,000 will be subject to gift tax, and in five years $600,000 will be subject to gift tax. Tip: Property that is likely to grow in value includes the cash value of life insurance, common stock, antiques, art, and real estate. Caution: Lifetime giving results in the carryover of your basis (generally, basis is the property's cost) in the property to the donee (as opposed to a gift at death that usually results in a new basis of fair market value on the date of your death). This means that the donee may recognize a larger capital gain when the property is sold than the donee would have if he or she received the property from you at death. Be sure this consequence is acceptable before making this type of gift. Take advantage of qualified transfers Qualified transfers are specific types of gifts you can make that are exempt from the federal gift tax, federal estate tax, and federal GSTT. A qualified transfer is any amount you pay on behalf of someone else, either as tuition to an educational institution or to pay medical expenses to a medical care provider. This is a great way to help your children or grandchildren through college or to help your elderly parents get the proper medical care they deserve. Take advantage of the annual gift tax exclusion The annual gift tax exclusion is a federal exclusion that allows you to give $13,000 per donee to an unlimited number of donees without incurring federal gift tax or federal GSTT. This exclusion allows you to distribute your property tax free and potentially put your estate into a lower tax bracket. The exclusion applies only to gifts of a
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present interest in property. For example, giving your niece cash today would qualify, but giving her the right to have your house in three years would not. Only certain transfers in trust qualify, and the rules are slightly different for gift tax and GSTT purposes. Tip: If you are married, gift splitting can double the annual gift tax exclusion. Gift-splitting rules apply. Tip: Some states may have the equivalent of the federal annual gift tax exclusion. Take advantage of the gift tax applicable exclusion amount and the GSTT exemption The gift tax applicable exclusion amount is used to offset cumulative lifetime gifts. The federal GSTT exemption works like the gift tax applicable exclusion amount for gifts made to skip persons (family individuals who are more than one generation below you and certain trusts for the benefit of such individuals). You may want to use the gift tax applicable exclusion amount and the GSTT exemption during your lifetime instead of waiting until your death to use the applicable exclusion amount at that time because of the time value of money--money is worth more today than it will be tomorrow. Some states may have the equivalent of the GSTT exemption and the federal applicable exclusion amount. Potentially reduce state death taxes State death taxes are generally imposed on property you own at the time of your death. Removing property from your estate during life can minimize state death taxes. Caution: Some states will include gifts you made during the three years prior to your death in your taxable estate. If death is imminent, gifting may not help reduce state death taxes. Shift income to a lower income tax bracket Because the income tax rate schedules are graduated, your total family federal and state income tax burden may be reduced if income-producing assets are distributed among several family members rather than being held in your hands only. Caution: Your potential federal income tax savings of transferring income-producing property to your children may be reduced by the kiddie tax. Shift capital gains to a lower income tax bracket Federal and state capital gains tax on the sale of appreciated property may be reduced by transferring the property to someone who is in a lower income tax bracket or who has losses to offset the gain. Remove certain assets in order to qualify for special tax treatment You may receive special estate tax treatment if your estate meets certain percentage tests (a certain percentage of your estate consists of specific types of assets). Removing certain nonbusiness holdings may help your estate meet these tests and so qualify for Section 303 (redemption of stock), Section 2032A (special use valuation), or Section 6166 (installment payout of taxes) tax treatment. Caution: This technique will work only if the gift is made more than three years prior to your death. Remove tax paid on lifetime gifts from your taxable estate Although the tax you pay on lifetime gifts is tax exclusive, the tax paid on gift-at-death transfers is tax inclusive. This means that funds used to pay tax on gift-at-death transfers may be includable in your estate for estate tax purposes, while funds used to pay tax on lifetime gifts are not. You can save tax overall by making lifetime gifts, because the amount of the tax you pay on those gifts is removed from your estate. Caution: Tax that you pay on gifts made within three years of your death may be added back into
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your estate for estate tax purposes.
How can you make a gift? A gift can take many forms. Each has advantages and limitations. Outright gifts An outright gift is made directly to the donee (the recipient). Making an outright gift gives the donee unrestricted control of the property. Outright gifts may present problems in two situations: • Gifts to minors: Outright gifts to minor children may not be a good idea, unless it is something that is meant to be enjoyed immediately, like a car. However, if it is a substantial gift, there is some risk that the child will spend the gift foolishly instead of spending it wisely or saving it. And since the child can't sell, lease, exchange, will, or otherwise deal with the property--minors can't enter into contracts by state law--the property will be tied up until the child attains the age of majority. Thus, it may be wasted. Technical Note: Minority is determined by state law and, generally, the age of majority is 18. Tip: You might want to consider making gifts to minors in the form of a guardianship under the Uniform Gifts/Transfers to Minors Act (UGMA or UTMA) or in trust (e.g., Section 2503(b) trust, Section 2503(c) trust, or Crummey trust). Caution: Gifts made under the UGMA or UTMA may reduce the child's chances for financial aid when he or she attends college. • Gifts to spendthrifts or those who are incapacitated may be unwise: A spendthrift is someone who spends money foolishly. An incapacitated person is someone who is either physically or mentally unable to make financial decisions. You may not want to put property in the direct and unrestricted control of either a spendthrift or an incapacitated person. Tip: Gifts to spendthrifts or incapacitated persons should be made in trust. Gifts in trust Gifts in trust are more difficult to make than outright gifts. Gifts in trust require the preparation of a trust document and may involve trustee fees, tax preparation fees, accountant's fees, or attorney's fees. However, here are some advantages to using a trust: • Flexibility of income distribution: You can control the distribution of the income and principal of the trust to the beneficiaries by giving the trustee sprinkling powers. Sprinkling powers give the trustee discretion over how to distribute the trust income and principal. This may be preferable if you don't want the donee to have the entire gift all at once but only as needed. • Professional asset management: The property can be put into the hands of a trustee who is a professional asset manager, such as a bank. This may be desirable if you do not want to assume the duties of the trustee. Professional management will ensure that the property is not wasted but wisely invested. • Creditor protection: A spendthrift trust is one that prohibits the beneficiary from transferring or assigning his or her interest in the trust to someone else. Putting property in a spendthrift trust keeps the property out of the hands of the beneficiary's creditors. Tip: Some gifts to charity should be made in trust. Partial-interest gifts (property rights given to both charitable and noncharitable interests, such as a trust paying income to charity, with the remainder going to noncharitable beneficiaries) must be made in some form of charitable trust like a charitable lead trust, charitable remainder annuity trust, pooled income fund, or charitable
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remainder unitrust to qualify for the gift tax charitable deduction. Forgiveness of a debt You can make an indirect gift by forgiving a debt. This means that someone owes you money and you tell him or her they don't have to pay you back. You have, in effect, given him or her the money. Because of the annual gift tax exclusion, forgiveness of a debt can be an excellent way to make a large tax-free gift. Example(s): Mr. A gives Ms. B $100,000 to start her own beauty salon. Ms. B signs an interest-bearing note that is payable on demand or at the end of three years. Within the three-year period, Mr. A forgives $10,000 each year on the loan. The $10,000 forgiveness of the loan is a gift, but no tax is due because it is fully excluded under the annual gift tax exclusion. At the end of three years, Ms. B makes a $20,000 payment on the note. The balance of the principal then due on the note is $50,000. During the next five years, Ms. B makes small payments on the note, and Mr. A forgives the remaining balance due on the loan in increments of $10,000 each year (all of which are fully deductible under the annual gift tax exclusion). Caution: You must clearly establish a debtor-creditor relationship. Be sure to establish evidence that your intent is to make a loan--put it in writing, charge market rate interest, get security or collateral, make periodic demands, or let the borrower make some payment or demonstrate the ability to pay. Interest-free or below-market loans An interest-free or below-market rate loan is an indirect gift. The gift is the foregone interest. The foregone interest is the difference between the interest computed using the applicable federal rate and the interest computed using the stated rate. Titling property in joint name If you add a joint name to your property, you may be making a gift. For example, if you add your son's name to yours on the deed to your house as a 50 percent owner, you have made a gift of half your house. When the gift occurs depends on the type of property. Generally, the gift occurs when the joint name is added. However, the gift may not occur right away for some types of property where the benefit is not received until later. For example, if you add your son's name to your checking account, there is no gift until your son withdraws funds. Tip: Titling property jointly in the name of your spouse may be fully deductible under the unlimited marital deduction. Caution: By adding a joint name, you give up control and may expose the asset to the joint owner's creditors.
To whom should you give? You will probably want to give to your family members. However, giving to certain groups may have particular tax ramifications. Your spouse Gifts you make to your spouse may be fully deductible from federal gift tax and federal estate tax under the unlimited marital deduction. The transfer must meet certain requirements to qualify. Special rules apply for transfers to a noncitizen spouse. Tip: Some states may also allow a marital deduction of some kind.
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Skip persons A skip person is an individual who is more than one generation below you (or certain trusts that benefit such individuals). Gifts to skip persons may be subject to the federal generation-skipping transfer tax (GSTT) (and, if one is imposed by your state, the state GSTT). This tax is imposed in addition to the estate tax. Charitable organizations Lifetime gifts to charity may be more advantageous than donations made at death because such gifts may be fully deductible from both federal gift tax and federal income tax. Because charitable donations are income tax deductible, you receive a double tax benefit from lifetime gifts. The gift must meet certain requirements to qualify. Tip: Some states may also allow a charitable deduction of some kind. Minor children Income-producing gifts to children may not help save federal income tax because of the kiddie tax. However, there are still ways to shift wealth and save taxes by giving to children: • Series EE U.S. savings bonds: If you give Series EE U.S. savings bonds (may also be called Patriot bonds) that will not mature until your child is over the age that triggers the kiddie tax, the income tax payable when the bond is redeemed will be taxed at your child's lower tax rate. • Growth stocks (or mutual funds): Give growth stocks (or mutual funds) that pay little or no current dividends. After your child is overthe agethat triggers the kiddie tax, any dividends will be taxed at your child's income tax rate. Further, if the stock is sold after your child is over the age that triggers the kiddie tax, the gain will be taxed at your child's income tax rate. • Gifts made under the Uniform Gifts/Transfers to Minors Act: Generally, gifts made in trust are gifts of future interest. Gifts of future interest are generally denied the annual gift tax exclusion. However, gifts made under the Uniform Gifts/Transfers to Minors Act (UGMA or UTMA) are eligible for the annual gift tax exclusion (and a custodian is allowed to maintain control over the property until the child reaches the age of majority). Technical Note: UGMA is retained by only a few states. In those states, money, securities, certain life insurance policies, and certain annuities may be the subject of a custodial gift. The UGMA has been replaced by UTMA in most states. The UTMA allows custodial transfers of nearly any kind of property. Since the laws of different states vary, it is important to check with your own state's laws. • Gifts made to a Section 2503(b) Trust: The Section 2503(b) Trust (Income Trust) can be used to make a gift in trust that qualifies for the annual gift tax exclusion. • Gifts made to a Section 2503(c) Trust: The Section 2503(c) Trust (Discretionary Trust) can be used to make a gift in trust that qualifies for the annual gift tax exclusion. • Gifts made to a Crummey trust: The Crummey trust can be used to make a gift in trust that qualifies for the annual gift tax exclusion. • Employ your children: A child's earned income is not subject to the kiddie tax. The amount will be taxable at your child's income tax rate. Additionally, your business will have a deduction at its tax bracket. Caution: Child labor laws may prohibit this. Caution: The deduction may be limited or disallowed if the compensation paid to the minor child is unreasonably high, taking into account the services actually performed by the child.
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When should you make a gift? Some gifts you make, such as life insurance or certain retained interests, may be brought back into your estate for federal estate tax and state death tax purposes. Any property you gave away more than three years ago is now safely out of your estate. So, the sooner you start taking advantage of the annual gift tax exclusion, the gift tax applicable exclusion amount, the GSTT exemption, and any other exclusions your state may allow, the better. For example, the lower the value of the property, the less use of the applicable exclusion amount. Additionally, you can't save up the annual gift tax exclusion from year to year. So what you don't use, you lose. Of course, you should make gifts of property that widely fluctuates in value when the market value is at its lowest because property is generally valued at its fair market value on the date the gift is made for tax purposes. Otherwise, only you can decide when the best time is to make a gift based upon your particular circumstances.
What property should you give? Selecting what property to give may be your most difficult decision. The best property depends on your circumstances and objectives. You should choose property that maximizes your personal goals and/or offers tax advantages
Are there any gifting traps you should avoid? If you want to minimize or avoid taxes, your gifts must be properly structured. All your efforts may be for naught if you should fall into common traps: The kiddie tax rules Beware of the kiddie tax rules when transferring income-producing property to children. Unearned income above $1,900 may be taxed at the parent's income tax rate. The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn't exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose unearned income doesn't exceed one-half of their support. Gifts of retained interests or powers Beware of making gifts of property in which you retain some financial interest (e.g., life estates, right of reversion, right of revocation) or powers (e.g., power of appointment). This property may be includable in your estate for estate tax purposes. Example(s): Frank, Sr. transfers ownership of his home to his son Frank, Jr. on the condition that Frank, Sr. is allowed to live in the home for the rest of his life. Frank, Sr. has retained a financial interest in the home, which may be includable in his estate for estate tax purposes. Income taxation of gifts in trust A trust is a taxpaying entity. Be sure to consider the consequences of paying income tax on trust income. Delays in making a gift of life insurance Do not delay in making a gift of a life insurance policy on your life. Transfers of policies on your life may be includable in your taxable estate if made within three years of your death. Delays in planning your estate to meet percentage tests Do not delay in removing certain nonbusiness holdings to help your estate meet the percentage tests to qualify for Section 303 (redemption of stock), Section 2032A (special use valuation), or Section 6166 (installment
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payout of taxes) tax treatment. This technique will only work if the gift is made more than three years prior to your death. Payments for tuition or medical care made to the donee Do not make payments for tuition or medical care to the donee (the beneficiary). You must make the payments directly to the educational institution or medical care provider in order to qualify the gift as tax exempt. Overlooking gift splitting Do not forget the gift-splitting privilege for spouses who qualify. This can double the annual gift tax exclusion. "Reverse" gifts made within one year of the donee's death Don't make a gift of appreciated property to a donee within one year of death if you will receive the property back. There will be no step-up in basis, and you may have needlessly paid gift tax and/or used your gift tax applicable exclusion amount. Overlooking the tax-exclusive nature of making lifetime gifts Don't assume that lifetime gifts and transfers made at death result in the same tax effect. Remember that the tax-exclusive nature of lifetime gifts results in overall tax savings because the tax is removed from your estate. Selecting property that does not attain your tax-savings objectives There are some types of property that you should avoid giving if you want to enjoy tax savings.
What else should you know about gifting? If you are married and live in a community property state, gifts of community property you make to third persons may be limited by state law. For example, you may need the express or implied consent of your spouse, or you may be limited by the amount you can give each donee. The IRS may consider transfers made by your attorney-in-fact (agent or representative) to be revocable transfers. That means that those gifts may be includable in your estate for estate tax purposes. If you want your attorney-in-fact to make gifts on your behalf, make sure that you give express written authority in a power of attorney.
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Gifting for Education Savings What is it? A gift is a voluntary transfer of money or property from one person to another person or entity (such as a trust) where the person making the gift receives either nothing or a lesser amount of money or property in return. In the context of education planning, gifting is usually implemented as a strategy when parents want to shift income to their child and reduce taxes. This ability to shift income and reduce taxes works best when the parents are in a high tax bracket and the child is in a low tax bracket. Caution: The Small Business and Work Opportunity Tax Act of 2007 expanded the kiddie tax rules beginning in 2008. The expanded application of the kiddie tax rules may make gifting to children less effective as a college savings strategy.
Strengths Shifts income to lower tax bracket The primary advantage of gifting assets to your child is that, in most cases, children are in a lower tax bracket than their parents. So over time, the money will likely grow to be worth more in the child's account because the child generally pays income tax at a lower rate. However, the expansion of the kiddie tax rules in recent years negates this advantage unless the child's annual unearned income is below a certain amount, as discussed below. Child retains parents' cost basis in gifted asset When you gift an asset to your child that has appreciated in value, such as appreciated stock, your child's basis (cost) in that asset is considered to be the same as your original cost, not the current value of the property. This means that upon sale of the asset, your child will have the same amount of capital gain that you would have had. The difference is that your child may owe less capital gains taxes if he or she is in a lower tax bracket. Example(s): Assume that you are in the 25 percent tax bracket and your child is in the 10 percent tax bracket and you gift 100 shares of stock to your child. You purchased the stock four years ago at $15 per share; it is now worth $60. Your child's basis in the stock is considered to be $1,500 (100 x $15). If your child sells the stock at its current price, he or she has recognized $4,500 gain, resulting in $225 in capital gains taxes (5 percent long-term capital gains rate for taxpayers in 10 percent tax bracket). By contrast, if you had kept the stock and sold it yourself, your gain would have been the same, but you would have owed $675 in taxes (15 percent long-term capital gains rate for taxpayers in 25 percent tax bracket). Capital gains tax rates are lower for individuals in 15 percent tax bracket and below If you're in a marginal income tax bracket greater than 15 percent, in most cases long-term capital gains that you recognize are taxed at a rate of 15 percent. Individuals in the 10 and 15 percent marginal tax brackets, however, will not pay capital gains tax on most long-term capital gains because of the 0 percent rate (in 2008 through 2010). If you gift appreciated assets to your child, then your child will have the same basis and holding period in the assets that you had. Your child can then sell the assets and use the money to pay for college. Caution: For sales and exchanges prior to May 6, 2003, individuals in marginal income tax brackets greater than 15 percent were subject to tax on most long-term capital gains at a rate of 20 percent, while individuals in the 10 or 15 percent brackets were subject to tax at a rate of 10 percent. In addition, special rules applied to property with a holding period of more than five years. Absent further legislative action, these rates will again be effective beginning January 1, 2011.
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Reduces size of gross estate When you gift assets to your child, you generally remove those assets from your gross estate. Thus, you reduce the chance your estate will owe estate tax.
Tradeoffs The kiddie tax may limit your tax savings The kiddie tax rules apply to children who are (1) under age 18, or (2) under age 19 or a full-time student under age 24, provided the child doesn't earn more than one-half of his or her financial support. Children in these categories are taxed at their parents' rate on all unearned income over $1,900. (The first $950 of unearned income is tax free and the next $950 is taxed at the child's rate.) Tip: To minimize the impact of the kiddie tax, parents might consider investing their child's savings in tax-free or tax-deferred investments so that any taxable income is postponed until after the child reaches age 24 (when the child is taxed at his or her own rate). Such investments can include U.S. savings bonds, tax-free municipal bonds, or growth stocks (which provide little, if any, current income). Alternatively, parents can try to hold just enough assets in their child's name so that the investment income remains under $1,900. Transferring assets to child may reduce his or her financial aid award Under the federal methodology for determining a family's financial need, a child's assets can have a greater financial aid impact than his or her parents. Under this formula, a child is expected to contribute 20 percent of his or her assets each year toward college costs, compared to 5.6 percent for parents. So $20,000 in a child's bank account would translate into a $4,000 expected contribution, whereas the same money in the parents' account would mean a $1,120 expected contribution. Gifting assets to your child is irrevocable Once you gift an asset to your child, your child owns it. That means that your child can use the money for anything--from college to a cross-country trip. Possible gift tax implications If the sum of the gifts you make to your child each year is equal to or less than the $13,000 annual gift tax exclusion or double that amount for married couples who are U.S. citizens and making joint gifts, the gifts are not subject to federal gift tax (though they may be subject to state gift tax). However, if gifts to your child are over the annual gift tax exclusion amount in a given year, a portion of the gifts may be subject to federal gift tax.
What are the most favorable types of property to gift to your child? There's no restriction on the type of property that can be gifted to your child; parents are free to gift any asset they wish. However, some types of assets are more favorable to gift than others due to the tax-saving opportunities. Two of these assets are discussed here: appreciated assets and income-producing property. Appreciated assets An appreciated asset is an asset that has a value in excess of the holder's adjusted tax basis in the asset. Though everyone certainly hopes their assets will appreciate in value, the downside is the capital gains taxes that could result from the sale of such assets. The strength of gifting an appreciated asset to your child is that if and when your child sells the asset, he or she will be subject to tax on any gains at his or her own rate. Generally, the capital gains tax rate is 0 percent for all individuals in the 15 percent tax bracket or below (in 2008 through 2010), compared to a 15 percent rate for
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individuals in all other brackets (provided the asset has been held over 12 months). Caution: For sales and exchanges prior to May 6, 2003, individuals in marginal income tax brackets greater than 15 percent were subject to tax on most long-term capital gains at a rate of 20 percent, while individuals in the 10 or 15 percent brackets were subject to tax at a rate of 10 percent. In addition, special rules applied to property with a holding period of more than five years. Absent further legislative action, these rates will again be effective beginning January 1, 2011. Income-producing property Income-producing property is just what the name suggests--it's property that produces income. Examples of such property include rental property, stocks that pay regular dividends, bonds that pay interest, and equipment leases. The strength of gifting income-producing property to your child is that, in most cases, you transfer the income stream to someone in a lower tax bracket than yourself.
Questions& Answers Is it true that a person can make a tax-free gift of tuition on behalf of a child? Yes. A tax-free gifts of tuition is a payment of tuition made directly to a college or university on behalf of a student for his or her education. The IRS won't consider this type of payment to be a gift for purposes of computing federal gift tax. In other words, you can make a gift of tuition for more than the annual gift tax exclusion in a given year, without federal gift tax consequences. To qualify, the payment must be for tuition only and made directly to the college. You can't gift the money to the child and then instruct the child to apply the money toward tuition. The gift of tuition must occur at the time your child is actually in college.
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Private Foundations What is a private foundation? A tax-exempt entity operated for charitable purposes Private foundations are tax-exempt entities, just like hospitals or universities. What makes them different from organizations that are known as public charities is that private foundations are set up, funded, and controlled by a single individual, family, or corporation. By contrast, public charities derive a significant percentage of their revenue from the general public and cannot be under the control of any one individual or family. Do you have to be fabulously wealthy to establish a private foundation? No, but a certain amount of wealth is a prerequisite, of course. The private foundation vehicle is a good tool that serves the interests of affluent individuals. Private foundations have been around for 150 years Private foundations trace their lineage back to the mid-19th century, and in some ways, they go back further than that. Anglo-Saxon law recognized private foundations as legal entities and the American legal system initially encouraged them through charitable trusts. Some of the early 19th century industrialists established private foundations that are still known today. Private foundations proliferated after WWII, mainly because of good economic conditions and favorable tax treatment. The Ford Foundation is probably the best-known example of a private foundation in the U.S. today. 1969 was start of modern era The year 1969 was critical in the development of today's private foundation law. Incredibly, there was no workable definition of a private foundation until then. After well-publicized abuses and congressional hearings concerning private foundations' attention to noncharitable interests, Congress passed the Tax Reform Act of 1969. The anti-private foundation sentiment in the late 1960's caused Congress to draft curious laws. Today, all charitable organizations are presumed to be private foundations unless they can qualify otherwise. Most do, so they are known as public charities. Those confirmed as private foundations usually share four characteristics: • They demonstrate charitable intent • Their funds come from one source, such as an individual, family, or company • Their operations are funded by investments • They make grants to other charitable organizations rather than operate the programs themselves More heavily regulated than public charities As a direct result of the 1969 tax reforms, private foundations are more heavily regulated than their public charity counterparts. They must pay certain taxes, keep up a mandated level of charitable activity, and be scrupulous in their transactions with their founders. This regulatory treatment stands in stark contrast to public charities, which, in some cases, may be carrying out quite similar charitable activities. May be good estate planning vehicle For those with sufficient resources and a charitable impulse, a private foundation may be a good estate planning vehicle. Funders enjoy wide latitude in their charitable activities, family members can be paid salaries for their work on the governing board, and the foundation can be an excellent income and estate planning vehicle.
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Comes in different flavors • Standard or family foundations--The most common type of foundation is the standard private foundation or family foundation. Generally, family foundations do not engage in charitable activities. Rather, they give grants to public charities. Analysts estimate there are approximately 35,000 to 45,000 such entities in the United States. The Ford Foundation is a well-known example. • Private operating foundations--Private operating foundations themselves engage in charitable activities (e.g., museums, nursing homes, and libraries). There are an estimated 2,000 private operating foundations and a comparable number of corporate foundations. Probably the best-known operating foundation is the J. Paul Getty Trust. • Community foundations--A related type of organization is called a community foundation, of which there are about 500 across the United States. A community foundation concentrates its activities within a defined geographic area and is typically controlled by a representative group of community members. In practice, a community foundation is a public charity, though it appears to share some of the characteristics of a private foundation. The New York Community Trust is an example of a private foundation.
Why would you want to establish a private foundation? Gives a high degree of control over your charitable dollar The essence of a private foundation is that a single person, family, or corporation generally controls it. This is the complete opposite of other public charities, and represents the only substantive way that donors of significant means can exercise such control over their charitable contributions. Can help minimize capital gain taxes Private foundations are usually set up as part of a strategy known as planned giving, a concept at the heart of sophisticated charitable activity. Planned giving normally involves assets that have appreciated in value, as opposed to cash. There are two ways to make a planned gift. The first is during your lifetime, when you, the donor, create a trust or some other form of agreement. The second is through a will. Planned giving takes advantage of the idea that a piece of property contains an income interest and a remainder interest. An income interest consists of the income the property produces, while a remainder interest is the projected value of the property at some later point, based on actuarial and other computations. The majority of planned gifts split these two interests by granting a remainder interest to a charitable entity, such as a private foundation. These gifts are made by using charitable remainder trusts. Typically, individuals receive the income interest. The way that private foundations can help minimize capital gain taxes relates to the appreciated value of the donated property. Ordinarily, when appreciated property is sold, the amount of appreciation is subject to capital gain tax. Donating the property to a private foundation allows the donor to escape taxation on the appreciated value and provides a charitable contribution deduction. Caution: Tax rules governing this area have changed frequently in recent years, often renewing existing provisions for a fixed period of time. Consult your tax advisor for the most recent changes. Can increase the value of your estate by reducing income taxes If a private foundation is created while the donor is living, contributions to the foundation are income tax deductible, subject to certain limitations. This can increase the value of your estate.
How do you establish a private foundation?
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There are five steps to follow in establishing a private foundation. Some of these steps may include additional tasks that depend on your individual circumstances, but generally this is the road map. Of course, it is important to consult with qualified legal and financial advisors familiar with your situation. Prepare a written plan It's a good idea to write down what you plan to do and how you plan to do it. The IRS will request this information later on anyway, but at this stage, you need to have a clear idea for yourself. Start with the foundation's mission, which is its larger overall purpose. Spell out how you expect to accomplish this mission, including the programs you plan to fund or operate, and the staff you think you will need. This is where you'll consider the details that you will need to have firmly in mind when things start rolling. Set up a corporation or trust whose assets will be exclusively dedicated to charitable purposes There are eight categories of activity that make an entity eligible to receive charitable donations, the first step in becoming a private foundation: charitable, educational, religious, scientific, literary, testing for public safety, fostering national or international amateur sports programs, and preventing cruelty to children or animals. Trusts have historically been the vehicle of choice for creating private foundations, but today it is also common to set up a corporation for this purpose. Why? Because nonprofit corporations offer some protection against liability for the principals. Also, the corporation's governing provisions can be changed by its existing directors. There are organizations accessible to potential donors that offer much help and advice for this stage of the process. One of them is The Council on Foundations in Washington, DC (www.cof.org). Another is BoardSource (www.boardsource.org). There also may be a regional association of grantmakers in your area. Prepare financial projections Now that you have a plan, the next logical step is to figure out how much it's all going to cost. Here is where you show the cash or assets you will give to the foundation and any other revenue you expect. A reason for financial projections is that they will help you work out the specifics of your situation and their relationship to the private foundation laws. Request tax-exempt status from the IRS Your hard work is about to pay off because the IRS wants to see evidence of planning and preparation before it issues tax-exempt status. Complete IRS Form 1023 (Application for Recognition of Exemption) to begin the whole process in the federal government's eyes. Like most IRS forms, this one is long and tedious but fairly straightforward. It will ask you for your basic identifying information, activities and operational information, technical (legal) requirements, and the financial projections you prepared in the steps discussed above. Now you're doing the financial projections to prove you're qualified for tax-exempt status instead of for your own internal planning. Fund the entity and set up financial record-keeping systems The final step is to transfer the donated property to the new private foundation. At the same time, you need to set up adequate accounting and internal controls. Although you funded this organization, the federal government has given it tax-exempt status based, in part, on the premise that you will manage it properly. Considering the number of requirements unique to private foundations and the close link between your tax status and this new entity, it's hard to underestimate the importance of having good systems in place. File Form 990-PF annually All private foundations are required to file an annual return, Form 990-PF (Return of Private Foundation), with the IRS.
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What are the pitfalls related to private foundations? It should come as no surprise that there are possible legal and financial pitfalls related to the creation and management of private foundations. The close relationship between a private foundation and the founder's tax obligations is fertile ground for missteps. Qualified professional advice can help you overcome any problems that might arise along the way, but the best approach is to avoid problems before they arise. The following is an overview of some major pitfalls--private inurement, self-dealing, distribution requirements, excess business holdings, jeopardizing investments, investment excise tax, and banned activities--and how to handle them. Private inurement Private inurement relates to the improper use of the net earnings from a tax-exempt organization by a related private party for nonexempt purposes. It is strictly prohibited for all tax-exempt entities, including private foundations. The most common form of private inurement is excessive or unreasonable compensation. Unreasonable rental and borrowing arrangements are two other examples. Self-dealing Persons who control and run the foundation are referred to as disqualified persons, and certain transactions between them and the private foundation are prohibited. The law specifically prohibits six types of self-dealing transactions: property-related, money lending, furnishing of goods or services, payment of compensation, transfer or use of assets, and agreements to pay government officials. Tip: The economic measurement of the transaction is irrelevant. If a disqualified person sells a valuable building for $1 to a private foundation, it is still not a permissible transaction. Distribution requirements Beginning in 1969, Congress required private foundations to transfer some mixture of either money or property to charitable purposes each year. There are different types of distribution requirements for different types of private foundations, but the underlying concept is that a private foundation must give away an amount equal to 5 percent of average fair market value of its investment assets, less any debt incurred to acquire the property. The key here is to make a distinction between assets needed directly for carrying out the foundation's exempt purposes and those held to produce income. Excessive business holdings Some private foundations want to own a business that is unrelated to the foundation's exempt purpose. While this is permissible, it is severely limited so as to preserve the charitable intent of the organization. Generally, the total ownership of a business by a private foundation and its disqualified persons is limited to 20 percent. Under some circumstances, the limit is slightly higher. Caution: Sometimes a private foundation is the beneficiary of a donation by a business entity. When this happens, the private foundation has a limited period of time to dispose of the asset. Jeopardizing investments Private foundation managers must see to it that the foundation's assets are not invested unwisely. Ordinary business practices should be enough to satisfy this requirement. In practical terms, private foundations usually avoid these pitfalls by delegating asset management duties to professional managers. Excise tax A private foundation must pay an excise tax of 2 percent each year on net investment income, which gives it the dubious distinction of being one of the very few types of tax-exempt organizations to have to do so. The reason for the tax is to cover the extra governmental costs of regulating private foundations (the original 4 percent tax was actually reduced in 1978 because it was producing more money than the actual regulation costs). Although
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this amount is minimal, good planning offers the chance of reducing the excise tax slightly. Banned activities There are a number of activities that can cause a private foundation to be taxed. The primary banned activities are: lobbying, partisan political activity, making grants to individuals without an IRS-approved plan, making grants to organizations other than public charities or tax-exempt operating foundations, and making grants where the grantor retains responsibility for expenditures under the grant.
What are the sanctions imposed on private foundations? Congress and the IRS have tried to shape the actions of private foundations in such a way that it is in the founders' interests to adhere to the rules because deviating from them will trigger an economic penalty. Therefore, while self-dealing is not prohibited per se, it will bring with it economic consequences so severe that to break the rules would be self-defeating. Although the IRS often has the authority to abate the triggered taxes, they do not always have that latitude.
How do private foundations end? A private foundation can terminate its existence, but the rules require payment of a termination tax to do so. To voluntarily terminate, a private foundation has to give the IRS a full explanation of its plan to terminate. It can transfer both its assets and its obligations to another private foundation or public charity. It can also choose to become a public charity. Finally, the IRS has the right to terminate private foundation status in the event of repeated and flagrant disregard of private foundation provisions. The termination tax is stringent. It will be the lower of the aggregate tax benefit resulting from the foundation's tax exempt status or the total value of the net assets of the foundation. However, the tax is not imposed when a private foundation converts to public charity status (by either transferring all of its assets to an existing public charity or becoming a public charity itself). The IRS also has the authority to abate this tax in certain other circumstances.
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Introduction to Estate Planning What is estate planning? Simply stated, estate planning is a method for determining how to distribute your property during your life and at your death. It is the process of developing and implementing a master plan that facilitates the distribution of your property after your death and according to your goals and objectives. At your death, you leave behind the people that you love and all your worldly goods. Without advance planning, you have no say about who gets what, and more of your property may go to others, like the federal government, instead of your loved ones. If you care about (1) how and to whom your property is distributed, and (2) ensuring that your property is preserved for your loved ones, you need to know more about estate planning. As a process, estate planning requires a little effort on your part. First, you'll want to come to terms with dying, at least to a degree that you can deal with the necessary planning. Understandably, your death can be a very uncomfortable subject, but unfortunately, the discussions in this area are full of references to your death, so it really can't be avoided. Some statements may seem too businesslike and unfeeling, but tiptoeing around the subject of dying will only make the planning process more difficult. You will understand the process more easily and implement a more successful master plan if you approach it in a straightforward manner.
Who needs estate planning? Not just for the wealthy Estate planning may be important to individuals with a wide range of financial situations. In fact, it may be more important if you have a smaller estate because the final expenses will have a much greater impact on your estate. Wasting even a single asset may cause your loved ones to suffer from a lack of financial resources. Your master plan can consist of strategies that are simple and inexpensive to implement (e.g., a will or life insurance). If your estate is larger, the estate planning process can be more complex and expensive. Implementing most strategies will probably require you to hire professional help of some kind, an attorney, an accountant, a trust officer, or an insurance agent, for example. If your estate is large or complex, you should consult with an estate planning expert such as a tax attorney or financial planner for advice before the implementation stage. In deciding on your course of action, you should always consider whether the benefit of the strategy outweighs the cost of its implementation. May be especially needed under certain circumstances You may need to plan your estate especially if: • Your estate is valued at more than the federal estate tax applicable exclusion amount (formerly known as the unified credit) (see tip below) or your state's death death exclusion amount • Your income tax bracket is in excess of 10 percent • You have children who are minors or who have special needs • Your spouse is uncomfortable with or incapable of handling financial matters • You're a business owner
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• You have property in more than one state • You intend to contribute to charity • You have special property, such as artwork or collectibles • You have strong feelings about health-care decisions You have privacy concerns or want to avoid probate Tip: The federal estate tax is repealed for 2010, unless Congress acts to reinstate the tax retroactively. In 2011 the tax will return with an applicable exclusion amount of $1 million. So, estates over $1 million may actually want to make appropriate plans to be on the safe side.
How to do it Designing a plan is a process that is unique to each estate owner. Don't be intimidated or overwhelmed at the prospect. Even the most complex plan can be achieved if you proceed step by step. Remember, the peace of mind that comes with developing a successful estate plan is worth the time, trouble, and expense. Understand your particular circumstances Begin the estate planning process by understanding your particular circumstances, such as your age, health, wealth, etc. Understand the factors that will affect your estate You will also need to have some understanding of the factors that may affect the distribution of your estate, such as taxes, probate, liquidity, and incapacity. Clarify your goals and objectives When your particular circumstances and the factors that may affect your estate are clear, your goals and objectives should come into focus. Understand the strategies that are available With these goals and objectives now clear, you can begin to consider the different estate planning strategies that are available to you. Seek professional help Seeking professional help (an attorney or financial advisor) will help you understand the strategies that are available and formulate and implement your master plan. Formulate and implement a plan Finally, after following these steps, you can formulate and implement a plan that works for you. Here are a few basic tips: (1) make sure you understand your plan, (2) rely on people you trust, and (3) keep your documents and information organized and within easy reach. Perform periodic reviews When you have implemented your master plan, be sure to perform a periodic review and, if necessary, make revisions that reflect any changing circumstances and tax laws.
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How do you begin? There are many estate planning strategies, including some that are implemented inter vivos (during life), such as making gifts, and others post-mortem (after death), such as disclaimers. Before you choose which strategies are right for you, you need to understand your particular circumstances. Gather and analyze the facts Understanding your particular circumstances results from gathering and analyzing the facts. The following questions may help you to accomplish this. If they are not easy to answer, you may have to make some estimates based on reasonable assumptions and expectations. Information regarding your financial condition • What is your current income? • What is your income likely to be in the future? • How much do you spend each year? • What are your expenses likely to be in the future? • What are your current assets and debts? • Are your assets currently owned solely or jointly? • What estate planning strategies have you already implemented? Family information • Who are the family members you intend to benefit? • What are the needs of each family member?
What other factors need to be considered? Decide what your goals and objectives are in light of your particular circumstances and in light of the factors that may affect your estate. The primary factors that may affect your estate are your beneficiaries, taxes, probate, liquidity, and incapacity. Taxes One of the largest potential expenses your estate may have to pay is taxes, which may include federal transfer taxes, state death taxes, and federal income taxes. Federal transfer taxes--The federal transfer taxes include (1) the federal gift tax and federal estate tax and (2) the federal generation-skipping transfer tax (GSTT). • Federal gift tax--Gift tax is imposed on property you transfer to others while you are living. You need a basic understanding of how the gift tax system works to minimize gift tax liability. Under the gift tax system, you are allowed a $1 million lifetime gift tax applicable exclusion amount that reduces your gift tax liability (any gift tax applicable exclusion amount you use during life effectively reduces the applicable exclusion amount that will be available at your death). Also, you are currently allowed to give $13,000 per donee gift tax free under the annual gift tax exclusion. Further, certain other types of transfers can be made gift tax free. You need to understand what these types of transfer are and how they work to take full advantage of them.
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• Federal estate tax--Generally speaking, estate tax is imposed on property you transfer to others at the time of your death. You need a basic understanding of how the estate tax system works for several reasons:Saving your property for your beneficiaries--Estate tax rates could reach as high as 55 percent in 2011, which means that an enormous chunk of your estate may go to the federal government instead of your beneficiaries. If you want to preserve your estate for your beneficiaries, you'll need to know how to minimize estate tax with respect to your property. • Reducing estate tax liability--Under the estate tax system, you are allowed an applicable exclusion amount (formerly referred to as the unified credit) that reduces your estate tax liability. Also, there are exclusions, deductions, and other credits available that allow you to pass a certain amount of your estate tax free. You need to understand what these exclusions, deductions, and credits are and how they work to take full advantage of them. • Providing for the payment of estate tax--Generally, estate tax must be paid within nine months after your death. To avoid depriving your beneficiaries of what you intend for them to receive, you should provide that specific and sufficient assets be set aside and used for this purpose. In addition, these assets should be sufficiently liquid to pay these expenses when they are due. • Planning for estate tax expense--Although calculating estate tax can be complex, you should estimate what the amount of your estate tax may be (if any), so that you can arrange to replace that wealth. • GSTT--Another federal transfer you need to understand is the federal generation-skipping transfer tax (GSTT). The GSTT is imposed on property you transfer to an individual who is two or more generations below you (e.g., a grandchild or great-nephew). Not surprisingly, the IRS wants to levy a tax on property as it is passed from generation to generation at each and every level. The purpose of the GSTT is to keep individuals from avoiding estate tax by skipping an intermediate generation. A flat tax rate equal to the highest estate tax then in effect is imposed on every generation-skipping transfer you make over a certain amount. Currently, some states also impose their own GSTT. Check with an attorney or your state to find out what may be subject to your state's GSTT, and how and when to file a state GSTT return. State death taxes--States also impose their own death taxes. You should be aware of what the death tax laws are in your state and how they may affect your estate. There are three types of state death taxes: (1) estate tax, (2) inheritance tax, and (3) credit estate tax (also called a sponge tax or pickup tax). Some states also impose their own gift tax and/or generation skipping transfer tax. • Estate tax--State estate tax is imposed on property you transfer to others at your death, much like federal estate tax. The state estate tax calculation for most states is similar to the federal calculation. • Inheritance tax--Unlike estate tax, the inheritance tax is imposed on your beneficiary's right to receive your property. Tax is due on each beneficiary's share of your estate. Beneficiaries are grouped into classes (generally based upon their familial relationship to you) and are taxed accordingly. Although inheritance tax is due on each heir's share of your estate, it's your personal representative who writes the check from your estate to pay it. • Credit estate tax--Some states impose a credit estate tax (also referred to as a sponge tax or pickup tax). Tip: Most states that imposed a credit estate tax have "decoupled" from the federal system (i.e., they're imposing some form of stand-alone estate tax.) Tip: The federal system allows a deduction for state death taxes for the estates of persons dying in 2005 through 2009. Prior to 2005, a credit was available, which will be reinstated in 2011. Federal income taxes--In the estate planning context, you should be aware of three federal income tax considerations: 1. Income taxation of trusts --If your estate plan includes the use of a trust, you need to know that a trust may be an income tax-paying entity. The trustee may be required to file an annual return and
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pay income taxes on trust income. 2. Decedent's final income tax return --Your personal representative or surviving spouse has the duty of filing your last income tax return that covers the tax year ending on the date of your death. 3. Income taxation of your estate --Your estate is considered a separate income taxpaying entity. Your personal representative must file and pay income taxes on any income your estate receives (e.g., interest from bonds, or dividends from stock). Probate Probate is the court-supervised process of proving, allowing, and administering your will. The probate process can be time-consuming, expensive, and open to public scrutiny. Avoiding probate may be one of your most important goals. To develop a successful avoidance strategy, you'll need to understand how the probate process works, how to estimate probate costs, and what is subject to probate. Liquidity Estate liquidity refers to the ability of your estate to pay taxes and other costs that arise after your death from cash and cash alternatives. If your property is mostly nonliquid (e.g., real estate, business interests), your estate may be forced to sell assets to meet its obligations as they become due. This could result in an economic loss, or your family selling assets that you intended for them to keep. Therefore, planning for estate liquidity should be one of your most important estate planning objectives. Incapacity Planning for incapacity is a vital yet often overlooked aspect of estate planning. Who will manage your property and make health-care decisions for you when you can no longer handle these responsibilities? You need to ask and answer this question because the consequences of being unprepared may have a devastating effect on your estate and loved ones. You should include plans for incapacity as a part of your overall estate plan.
What are your goals and objectives? Your goals and objectives are personal, but you can't formulate a successful plan without a clear and precise understanding of what they are. They can be based on your particular circumstances and the factors that may affect your estate, as discussed earlier, but your feelings and desires are just as important. The following are some goals and objectives you might consider: • Provide financial security for your family • Ensure that your property is preserved and passed on to your beneficiaries • Avoid disputes among family members, business owners, or with third parties (such as the IRS) • Provide for your children's or grandchildren's education • Provide for your favorite charity • Maintain control over or ensure the competent management of your property in case of incapacity • Minimize estate taxes and other costs • Avoid probate • Provide adequate liquidity for the settlement of your estate • Transfer ownership of your business to your beneficiaries
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What are estate planning strategies? An estate planning strategy is any method that facilitates the distribution of your assets and the settlement of your estate according to your wishes. There are several estate planning strategies available to you. Intestate succession Intestate succession is a strategy by default and is a means of transferring your property to your heirs if you have failed to make other plans such as a will or trust. State law controls how and to whom your property is distributed, who administers your estate, and who takes care of your minor children. Without directions, your opinions and feelings are not considered. Indeed, one of your primary goals in planning your estate may be to avoid intestate succession. Last will and testament A will is a legal document that lets you state how you want your property distributed after you die, who shall administer your estate, and who will care for your minor children. This is probably the most important tool available to you. Anyone with property or minor children should have a will. Will substitutes A will substitute, for example, Totten Trust and payable on death bank accounts, allows you to designate a beneficiary of certain property that will automatically pass to that beneficiary after you die and avoids passing through probate. Trusts A trust is a separate legal entity that holds your assets that are then used for the benefit of one or more people (e.g., you, your spouse, or your children). There are different types of trusts, each serving a different purpose, and include marital trusts and charitable trusts. You will need an attorney to create a trust. Joint ownership Joint ownership is holding property in concert with one or more persons or entities. There are different types of joint ownership, such as tenancy in common and community property, each with different legal definitions, requirements, and consequences. Life insurance Life insurance is a contract under which proceeds are paid to a designated beneficiary at your death. Life insurance plays a part in most estate plans. Gifts A gift is a transfer of property, not a bona fide sale, that you make during your life to family, friends, or charity. Making gifts can be personally gratifying as well as an effective estate planning tool. Tax exclusions, deductions, and credits There are several important estate planning tools you can use that are offered by the federal government. These include the annual gift tax exclusion, the applicable exclusion amount, the unlimited marital deduction, split gifts, and the charitable deduction.
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Selecting a Trustee What is it? In general A trustee is a person (or institution) selected to administer a trust. A trustee's role is to adhere to the terms of the trust document and fulfill its objectives. A trustee can be an individual (professional or nonprofessional) or a corporate trustee, such as a bank or trust company. You, as the grantor, should choose a trustee carefully because an inappropriate choice could invalidate the trust and have serious tax consequences. You must also weigh many other personal, family, business, investment, and nontax concerns. For a large or complicated trust, a combination of individual and corporate trustees may best provide the expertise needed to manage the trust with the flexibility to respond to beneficiaries' changing needs. Trust administration Trust administration is the area of law that defines a trustee's duties, powers, and liabilities in relation to the beneficiaries. A trustee has specific duties. The scope of a trustee's powers depends on the extent of those duties. Because the trustee is personally liable for breaches of duty, the extent of a trustee's duties also determines his or her liability.
Selecting a trustee Eligibility and tax considerations As the trust's grantor (the person establishing the trust), you can name any of the following as a trustee: yourself, your spouse, family, friends, the beneficiaries, business associates, professional advisors, a bank, or a trust company. Caution: However, you must investigate carefully before appointing a trustee because the tax consequences can vary widely, depending on whom you name. If the trustee you appoint doesn't meet state trust law requirements, the trust will be invalid and provide none of the intended tax benefits. There are a number of situations in which it's inadvisable to appoint yourself or a beneficiary as trustee: • A sole beneficiary cannot be sole trustee--According to state trust law requirements, if the sole beneficiary is the sole trustee, the trust is invalid. A beneficiary can be a trustee only if there are other beneficiaries and/or other trustees. Example(s): If Sue sets up a trust with herself as the sole beneficiary, her trust is invalid if she is also the sole trustee. This is not because she can't be both grantor and trustee. It's because she can't be both sole beneficiary and sole trustee. However, if she appoints Dan, her tax attorney, as cotrustee, or she if adds her niece, Jessie, as another beneficiary, her trust may be valid. • Testamentary trusts --It's inadvisable to name a beneficiary as the trustee of a testamentary trust. If the trust document is drafted with the sole beneficiary as the sole trustee, the trust could be invalidated and the IRS could include the assets in the beneficiaries' gross estates for estate tax purposes. Example(s): Glenn appoints his spouse, Anna, as the sole trustee of a trust intended to avoid estate taxes at her death. If the trust is not properly drafted, the IRS could include the trust in Anna's gross estate because she cannot be both sole trustee and sole beneficiary. • Irrevocable trusts --If your primary purpose in setting up an irrevocable trust is to avoid federal and
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state income, estate, or generation-skipping transfer taxes , you should select an independent trustee. You could appoint yourself, but only in certain restricted circumstances and with severely diminished powers. Otherwise, you face the risk that the IRS could include the trust assets in your gross estate. Example(s): Mrs. Dickinson, a widow, sets up an irrevocable trust for her child, and names herself as trustee. If she dies, the IRS could include the trust assets in her gross estate, even though the trust was irrevocable. • Revocable trusts --For tax purposes, it doesn't matter who you name as trustee. You'll be taxed on the income regardless of whether the trustee is you, your spouse, your family member, your friend, a beneficiary, a business associate, a professional, or a bank or trust company. Other considerations A trustee's responsibilities often span at least one generation and may extend beyond two or three. This should have a significant impact on your choice of trustee or on your decision to appoint cotrustees or successor trustees. You must also weigh and consider many other personal, family, business, investment, and nontax factors. For example, does your candidate possess the necessary investment, accounting, and tax planning expertise? On the other hand, does he or she know the beneficiaries and will he or she be sensitive to their changing needs? Combining professionals and nonprofessionals as cotrustees Combining a professional and a nonprofessional as cotrustees can provide the longevity the role requires, protect against possible adverse tax consequences, and balance the specialized knowledge of a professional trustee with the personal touch of a family member or trusted friend. If your estate is large or the trust provisions complex, you should consider selecting one or more professional trustees. Laws and trust provisions govern trustee's conduct State laws govern a trustee's conduct. However, you can modify the effect of these laws to some extent through appropriate provisions in the trust document.
What are the duties of a trustee? In general A trustee has many specific duties to fulfill, including the duty to preserve, protect, and invest the trust assets. Some of the more important duties follow. However, keep in mind that as a grantor you may modify the trustee's duties to some extent through appropriate provisions in the trust document. Duty of loyalty The most basic duty of a trustee is that of loyalty to the beneficiaries. This duty needn't be specified in the trust document. It arises out of the fiduciary relationship between the trustee and the beneficiaries. This requires the trustee to administer the trust solely in the interests of the beneficiaries. In case of conflict of interest between the trustee and the beneficiaries, the trustee must resolve the conflict in favor of the beneficiaries, since this is the purpose of the trust. Duty to keep and render accounts A trustee must keep clear and accurate records of income, expenses, and investment gains and losses. These records are necessary for filing the annual fiduciary income tax return. Additionally, the trustee has a personal stake in maintaining accurate records. First, he or she is personally liable for costs that arise due to incomplete or inaccurate records. Second, the court can deny or decrease the trustee's pay or remove him or her from office. Third, beneficiaries may, within reason, compel a financial accounting.
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Duty not to delegate A trustee may not delegate the administration of the trust or the performance of his or her duties to others, unless the terms of the trust allow it. On the other hand, in areas where the trustee does not possess specialized knowledge or skill, it would be prudent for the trustee to employ professionals, such as accountants, appraisers, attorneys, bankers, and brokers. No hard and fast rules exist about this. Individual circumstances must dictate the appropriate actions. Duty to keep trust property separate A trustee commits a breach of trust if he or she commingles trust assets with his or her personal assets, even if the commingling provides him or her with no benefit. This rule makes trust assets easier to trace, prevents them from being seized by the trustee's personal creditors, and makes them less subject to waste. Even if the trustee doesn't commingle trust assets, he or she commits a breach of trust if he or she takes title to the assets. Trust assets must belong to the trust. Otherwise, the trustee could claim that profitable investments were his or her property, while unprofitable investments belonged to the trust. Duty to exercise reasonable care and skill A trustee must exercise reasonable skill and care in administering the trust. The trustee's actions must meet the prudent person standard, meaning he or she must administer trust assets with the same degree of skill and care that a person of ordinary prudence would use in managing his or her own personal assets. Thus, a trustee can be liable for mismanaging trust assets if his or her actions fail to measure up to the prudent person standard. Duty regarding investment A trustee must satisfy the prudent person standard when investing trust assets. He or she must consider both the safety of the capital as well as the likelihood of income. The trustee is not required to invest the funds for capital appreciation. Rather, his or her main responsibility is to conserve the original trust assets and invest them to yield a reasonable income. On the other hand, the trustee is not required to invest in the most conservative investments, such as government bonds. If another investment prudently yields a higher return, the trustee may purchase it. The trustee's goal should be to preserve the assets to carry out the objectives of the trust.
What are the powers of a trustee? In general Since a trustee's duties and powers are interrelated, the scope of a trustee's powers depends on the extent of his or her duties. A trustee's privileged powers are those he or she can exercise without violating a duty to the beneficiaries. A combination of state law and trust provisions grant powers to the trustee. Although a power may not be specifically granted, it may be implied from the trust terms. As the grantor, you can expressly confer a power through a provision in the trust agreement. Likewise, you can prohibit a trustee from exercising a specific power. Power to incur expenses A trustee may incur expenses that are reasonable, necessary, and appropriate to preserve trust assets. Power of sale A trustee may sell trust assets to pay debts, administration expenses, and taxes. The terms of the trust dictate the scope of this power. For example, salable assets may include real estate unless the trust agreement prevents it. If the terms of the trust were unclear, or if a required sale of assets would defeat or hamper the trust's objectives, the trustee must obtain court approval to deviate from the terms of the trust.
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Power to mortgage or lease A trustee may mortgage trust property or pledge it as collateral for a loan if a statute or the terms of the trust specifically allows it. Otherwise, the trustee may not mortgage or pledge the property since this could result in its loss. A trustee, however, usually may lease trust property unless the trust agreement specifically forbids it. This is because the trustee has a duty to make the property productive. If the trust contains land, the principal way of making land productive is by leasing it. Power to continue a business A court may allow a trustee to operate a business if its sale would cause a loss to the trust. Under some circumstances, a trustee may continue business operations for a brief period of time without court approval in order to sell the business as a going concern. Otherwise, a trustee may not carry on the operations of an active business unless the trust agreement specifically allows it. In fact, the trustee has a duty to dispose of the business and invest the proceeds in appropriate investments.
What are the liabilities of a trustee? In general If a trustee intentionally or negligently violates a duty to the beneficiaries or misuses a power, he or she commits a breach of trust. The extent of a trustee's liability depends on the scope of his or her duties and powers. If a breach of trust causes a loss or depreciation in the value of the trust assets, the trustee is personally liable for the amount of the loss. Likewise, if a breach of trust results in a gain, the trustee must return any profit to the trust.
What is a trust protector? A trust protector is an individual, committee, or entity named in a trust document that is given power over the trustee and authority to make major changes to the trust document. A trust protector does not manage the day-to-day administration of the trust; that is the job of the trustee. The purpose of a trust protector is to give flexibility to an irrevocable trust, and to have a check and balance against trustee failures and abuse. Typically, a trust protector can amend provisions in the trust document in order to address legal and tax law changes, changes in the circumstances of the beneficiaries, or any other possible future circumstance. A trust protector can also act as a liaison between the trustee and the beneficiaries, helping to resolve any disputes that may arise. There is no set list of powers that can be given to a trust protector. The grantor must anticipate which powers might be necessary in order to carry out his or her intentions and the objectives of the trust. Those powers (and limitations) should be carefully defined in the trust document (or separate letter, if a trust protector is named after the trust has been created). Additionally, the grantor should provide some guidance to the trust protector regarding what is expected of him or her. The powers given to a trust protector can be limited or broad. For example, a trust protector can be given the authority to oversee, direct, remove, add, or replace the trustee, or expand or limit the trustee's powers. A trust protector can also be given the power to add or delete beneficiaries, increase or decrease the interests of any beneficiaries, veto or direct trust distributions, regulate trust investments, change the trust situs or governing law, or even terminate the trust. The grantor, however, should list only those powers that will further the trust's purpose, and resist an all-inclusive listing, which may cause friction between the trust protector and the trustee, or result in undesirable legal or tax consequences. As the name implies, a trust protector is meant to be a safety measure, giving the grantor peace of mind. A grantor may want to name a trust protector if he or she:
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• Is concerned that the trustee will fail to exercise his or her duties in a satisfactory manner • Would like to withhold certain powers from the trustee • Would like a neutral third party to act as moderator between the trustee and the beneficiaries
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Personal Liability Insurance What is it? Personal liability insurance protects your assets if you injure another person or damage someone else's property. It's known as third-party insurance because it protects you if a third party files a claim against you. If you are found legally responsible for causing an injury or property damage, your personal liability insurance will provide a legal defense, if necessary, and pay the claim up to the limits of the policy. Personal liability insurance can be purchased as part of a package policy (such as a homeowners or automobile insurance policy) or as a separate policy (such as a personal umbrella liability policy).
Determining your need for personal liability insurance Do you need personal liability insurance? Some people mistakenly believe that personal liability insurance is necessary only if you are wealthy (and more likely to be sued because you have more assets than most people) or if you are reckless. However, accidents can happen anywhere or to anyone. You may, for instance, hit a bicyclist or accidentally spill hot coffee on your neighbor's arm. Your cat may scratch your neighbor's car or your friend may fall down your icy stairs. No matter how careful you are, you may one day be sued because you injured someone or damaged someone's property. Although you can't avoid all accidents, you can transfer some of the financial risk you face to an insurance company by buying personal liability coverage. Tip: Liability coverage under your policy may extend to your relatives as well. For instance, your father may be covered if he drives your car and injures another driver. Or, if your child accidentally breaks your neighbor's window, your policy may pay the damages resulting from the claim. Check your liability policy to determine how it defines a relative because the definition varies from policy to policy. How much personal liability coverage do you need? You probably need more liability coverage than you think you do, even if you have few assets to protect. Lawsuits and claims are being filed more frequently than in the past, and the cost of defending yourself may be high. If you have no liability insurance, you will likely have to pay the entire cost out of pocket. If you do have liability insurance, your insurance company might settle out of court because in a major suit, your insurer's legal fees can exceed your policy's liability limit. In addition, juries frequently award damages that exceed the actual monetary amount of damage done. They award money for pain and suffering, mental anguish, and punitive damages. Even if you have liability insurance, you may find yourself owing money if court-ordered damages against you exceed the liability limits of your policy. If you don't have the money to pay damages now, your future earnings and assets may be subject to liens and/or garnishment. Because there's no optimum amount for every individual, how much personal liability coverage you need depends partly on your tolerance for risk. Can you afford to pay the cost of a claim out of pocket or would even a small claim threaten your finances? If you already have liability coverage, take a look at your current policy. Determine whether your liability limits are high enough, or if there are any coverage gaps you'd like to fill (see below for more information on coverage under typical personal liability policies). For more information on purchasing personal liability insurance, see Evaluating, Comparing, Replacing, and Conserving Personal Liability Insurance Policies.
Basic liability protection under a homeowners or automobile insurance policy
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If you own a homeowners or automobile insurance policy or another type of property insurance (e.g., mobile home insurance or renter's insurance), you have basic liability coverage. These policies will protect you against many liability claims. Your insurance company will defend or settle claims and lawsuits brought against you and pay the sum owed for covered damages (bodily injury or property damage) up to the liability limits of the policy (usually $100,000 to $300,000 per occurrence). No deductible applies. If you want maximum liability coverage or if you want broader coverage, consider purchasing a personal umbrella liability policy (see below). Tip: Bodily injury and property damage liability insurance for automobile owners is often mandatory under state law, although a few states don't require you to carry even basic automobile insurance. When required, mandatory minimum liability limits are usually low ($40,000 per accident is common). Bodily injury and property damage liability insurance for automobile owners is usually sold with split limits (e.g., $100,000/$300,000/$50,000), which means that your policy provides coverage up to $100,000 for any one person you injure, $300,000 for all the people you injure, and up to $50,000 for property damage. For more information, see Automobile Insurance: Part A Liability Coverage. For more information on other types of basic and comprehensive liability policies, see Personal Liability Insurance Policy Types.
Comprehensive personal liability insurance coverage under a personal umbrella liability policy What is a personal umbrella liability policy? A personal umbrella liability policy supplements the basic liability protection you already have by insuring you against large losses or losses not covered under your other personal liability policies. Although an umbrella policy is often added to an existing homeowners or automobile policy, it can also be purchased as a stand-alone policy from a different insurer. In either case, your insurer will ordinarily require you to carry basic liability insurance with certain minimum limits. Example(s): Before his insurance company would issue him a $1 million umbrella policy, Hal had to raise his homeowners insurance liability limit to $100,000 and his automobile insurance liability limit to $100,000/$300,000/$50,000. Higher liability limits than basic liability coverage One reason to purchase a personal umbrella liability policy is that it will provide you with a higher amount of liability coverage than a basic liability policy. Umbrella liability policies are normally issued with a liability limit of $1 million per occurrence. However, the umbrella policy may pay numerous claims of $1 million each per policy period, so your actual protection may be more. Some companies set limits, however, on how much can be paid out during the policy period or over a lifetime. A common limit is $10 million. Since an umbrella liability policy is issued in conjunction with basic liability coverage, your total liability protection will be the combined limits of each policy. For instance, if you have an auto policy with a liability limit of $100,000 and a $1 million umbrella liability policy, then your total liability protection will be $1,100,000. Broader coverage than other types of liability insurance An umbrella liability policy will protect you from losses not covered under basic liability insurance. It covers you against damages for unusual occurrences, including personal injury losses due to libel, slander, wrongful eviction, false arrest, and invasion of privacy. Your umbrella liability policy might also pay for damages incurred worldwide. In addition, an umbrella policy might pay a proportionate share of a claim even if your basic liability insurance policy cannot pay its portion, either because you failed to comply with the conditions of the policy or because the company itself has become insolvent.
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Claims are paid under an umbrella policy only after basic liability coverage is exhausted or unavailable If you have purchased an umbrella liability policy, it will pay a claim in one of two main ways after you have satisfied a deductible: • If you are found legally responsible for injuring someone or for damaging property, your umbrella policy will pay that part of the claim in excess of the liability limits under your basic liability coverage Example(s): Hal purchased a homeowners insurance policy (with liability coverage of $100,000) and a $1 million umbrella liability policy. When Hal's swimming pool sprang a leak and caused $25,000 worth of damage to his neighbor's yard, Hal's homeowners insurance paid the total claim. However, when Hal was sued after a rotting oak tree on his property toppled and injured his neighbor's daughter, his homeowners liability coverage paid only the first $100,000 in damages (the liability limit on his policy). The remaining $900,000 of the court-ordered settlement was paid by Hal's umbrella liability policy. • Your umbrella liability policy will pay total damages for bodily injury and liability if the liability exposure is not covered under your basic liability coverage but is covered under your umbrella policy Example(s): Hal borrowed his brother's lawnmower and ran over his neighbor's deaf cat that was napping in the yard. Because the damage was caused by nonowned property in Hal's care (which is specifically excluded from his homeowners policy liability coverage), Hal's personal liability umbrella policy paid the $1,500 veterinary bill. Caution: Although a personal umbrella liability policy is sometimes called excess personal liability insurance, it is really not the same thing. Excess liability insurance typically provides additional coverage only if the basic policy provides coverage as well, whereas an umbrella liability policy will provide coverage that is sometimes different than that provided under the basic liability policy.
What personal liability insurance does not cover Although a personal umbrella liability policy covers more types of hazards than basic personal liability policies, no personal liability insurance policy will protect you against every loss you might face. All types of personal liability insurance generally exclude the following: • Claims stemming from the insured's business or profession (some types of business activities may be covered under a homeowners or automobile policy, so check your policy) • Claims resulting from the insured acting intentionally to cause injury or damage • Damage to property owned by the insured Other common exclusions under a homeowners policy are damage caused by communicable diseases and acts of war. An automobile policy might exclude accidents and losses that occur overseas or while a vehicle is in transport. Umbrella policies often exclude liability losses related to aircraft, damages caused by watercraft not covered under your homeowners policy, or injuries suffered by someone covered by workers' compensation. For information on liability insurance for business owners, see Business Liability Insurance.
Questions & Answers Can anyone purchase a personal umbrella liability policy? No. It's the underwriter's job to determine who may purchase a personal umbrella liability policy. Once an individual has applied for the policy, the underwriter will evaluate the application and may reject applicants who pose an undue risk to the company. For instance, broadcasters may be denied coverage because they face a high risk of claims alleging personal injury. Politicians and actors may be denied coverage because their jobs
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expose them to publicity. Individuals whose property poses a hazard (such as someone who owns an unfenced swimming pool) may also be denied coverage. Is a personal umbrella liability policy expensive? Not for the coverage it offers. An umbrella liability policy will generally cost between $150 to $300 per year and will significantly expand liability coverage (typically $500,000 to $1 million of coverage). However, you may also pay more for your homeowners or automobile coverage if you are required to increase your policy limits.
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Capital Gains Tax What is capital gains tax? Capital gains tax is imposed on gains realized from the sale of capital assets such as a home, investments, and business interests. Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act) and the Tax Increase Prevention and Reconciliation Act of 2005 (2005 Tax Act), certain dividends are also taxed at capital gains tax rates. Generally, capital gains tax rates are lower than the rates applied to ordinary income.
Capital gains tax on sale or exchange of capital assets If you sell or exchange a capital asset for more than its basis (cost), the profit is a capital gain. If you sell or exchange a capital asset at a loss, you can use the loss to offset capital gains (subject to the netting rules, discussed below). If your capital losses exceed your gains, you can offset a certain amount of ordinary income and/or carry the loss forward into future tax years. The tax rate that will apply to the sale or exchange of a capital asset depends on a number of factors including the type of asset, how long you owned (held) the asset, and your marginal tax bracket. Tip: Under the homesale exclusion, gain on the sale of your principal residence (up to certain limits) can be excluded from income, as long as certain conditions are met. Holding period Holding period refers to the length of time you held a capital asset before selling or exchanging it. A gain is classified as short-term if you held the asset for a year or less before selling it, and long-term if the asset was held for longer than a year. This distinction is important because net short-term capital gains are taxed at ordinary income rates, whereas long-term capital gains are taxed at the more favorable long-term capital gains tax rates. Further, assets held for more than five years may qualify for a special capital gains tax rate. How do capital gains tax rates differ from ordinary income tax rates? Capital gain income is generally preferable to ordinary income. Currently, the highest marginal income tax rate is 35 percent, while long-term capital gains tax rates vary from 5 percent to 28 percent, depending on the asset and your marginal tax rate. Generally, current long-term capital gains tax rates can be grouped as follows: • 28 percent for collectibles and small business stock • 25 percent for unrecaptured Section 1250 Gain • 15 percent for sales or exchanges made on or after May 6, 2003 for taxpayers in marginal tax brackets higher than 15 percent (for assets that do not fall within the 28 percent or 25 percent groups) • 0 percent for sales or exchanges made in tax years 2008 through 2010 for taxpayers in marginal tax brackets of 15 percent or 10 percent (for assets that do not fall within the 28 percent or 25 percent groups)
If your capital gain in a given year pushes you into a higher tax bracket, which capital gain rate do you use? Suppose you are normally in the 15 percent marginal tax bracket, but in December of this year, you sell an asset held for two years and realize a substantial long-term capital gain. Will the full capital gain be untaxed because of the 0 percent rate? Maybe not. If your capital gain pushes you into a higher tax bracket, you can use a preferred
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capital gains tax rate of 0 percent on a portion of the capital gain only. The remainder of your capital gain will be taxed at the higher 15 percent rate. Example(s): Assume John is single and he's normally in the 15 percent tax bracket. In fact, his ordinary income this year falls short of the 25 percent tax bracket by $10,000. However, John sells an asset in December of this year and realizes a long-term capital gain of $40,000. The first $10,000 of his capital gain will not be taxed because of the 0 percent rate, and the remaining $30,000 will be taxed at 15 percent.
What are the netting rules? In order to properly compute your capital gains tax, you should be aware of the manner in which capital gains and losses may offset one another. These rules are known as the "netting rules." Generally speaking, the tax code prescribes that short-term capital gains and losses must be netted against each other first. Next, long-term capital gains and losses are netted against one another according to a set of ordering rules. Finally, net short-term gains or losses must be netted against net long-term gains or losses in a prescribed manner. The ordering rules apply if you have long-term capital gains that are subject to different rates of tax. With respect to long-term capital gains and losses, the following rules apply: • Long-term gains and losses are first grouped by tax rate (28 percent group, 25 percent group, and (for taxpayers in marginal brackets over 15 percent) 15 percent group). • Losses for each long-term tax rate group are used to offset gains within the group, resulting in a net long-term gain or loss for each group. • If a net short-term capital loss exists, it reduces net long-term gain from the 28 percent group first, then from the 25 percent group, and finally from the15 percent group. • A net loss from the 28 percent group is used first to reduce gain from the 25 percent group, then to reduce net gain from the 15 percent group. And a net loss from the 15 percent group is used first to reduce net gain from the 28 percent group and then to reduce gain from the 25 percent group. • Any remaining net capital gain in a particular rate group is taxed at that group's marginal rate. Example(s): Assume Hal is in the top marginal tax bracket and has a short-term capital loss of $20,000. He has $5,000 worth of long-term gains on collectibles (the 28 percent group.) He also has a Section 1250 gain of $15,000 (25 percent group), and $25,000 worth of long-term gain from the sale of stock (15 percent group). Hal's net capital gain is $25,000 (total gain of $45,000 $20,000 short-term loss). His short-term loss completely offsets the $5,000 of collectibles gains and the Section 1250 gain of $15,000. Thus, Hal ends up with $25,000 worth of long-term capital gains, taxed at 15 percent. Net capital losses Capital losses are netted against capital gains. Up to $3,000 of excess capital losses is deductible against ordinary income each year. Unused net capital losses are carried forward indefinitely and may offset capital gains, plus up to $3,000 of ordinary income during each subsequent year. (The $3,000 limit is reduced to $1,500 for married persons filing separately.) Example(s): Assume Jane has a short-term capital gain of $1,200 and a short-term capital loss of $1,300, resulting in a net short-term capital loss of $100. She also has a net long-term capital gain of $600 and a net long-term capital loss of $4,200, resulting in a net long-term capital loss of $3,600. The excess of Jane's capital losses over capital gains is $3,700 ($100 + $3,600). This excess is deductible from ordinary income up to a maximum of $3,000 this year; the remainder may be carried over to future years.
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How do you use the capital gains tax to lower your taxes? Time your capital gain recognition Careful planning may save you taxes. For example, you may be able to wait until next year before selling a capital asset so that your capital gain or loss is recognized when you may be in a lower tax bracket. Timing is important because capital gains increase your adjusted gross income (AGI). For the 2009 tax year, if you file married filing separately and your AGI is more than $83,400, or if you use any other filing status and your AGI is more than $166,800, some of your itemized deductions may be phased out or disallowed (there is no itemized deduction phaseout for tax year 2010). Personal exemption amounts will also be decreased or disallowed if your AGI reaches a specified threshold figure. Plan your year-end capital gain and loss status If you realize a capital gain this year, you should (1) review your portfolio for potential losses, (2) recognize losses to offset your gain, and (3) use $3,000 ($1,500 if married filing separately) worth of losses (if applicable) to offset ordinary income. If you have a capital loss this year (or have a loss carryforward), you should review your portfolio for gains for offset purposes. This may lower your overall tax liability. For property held as an investment, elect to include gain in investment income Taxpayers may elect to treat capital gains from investment property as investment income instead. If such an election is made, gains will be taxed at ordinary rates and can be used to offset investment interest expenses. This may be advantageous for taxpayers who have sufficient capital losses to offset capital gains, and insufficient investment income to offset investment interest expenses (remember that investment interest expenses can only be used to offset investment income, although they can be carried forward and used in future tax years).
Capital gains taxation of dividends Under the 2003 and 2005 Tax Acts, long-term capital gains tax rates also apply to certain dividends received by individual shareholders from domestic and qualified foreign corporations (for taxable years beginning after 2002 and before 2011). Such dividends must be reported on Schedule D along with other capital gains. However, capital losses cannot be used to offset dividend income taxed at long-term capital gains rates. Thus dividends increase net capital gains, but can't be used to reduce net capital gains to less than zero. Many special rules and exclusions apply to the taxation of dividends.
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Investment Tax Planning Introduction Investment planning can be important for several reasons. However, any discussion of investment planning is incomplete without a thorough understanding of the applicable income tax ramifications. Tax planning can help you reduce the tax cost of your investments. Once you've created an investment plan to work toward your various financial goals, you should take advantage of the tax rules to ensure that you maximize the after-tax return on your investments. In other words, your goal is to select tax-favorable investments that are consistent with your overall investment plan. In order to engage in investment tax planning, you need to understand how investments are taxed (including the concepts of capital gain income and ordinary income) and how to compare different investment vehicles. You also need to know how your own tax situation (i.e., your tax bracket, holding period, and tax basis) affects the taxation of your capital assets. Caution: Investment choices should not be based on tax considerations alone, but should be based on several factors including your time horizons and risk tolerance.
How does investment tax planning work? Similar investments may carry substantially different tax costs. It is important to identify the differences and evaluate the costs. Consider the following points: Investment earnings are taxed in different ways A myriad of investment vehicles are available to you. For instance, you can invest in stocks, bonds, mutual funds, money market funds, real estate, commodities, or your own business. Investment earnings are taxed in many different ways. Consequently, some investments earn less after tax than others. By taking advantage of these differences, you may save money. In addition, your tax savings can preserve your investments and, as a result, enhance future investment growth. Investment tax planning can maximize your wealth Tax investment planning involves maximizing the after-tax return on your investments. This is beneficial because the wealth that remains after you pay your taxes is ultimately more important to you than the value of your investments. It's the after-tax payout that enables you to finance a home, a child's education, a vacation, or your retirement. Thus, one goal of investment tax planning is to maximize future wealth. To do so, you need to know a little bit about taxes. In particular, you need to know the following: • How your investments are taxed • The before- and after-tax rates of return on your investments • How to compare investments in light of after-tax return
How are your investments taxed? In order to understand how investments are taxed, you first need to become familiar with the following basic concepts: • Capital gains and losses • Qualified dividends
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• Ordinary (investment) income • Investment expenses • Tax-exempt income • Tax-deferred income Capital gains and losses While you hold a capital asset (e.g., your home, stocks, bonds, mutual funds, real estate, collectibles), you will not pay taxes on any increase in value. However, when you sell or exchange the asset, you will realize a capital gain (if you sell it for a profit) or loss (if you sell for less than the asset's cost). If you sell an asset after only a year or less, you will have a short-term capital gain. Short-term capital gains are taxed at ordinary income tax rates (i.e., your marginal income tax rate). If you own an asset for more than a year before you sell it, you will have a long-term capital gain. Long-term capital gains tax rates are generally more favorable than ordinary income tax rates. Currently, the highest ordinary income tax rate is 35 percent whereas the highest long-term capital gains tax rate (for most assets) is 15 percent (for sales and exchanges on or after may 6, 2003). That's a difference of 20 percent. Thus, holding an asset for long-term growth is a tax-saving strategy. Caution: The Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act) and the Tax Increase Prevention and Reconciliation Act of 2005 (2005 Tax Act) reduced long-term capital gains tax rates for sales and exchanges made on or after May 6, 2003 and before January 1, 2011. These rates are 15 percent for taxpayers in marginal tax brackets higher than 15 percent, and 5 percent (zero percent in 2008-2010) for taxpayers in the 15 percent and 10 percent marginal tax brackets. In 2011, the rates revert to pre-2003 Tax Act levels--20 percent and 10 percent, respectively. Thus, investors may want to time the sale of highly appreciated assets to take advantage of the lower rates. You may offset capital gains with capital losses (short-term losses against short-term gains and long-term losses against long-term gains). If you have more losses than gains in a given year, you may offset up to $3,000 of ordinary income ($1,500 if married filing separately). Any remaining losses can be carried forward into future tax years. Thus, timing losses to offset gains is a tax-saving investment strategy. Tip: You may also elect to include net capital gains from property held for investment as ordinary (investment) income. If you do so, such income will be taxed at ordinary income tax rates, not capital gains tax rates. This may be advantageous if you don't have capital losses, but do have investment interest expenses. Investment interest expense may only be deducted to the extent of investment income (though it can also be carried forward to future years). This election must be specifically made--if you do not make the election, the IRS will classify the income as capital gain income. Capital gain is computed by subtracting the sale price from the asset's basis. Basis is your cost and includes the price you paid for the assets plus the cost of capital improvements. The higher your basis, the smaller your capital gain and the smaller your tax liability. Thus, you should keep careful records of the basis of an asset. This is especially important if you buy shares of stock in the same company at different times and different prices. This will allow you to control the tax consequences by picking particular shares to sell or hold. Tip: If you want to sell an asset now but defer the recognition of the gain until later tax years, you may be able to arrange an installment sale with the buyer (but not for stocks or bonds). That way, you report and pay tax on the income as you receive it. Qualified dividends Qualified dividends are dividends received during the tax year by an individual shareholder from a domestic corporation or a qualified foreign corporation. Under the 2003 and 2005 Tax Acts, effective for tax years 2003 through 2010, such dividends are taxable at the same rates that apply to long-term capital gains. This tax
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treatment applies to both regular tax and the alternative minimum tax. Absent further legislative action, dividend tax rates revert to pre-2003 Tax Act levels (i.e., they will be taxed at ordinary income tax rates) beginning in 2011. Eligible dividends include dividends received directly from a domestic corporation or a qualified foreign corporation as well as qualified dividends passed through to investors by stock mutual funds, other regulated investment companies, partnerships, or real estate investment trusts (REITs). Thus, it may be advantageous to invest in vehicles that pay qualified dividends, especially if you need current income. Distributions from tax-deferred vehicles, such as IRAs, retirement plans, annuities, and Coverdell education savings plans, do not qualify even if the funds represent dividends from stock. Thus, holding investments that pay qualified dividends within a tax-deferred plan may no longer be desirable. Tip: Though qualified dividends are taxed at long-term capital gains tax rates, they cannot be offset by capital losses. However, as with capital gains, you can elect to include these dividends in investment income. If you do so, such income will be taxed at ordinary income tax rates, not capital gains tax rates. This may be advantageous if you have investment interest expenses in excess of investment income. Investment interest expense may only be deducted to the extent of investment income (though it can also be carried forward to future years). This election must be specifically made--if you do not make the election, the IRS will classify the income as net capital gain. Ordinary (investment) income Ordinary investment income consists of any investment income that is not capital gain income, qualified dividends, or tax-exempt income, and is taxed at ordinary income tax rates. Investment income is generated by investment property such as bonds and bond mutual funds. Examples of ordinary investment income include interest and dividends that are actually interest (and therefore don't qualify for taxation at long-term capital gains tax rates). Generally, ordinary income tax treatment is not as favorable as long-term capital gains tax treatment. Investment expenses If you borrow money to buy investment property, you probably pay investment interest. Investment interest may be used to offset investment income only. Excess investment interest may be carried forward to future years. Other investment expenses (e.g., commissions, fees) are deductible as an itemized deduction on Schedule A and are subject to the 2 percent limit. Passive income and losses A passive activity is an investment in a business in which you are not an active participant. Rental real estate and limited partnerships are two common examples. Income generated by a passive activity and gain from the sale or exchange of a passive activity is included in passive income and taxed at ordinary income tax rates. Generally, losses from passive activities may offset income from passive activities only--they cannot be used to offset ordinary income or capital gain income. However, excess losses in a given year can be carried forward into future tax years. Tax-exempt income There are a number of tax-exempt investment vehicles. One of the more common vehicles is the municipal bond. Usually, interest paid on municipal bonds is not subject to federal or state tax (at least not in the state of issue). When deciding whether to invest in taxable bonds or tax-exempt bonds, it is important to compare the after-tax rate of return on municipals with that on taxable bonds with similar risk. Caution: While the interest on municipal bonds is tax exempt, capital gains tax may be imposed when you sell the bonds. Caution: The interest on U.S. Government bonds is not exempt from federal income tax. However, the interest on federal securities is tax exempt at the state level.
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Tip: Roth IRAs, although technically vehicles for holding investments and not truly investments themselves, should be discussed under the heading of tax-exempt income. A Roth IRA is a vehicle in which you can invest a limited amount of money each year for retirement and certain other limited purposes (assuming that you satisfy certain criteria including adjusted gross income (AGI) limits). The income and gains on the account are not taxed at all as long as you follow all applicable rules. Be aware, though, that if all applicable rules are not followed, withdrawals will not only be subject to tax, they may also be subject to a penalty. Tax-free growth is clearly one of the most powerful investment tools available for creating wealth. However, you must use after-tax dollars to make the initial investment and subsequent contributions. No IRA deduction is allowed for contributions to Roth IRAs. Tax-deferred income Tax-deferred investments produce earnings that are not taxed until withdrawn. These earnings are reinvested and continue to fuel investment growth. This is one of the most powerful investment tools available. First, there is a time-value of money advantage. The longer you can keep the money in your own pocket and out of the hands of the IRS, the greater the potential benefit will be to you. Second, since our income tax rates are progressive, you may find yourself in a lower tax bracket in the year the earnings are finally taxed. If so, the actual amount of tax paid on those investment earnings will be less. On the other hand, if you find yourself in a higher tax bracket in the year the earnings are finally taxed, the amount of tax paid on the earnings will be higher (assuming all else is equal). Caution: Many retirement vehicles are designed to provide tax-deferred growth. The downside of this benefit is that all distributions from the retirement plan are taxed at ordinary income rates rather than at capital gains rates. This can result in potentially higher taxation in light of the progressively higher ordinary income tax rates.
What are before- and after-tax rates of return? To compare investments, you must understand before- and after-tax rates of return. Ultimately, you want to compare the after-tax rate of returns of similar investments. The rate of return is the ratio of the annual amount an investment earns compared to the cost of the investment. Thus, if an investment cost you $10 and earned $1, the rate of return is 10 percent. Before-tax rate of return The before-tax rate of return is the annual market-rate of return. For example, a $10 bond that pays $1 per year in interest and is sold for $10 earns a 10 percent before-tax rate of return. After-tax rate of return The after-tax rate of return is the ratio of the after-tax income and gain to the amount invested. With the exception of tax-free investments, this rate is always lower than the before-tax or market rate of return. What do you need to know to compute the after-tax rate of return? Generally, you need to know the following: • What is the tax treatment of your investments (ordinary income, capital gains, tax exempt, tax deferred)? • What is your tax situation (your marginal tax rate, your holding periods, whether you've invested in tax-deferred retirement accounts)?
How do you comparison shop for investments? Comparison shopping for investments allows you to compare the after-tax return on two similar investments. In order to effectively make this assessment, you must consider two other issues: • Tax classification of the investment
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• Your tax situation Tax treatment of the investment You need to know whether the investment vehicle generates capital gains, ordinary income, tax-free, or tax-deferred income. There are two components to the after-tax rate of return: the portion attributable to earnings (such as interest) and the amount derived from a subsequent sale. You also need to know whether any capital gains will be treated as long-term or short-term capital gains. Special rules can apply to certain kinds of investments such as wash sales, qualifying small business stock, short sales, installment sales, like-kind exchanges, and others. In addition, you may wish to know about market discount rules, anti-conversion rules, and tax shelters. Your tax treatment Your investment tax situation depends on several factors. In particular, you'll need to know the adjusted tax basis of your capital assets, the sale price of the assets, the holding period, the amount of the capital gain or loss, the amount of your ordinary investment income or losses, and your marginal tax bracket.
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Major Asset Classes When determining how to diversify an investment portfolio, you should consider the variety of broad types, or classes, of investments that are available. Listed below are the general asset classes most frequently considered when designing a portfolio.
Cash • Bank accounts, money market funds, CDs
Stocks Classified by: • Geography: domestic (U.S. only), global (includes U.S.), international (foreign only) • Company size: large cap, mid cap, small cap, micro cap • Style: aggressive growth, growth, value, income
Bonds Classified by: • Geography: domestic (U.S. only), global (includes U.S.), international (foreign only) • Type of issuer: government, municipal, corporate • Default risk: investment grade (lower risk), high yield (higher risk) • Time factor: long term, intermediate term, short term
Real Estate • Your home, vacation property, rental property, real estate investment trusts (REITs)
Other • Private equity, hedge funds, futures, options, foreign currencies, precious metals
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Table of Federal Estate Tax Brackets and Exemption Limits Current federal estate tax law (1) increases the estate tax exemption from $2 million in 2008 to $3.5 million in 2009, (2) imposes a top estate tax rate of 45 percent, (3) repeals the estate tax for 2010 only, and (4) reinstates the estate tax in 2011, with an exemption amount of $1 million and a top tax rate of 55 percent. Year
Amount exempt from federal estate tax
Highest federal estate tax rates
2008
$2 million
45%
2009
$3.5 million
45%
2010
federal estate tax scheduled to be repealed*
federal estate scheduled to be repealed - no tax*
2011
scheduled to revert to prior law*
scheduled to revert to prior law*
*The previous federal estate tax will be reinstated in 2011 under the sunset provisions of the Tax Relief Act of 2001 unless Congress takes additional action. The top federal estate tax rate will be restored to 55 percent, and the federal estate tax exemption amount will return to $1 million.
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The Best Property to Give to Charity Giving to charity is not only personally satisfying, the IRS (and possibly your state) also rewards you with generous tax breaks. • Current income tax deduction if you itemize, subject to certain percentage limitations for any one year • Tax benefit received reduces the cost of the donation (e.g., a $100 donation from someone in a 30 percent tax bracket has a net cost of $70) • Reduces or eliminates capital gains tax if appreciated property is given • No transfer (gift and estate) taxes imposed • Removes any future appreciation of the donated property from your taxable estate
Highly appreciated or rapidly appreciating property* Such as: • Intangible personal and real property (e.g., stock or real estate) • Tangible personal property (e.g., art, jewelry)
Cash • Easy to give--the type of donation most charities like best • Be sure to get a receipt or keep a bank record, regardless of the amount
Income-producing property* Such as: • Artwork (if given by the artist) • Inventory • Section 306 stock (stock acquired in a nontaxable corporate transaction)
Tangible personal property* Such as: • Cars • Jewelry • Paintings
Remainder interests in property Lets you use the property, or income from the property, until a later date. Gift and estate tax deductions are not allowed unless a trust is used. You may only take the income tax deduction in the year that the gift is actually conveyed.
* You may need to have certain types of property appraised.
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A/B Trust Diagram: $7 Million Estate
* Because each spouse is making full use of his or her $3.5 million applicable exclusion amount, this strategy allows a married couple to pass $7 million to their children or others free from federal estate taxes in 2009.
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How a Charitable Lead Trust Works
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How a Charitable Remainder Trust Works
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Building an Investment Portfolio
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Steps to Financial Planning Success
Keep your investment plan fresh
Sign necessary documents Purchase necessary insurance Make changes as needed
Review team suggestions
Determine if current needs are being met Determine if future needs have been contemplated
Assets/Liabilities Goals Insurance Plan Business Plan Investment Plan
Attorney Financial Planning Professional Insurance Professional
Tax Plan Cash Flow Objectives Estate Plan Retirement Plan
Stockbroker Tax Advisor
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Personal Liability Umbrella Insurance
Like a roof over your head, the liability coverage under your homeowners and auto policies is your primary layer of protection. But if you need additional liability protection of up to $1 million or more, you'll need to turn to an umbrella policy. Personal umbrella liability protection is secondary coverage that works in conjunction with your primary policy. When the liability limit of your primary policy is exhausted, the umbrella policy will open up, paying the balance of a liability claim against you (up to the umbrella policy's limit). For example, let's say you are found liable for a bodily injury claim totaling $1.3 million as a result of an auto accident. If your auto policy liability limit was $300,000 and you had a $1 million umbrella policy, your auto policy would pay the first $300,000 and the umbrella would cover the remainder of the claim.
Primary - When limits of primary liability policy are reached... Secondary - Umbrella policy opens up, providing secondary level of protection.
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How an Irrevocable Trust Protects Assets
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How a Domestic Self-Settled Trust Protects Assets
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How an Offshore (Foreign) Trust Protects Assets
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Sudden Wealth What would you do with an extra $10,000? Maybe you'd pay off some debt, get rid of some college loans, or take a much-needed vacation. What if you suddenly had an extra million or 10 million or more? Whether you picked the right six numbers in your state's lottery or your dear Aunt Sally left you her condo in Boca Raton, you have some issues to deal with. You'll need to evaluate your new financial position and consider how your sudden wealth will affect your financial goals.
Evaluate your new financial position Just how wealthy are you? You'll want to figure that out before you make any major life decisions (e.g., to retire). Your first impulse may be to go out and buy things, but that may not be in your best interest. Even if you're used to handling your own finances, now's the time to watch your spending habits carefully. Sudden wealth can turn even the most cautious person into an impulse buyer. Of course, you'll want your current wealth to last, so you'll need to consider your future needs, not just your current desires. Answering these questions may help you evaluate your short- and long-term needs and goals: • Do you have outstanding debt that you'd like to pay off? • Do you need more current income? • Do you plan to pay for your children's education? • Do you need to bolster your retirement savings? • Are you planning to buy a first or second home? • Are you considering giving to loved ones or a favorite charity? • Are there ways to minimize any upcoming income and estate taxes? Note: Experts are available to help you with all of your planning needs. If you don't already have a financial planner, insurance agent, accountant, or attorney, now would be a good time to find professionals to guide you through this new experience.
Impact on investing What will you do with your new assets? Consider these questions: • Do you have enough money to pay your bills and your taxes? • How might investing increase or decrease your taxes? • Do you have assets that you could quickly sell if you needed cash in an emergency? • Are your investments growing quickly enough to keep up with or beat inflation? • Will you have enough money to meet your retirement needs and other long-term goals? • How much risk can you tolerate when investing? • How diversified are your investments?
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The answers to these questions may help you formulate a new investment plan. Remember, though, there's no rush. You can put your funds in an accessible interest-bearing account such as a savings account, money market account, or short-term certificate of deposit until you have time to plan and think things through. You may wish to meet with an investment advisor for help with these decisions. Once you've taken care of these basics, set aside some money to treat yourself to something you wouldn't have bought or done before--it's OK to have fun with some of your new money!
Impact on insurance It's sad to say, but being wealthy may make you more vulnerable to lawsuits. Although you may be able to pay for any damage (to yourself or others) that you cause, you may want to re-evaluate your current insurance policies and consider purchasing an umbrella liability policy. If you plan on buying expensive items such as jewelry or artwork, you may need more property/casualty insurance to cover these items in case of loss or theft. Finally, it may be the right time to re-examine your life insurance needs. More life insurance may be necessary to cover your estate tax bill so your beneficiaries receive more of your estate after taxes.
Impact on estate planning Now that your wealth has increased, it's time to re-evaluate your estate plan. Estate planning involves conserving your money and putting it to work so that it best fulfills your goals. It also means minimizing your taxes and creating financial security for your family. Is your will up to date? A will is the document that determines how your worldly possessions will be distributed after your death. You'll want to make sure that your current will accurately reflects your wishes. If your newfound wealth is significant, you should meet with your attorney as soon as possible. You may want to make a new will and destroy the old one instead of simply making changes by adding a codicil. Carefully consider whether the beneficiaries of your estate are capable of managing the inheritance on their own. For instance, if you have minor children, you should consider setting up a trust to protect their interests and control the age at which they receive their funds. It's probably also a good idea to consult a tax attorney or financial professional to look into the amount of federal estate tax and state death taxes that your estate may have to pay upon your death. If your estate will be worth more than the applicable exclusion amount ($3.5 million in 2009), consider looking at ways to minimize estate taxes.
Giving it all away--or maybe just some of it Is gift giving part of your overall plan? You may want to give gifts of cash or property to your loved ones or to your favorite charities. It's a good idea to wait until you've come up with a financial plan before giving or lending money to anyone, even family members. If you decide to give or lend any money, put everything in writing. This will protect your rights and avoid hurt feelings down the road. In particular, keep in mind that: • If you forgive a debt owed by a family member, you may owe gift tax on the transaction • You can make individual gifts of up to $13,000 each calendar year without incurring any gift tax liability ($26,000 if you are married, and you and your spouse can split the gift) • If you pay the school directly, you can give an unlimited amount to pay for someone's education without having to pay gift tax (you can do the same with medical bills) • If you make a gift to charity during your lifetime, you may be able to deduct the amount of the gift on your income tax return, within certain limits, based on your adjusted gross income Note: Because the tax implications are complex, you should consult a tax professional for more information
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before making sizable gifts.
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Investment Planning: The Basics Why do so many people never obtain the financial independence that they desire? Often it's because they just don't take that first step--getting started. Besides procrastination, other excuses people make are that investing is too risky, too complicated, too time consuming, and only for the rich. The fact is, there's nothing complicated about common investing techniques, and it usually doesn't take much time to understand the basics. The biggest risk you face is not educating yourself about which investments may be able to help you achieve your financial goals and how to approach the investing process.
Saving versus investing Both saving and investing have a place in your finances. However, don't confuse the two. With savings, your principal typically remains constant and earns interest or dividends. Savings are kept in certificates of deposit (CDs), checking accounts, and savings accounts. By comparison, investments can go up or down in value and may or may not pay interest or dividends. Examples of investments include stocks, bonds, mutual funds, collectibles, precious metals, and real estate.
Why invest? You invest for the future, and the future is expensive. For example, college expenses are increasing more rapidly than the rate of overall inflation. And because people are living longer, retirement costs are often higher than many people expect. You have to take responsibility for your own finances, even if you need expert help to do so. Government programs such as Social Security will probably play a less significant role for you than they did for previous generations. Corporations are switching from guaranteed pensions to plans that require you to make contributions and choose investments. The better you manage your dollars, the more likely it is that you'll have the money to make the future what you want it to be. Because everyone has different goals and expectations, everyone has different reasons for investing. Understanding how to match those reasons with your investments is simply one aspect of managing your money to provide a comfortable life and financial security for you and your family.
What is the best way to invest? • Get in the habit of saving. Set aside a portion of your income regularly. • Invest in financial markets so your money can grow at a meaningful rate. • Don't put all your eggs in one basket. Though it doesn't guarantee a profit or ensure against the possibility of loss, having multiple types of investments may help reduce the impact of a loss on any single investment. • Focus on long-term potential rather than short-term price fluctuations. • Ask questions and become educated before making any investment. • Invest with your head, not with your stomach or heart. Avoid the urge to invest based on how you feel about an investment.
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Before you start Organize your finances to help manage your money more efficiently. Remember, investing is just one component of your overall financial plan. Get a clear picture of where you are today. What's your net worth? Compare your assets with your liabilities. Look at your cash flow. Be clear on where your income is going each month. List your expenses. You can typically identify enough expenses to account for at least 95 percent of your income. If not, go back and look again. You could use those lost dollars for investing. Are you drowning in credit card debt? If so, pay it off as quickly as possible before you start investing. Every dollar that you save in interest charges is one more dollar that you can invest for your future. Establish a solid financial base: Make sure you have an adequate emergency fund, sufficient insurance coverage, and a realistic budget. Also, take full advantage of benefits and retirement plans that your employer offers.
Understand the impact of time Take advantage of the power of compounding. Compounding is the earning of interest on interest, or the reinvestment of income. For instance, if you invest $1,000 and get a return of 8 percent, you will earn $80. By reinvesting the earnings and assuming the same rate of return, the following year you will earn $86.40 on your $1,080 investment. The following year, $1,166.40 will earn $93.31. (This hypothetical example is intended as an illustration and does not reflect the performance of a specific investment). Use the Rule of 72 to judge an investment's potential. Divide the projected return into 72. The answer is the number of years that it will take for the investment to double in value. For example, an investment that earns 8 percent per year will double in 9 years.
Consider working with a financial professional Whether you need a financial professional depends on your own comfort level. If you have the time and energy to educate yourself, you may not feel you need assistance. However, don't underestimate the value of the experience and knowledge that a financial professional can offer in helping you define your goals and objectives, creating a net worth statement and spending plan, determining the level and type of risk that's right for you, and working with you to create a comprehensive financial plan. For many, working with a professional is the single most important investment that they make.
Review your progress Financial management is an ongoing process. Keep good records and recalculate your net worth annually. This will help you for tax purposes, and show you how your investments are doing over time. Once you take that first step of getting started, you will be better able to manage your money to pay for today's needs and pursue tomorrow's goals.
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Creating an Investment Portfolio You've identified your goals and done some basic research. You understand the difference between a stock and a bond. But how do you actually go about creating an investment portfolio? What specific investments are right for you? What resources are out there to help you with investment decisions? Do you need a financial professional to help you get started?
A good investment portfolio will spread your risk It is an almost universally accepted concept that most portfolios should include a mix of investments, such as stocks, bonds, mutual funds, and other investment vehicles. A portfolio should also be balanced. That is, the portfolio should contain investments with varying levels and types of risk to help minimize the overall impact if one of the portfolio holdings declines significantly. Many investors make the mistake of putting all their eggs in one basket. For example, if you invest in one stock, and that stock goes through the roof, a fortune can be made. On the other hand, that stock can lose all its value, resulting in a total loss of your investment. Spreading your investment over multiple asset classes should help reduce your risk of losing your entire investment.
Asset allocation: How many eggs in which baskets? Asset allocation is one of the first steps in creating a diversified investment portfolio. Asset allocation means deciding how your investment dollars should be allocated among broad investment classes, such as stocks, bonds, and cash alternatives. Rather than focusing on individual investments (such as which company's stock to buy), asset allocation approaches diversification from a more general viewpoint. For example, what percentage of your portfolio should be in stocks? The underlying principle is that different classes of investments have shown different rates of return and levels of price volatility over time. Also, since different asset classes often respond differently to the same news, your stocks may go down while your bonds go up, or vice versa. Though neither diversification nor asset allocation can guarantee a profit or ensure against a potential loss, diversifying your investments over various asset classes can help you try to minimize volatility and maximize potential return. So, how do you choose the mix that's right for you? Countless resources are available to assist you, including interactive tools and sample allocation models. Most of these take into account a number of variables in suggesting an asset allocation strategy. Some of those factors are objective (e.g., your age, your financial resources, your time frame for investing, and your investment objectives). Others are more subjective, such as your tolerance for risk or your outlook on the economy. A financial professional can help you tailor an allocation mix to your needs.
More on diversification Diversification isn't limited to asset allocation, either. Even within an investment class, different investments may offer different levels of volatility and potential return. For example, with the stock portion of your portfolio, you might choose to balance higher-volatility stocks with those that have historically been more stable (though past performance is no guarantee of future results). Because most mutual funds invest in dozens to hundreds of securities, including stocks, bonds, or other investment vehicles, purchasing shares in a mutual fund reduces your exposure to any one security. In addition to instant diversification, if the fund is actively managed, you get the benefit of a professional money manager making investment decisions on your behalf. Note:Before investing in a mutual fund, carefully consider its investment objectives, risks, charges and expenses, which are outlined in the prospectus that is available from the fund. Obtain and read a fund's prospectus carefully before investing.
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Choose investments that match your tolerance for risk Your tolerance for risk is affected by several factors, including your objectives and goals, timeline(s) for using this money, life stage, personality, knowledge, other financial resources, and investment experience. You'll want to choose a mix of investments that has the potential to provide the highest possible return at the level of risk you feel comfortable with on an ongoing basis. For that reason, an investment professional will normally ask you questions so that he or she can gauge your risk tolerance and then tailor a portfolio to your risk profile.
Investment professionals and advisors A wealth of investment information is available if you want to do your own research before making investment decisions. However, many people aren't comfortable sifting through balance sheets, profit-and-loss statements, and performance reports. Others just don't have the time, energy, or desire to do the kind of thorough analysis that marks a smart investor. For these people, an investment advisor or professional can be invaluable. Investment advisors and professionals generally fall into three groups: stockbrokers, professional money managers, and financial planners. In choosing a financial professional, consider his or her legal responsibilities in selecting securities for you, how the individual or firm is compensated for its services, and whether an individual's qualifications and experience are well suited to your needs. Ask friends, family and coworkers if they can recommend professionals whom they have used and worked with well. Ask for references, and check with local and federal regulatory agencies to find out whether there have been any customer complaints or disciplinary actions against an individual in the past. Consider how well an individual listens to your goals, objectives and concerns.
Stockbrokers Stockbrokers work for brokerage houses, generally on commission. Though any investment recommendations they make are required by the SEC to be suitable for you as an investor, a broker may or may not be able to put together an overall financial plan for you, depending on his or her training and accreditation. Verify that an individual broker has the requisite skill and knowledge to assist you in your investment decisions.
Professional money managers Professional money managers were once available only for extremely high net-worth individuals. But that has changed a bit now that competition for investment dollars has grown so much, due in part to the proliferation of discount brokers on the Internet. Now, many professional money managers have considerably lowered their initial investment requirements in an effort to attract more clients. A professional money manager designs an investment portfolio tailored to the client's investment objectives. Fees are usually based on a sliding scale as a percentage of assets under management--the more in the account, the lower the percentage you are charged. Management fees and expenses can vary widely among managers, and all fees and charges should be fully disclosed.
Financial planners A financial planner can help you set financial goals and develop and help implement an appropriate financial plan that manages all aspects of your financial picture, including investing, retirement planning, estate planning, and protection planning. Ideally, a financial planner looks at your finances as an interrelated whole. Because anyone can call himself or herself a financial planner without being educated or licensed in the area, you should choose a financial planner carefully. Make sure you understand the kind of services the planner will provide you and what his or her qualifications are. Look for a financial planner with one or more of the following credentials:
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• CERTIFIED FINANCIAL PLANNER™(CFP®) • Chartered Financial Consultant® (ChFC®) and Chartered Life Underwriter® (CLU®) • Accredited Personal Financial Specialist (PFS) • Registered Financial Consultant® (RFC®) • Registered Investment Advisor (RIA) Financial planners can be either fee based or commission based, so make sure you understand how a planner is compensated. As with any financial professional, it's your responsibility to ensure that the person you're considering is a good fit for you and your objectives.
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Life Insurance: Do You Need It? At some point in your life, you'll probably be faced with the question of whether you need life insurance. Life insurance is a way to protect your loved ones financially after you die and your income stops. The answer to whether you need life insurance depends on your personal and financial circumstances.
Should you buy life insurance? You should probably consider buying life insurance if any one of the following is true: • You are married and your spouse depends on your income • You have children • You have an aging parent or disabled relative who depends on you for support • Your retirement savings and pension won't be enough for your spouse to live on • You have a large estate and expect to owe estate taxes • You own a business, especially if you have a partner • You have a substantial joint financial obligation such as a personal loan for which another person would be legally responsible after your death In all of these cases, the proceeds from an insurance policy can help your loved ones continue to manage financially during the difficult weeks, months, and years after your death. The proceeds can also be used to meet funeral and other final expenses, which can run into thousands of dollars. If you're still unsure about whether you should buy life insurance, a good question to ask yourself is: If I died today with no life insurance, would my family need to make substantial financial sacrifices and give up the lifestyle to which they've become accustomed in order to meet their financial obligations (e.g., car payments, mortgage, college tuition)?
If you need life insurance, don't delay Once you decide you need life insurance, don't put off buying it. Although no one wants to think about and plan for his or her own death, you don't want to make the mistake of waiting until it's too late.
Periodically review your coverage Once you purchase a life insurance policy, make sure to periodically review your coverage--especially when you have a significant life event (e.g., birth of a child, death of a family member)--and make sure that it adequately meets your insurance needs. The most common mistake that people make is to be underinsured. For example, if a portion of your life insurance proceeds are to be earmarked for your child's college education, the more children you have, the more life insurance you'll need. But it's also possible to be overinsured, and that's a mistake, too--the extra money you spend on premiums could be used for other things. If you need help reviewing your coverage, contact your insurance agent or broker.
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Life Insurance Basics Life insurance is an agreement between you (the policy owner) and an insurer. Under the terms of a life insurance policy, the insurer promises to pay a certain sum to a person you choose (your beneficiary) upon your death, in exchange for your premium payments. Proper life insurance coverage should provide you with peace of mind, since you know that those you care about will be financially protected after you die.
The many uses of life insurance One of the most common reasons for buying life insurance is to replace the loss of income that would occur in the event of your death. When you die and your paychecks stop, your family may be left with limited resources. Proceeds from a life insurance policy make cash available to support your family almost immediately upon your death. Life insurance is also commonly used to pay any debts that you may leave behind. Life insurance can be used to pay off mortgages, car loans, and credit card debts, leaving other remaining assets intact for your family. Life insurance proceeds can also be used to pay for final expenses and estate taxes. Finally, life insurance can create an estate for your heirs.
How much life insurance do you need? Your life insurance needs will depend on a number of factors, including whether you're married, the size of your family, the nature of your financial obligations, your career stage, and your goals. For example, when you're young, you may not have a great need for life insurance. However, as you take on more responsibilities and your family grows, your need for life insurance increases. There are plenty of tools to help you determine how much coverage you should have. Your best resource may be a financial professional. At the most basic level, the amount of life insurance coverage that you need corresponds directly to your answers to these questions: • What immediate financial expenses (e.g., debt repayment, funeral expenses) would your family face upon your death? • How much of your salary is devoted to current expenses and future needs? • How long would your dependents need support if you were to die tomorrow? • How much money would you want to leave for special situations upon your death, such as funding your children's education, gifts to charities, or an inheritance for your children? Since your needs will change over time, you'll need to continually re-evaluate your need for coverage.
How much life insurance can you afford? How do you balance the cost of insurance coverage with the amount of coverage that your family needs? Just as several variables determine the amount of coverage that you need, many factors determine the cost of coverage. The type of policy that you choose, the amount of coverage, your age, and your health all play a part. The amount of coverage you can afford is tied to your current and expected future financial situation, as well. A financial professional or insurance agent can be invaluable in helping you select the right insurance plan.
What's in a life insurance contract? A life insurance contract is made up of legal provisions, your application (which identifies who you are and your medical declarations), and a policy specifications page that describes the policy you have selected, including any options and riders that you have purchased in return for an additional premium.
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Provisions describe the conditions, rights, and obligations of the parties to the contract (e.g., the grace period for payment of premiums, suicide and incontestability clauses). The policy specifications page describes the amount to be paid upon your death and the amount of premiums required to keep the policy in effect. Also stated are any riders and options added to the standard policy. Some riders include the waiver of premium rider, which allows you to skip premium payments during periods of disability; the guaranteed insurability rider, which permits you to raise the amount of your insurance without a further medical exam; and accidental death benefits. The insurer may add an endorsement to the policy at the time of issue to amend a provision of the standard contract.
Types of life insurance policies The two basic types of life insurance are term life and permanent (cash value) life. Term policies provide life insurance protection for a specific period of time. If you die during the coverage period, your beneficiary receives the policy death benefit. If you live to the end of the term, the policy simply terminates, unless it automatically renews for a new period. Term policies are available for periods of 1 to 30 years or more and may, in some cases, be renewed until you reach age 95. Premium payments may be increasing, as with annually renewable 1-year (period) term, or level (equal) for up to 30-year term periods. Permanent insurance policies provide protection for your entire life, provided you pay the premium to keep the policy in force. Premium payments are greater than necessary to provide the life insurance benefit in the early years of the policy, so that a reserve can be accumulated to make up the shortfall in premiums necessary to provide the insurance in the later years. Should the policyowner discontinue the policy, this reserve, known as the cash value, is returned to the policyowner. Permanent life insurance can be further broken down into the following basic categories: • Whole life: You generally make level (equal) premium payments for life. The death benefit and cash value are predetermined and guaranteed. Any guarantees associated with payment of death benefits, income options, or rates of return are based on the claims-paying ability of the insurer. • Universal life: You may pay premiums at any time, in any amount (subject to certain limits), as long as policy expenses and the cost of insurance coverage are met. The amount of insurance coverage can be decreased, and the cash value will grow at a declared interest rate, which may vary over time. • Variable life: As with whole life, you pay a level premium for life. However, the death benefit and cash value fluctuate depending on the performance of investments in what are known as subaccounts. A subaccount is a pool of investor funds professionally managed to pursue a stated investment objective. The policyowner selects the subaccounts in which the cash value should be invested. • Variable universal life: A combination of universal and variable life. You may pay premiums at any time, in any amount (subject to limits), as long as policy expenses and the cost of insurance coverage are met. The amount of insurance coverage can be decreased, and the cash value goes up or down based on the performance of investments in the subaccounts. Note:Variable life and variable universal life insurance policies are offered by prospectus, which you can obtain from your financial professional or the insurance company. The prospectus contains detailed information about investment objectives, risks, charges, and expenses. You should read the prospectus and consider this information carefully before purchasing a variable life or variable universal life insurance policy.
Your beneficiaries You must name a primary beneficiary to receive the proceeds of your insurance policy. You may name a contingent beneficiary to receive the proceeds if your primary beneficiary dies before the insured. Your beneficiary may be a person, corporation, or other legal entity. You may name multiple beneficiaries and specify what percentage of the net death benefit each is to receive. You should carefully consider the ramifications of
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your beneficiary designations to ensure that your wishes are carried out as you intend. Generally, you can change your beneficiary at any time. Changing your beneficiary usually requires nothing more than signing a new designation form and sending it to your insurance company. If you have named someone as an irrevocable (permanent) beneficiary, however, you will need that person's permission to adjust any of the policy's provisions.
Where can you buy life insurance? You can often get insurance coverage from your employer (i.e., through a group life insurance plan offered by your employer) or through an association to which you belong (which may also offer group life insurance). You can also buy insurance through a licensed life insurance agent or broker, or directly from an insurance company. Any policy that you buy is only as good as the company that issues it, so investigate the company offering you the insurance. Ratings services, such as A. M. Best, Moody's, and Standard & Poor's, evaluate an insurer's financial strength. The company offering you coverage should provide you with this information.
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Umbrella Liability Insurance When your local weather forecaster tells you that it's going to rain, what do you do? That's easy--you reach for your umbrella. So why not purchase an umbrella that can protect you in stormy financial weather? Umbrella liability insurance (ULI) can do just that. By providing liability protection above and beyond the basic coverage that homeowners/renters and auto insurance policies offer, ULI can protect you against the catastrophic losses that can occur if you are sued. Although ULI can be purchased as a separate policy, your insurer will require that you have basic liability coverage (i.e., homeowners/renters insurance, auto insurance, or both) before you can purchase an umbrella liability policy. ULI is often referred to as excess coverage. If you are found to be legally responsible for injuring someone or damaging someone's property, the umbrella policy will either pay for the part of the claim in excess of the limits of your basic liability policy, or pay for certain losses that are not covered.
Why now? It's not even raining These days, it's not unusual to hear of $2 million, $10 million, and even $20 million court judgments against individuals. If someone is injured in your home, or if you cause a serious auto accident, you could have to pay such a judgment. If you don't have an umbrella liability policy at the time of the accident, anything above the limits of your homeowners/renters or auto insurance policy will have to come out of your pocket. Here's an example of how ULI works to protect you. Say you have an auto insurance policy with a liability limit of $100,000 per accident. You also have a $1 million umbrella liability policy. You're later found responsible for a serious automobile accident, and the court finds you liable for $700,000 in damages. In this case, your auto insurance would pay the first $100,000 of the judgment, which would satisfy the deductible under your umbrella policy. Your umbrella policy would then cover the portion of the judgment not covered by your auto insurance ($600,000). You should also be aware that certain types of liability claims (e.g., libel and slander) are not covered under basic homeowners, auto, or other types of insurance policies. An endorsement can be added to these policies to provide some protection against these types of personal injury claims. Or, you can purchase ULI, which does cover these claims.
What's covered? A typical umbrella liability policy provides the following protection, up to the coverage limits specified in the policy: • Protection for claims of bodily injuries or property damage caused by you, members of your household, or hazards on your property, for which you are found legally liable • Personal liability coverage for incidents that occur on or off your property • Additional protection above your basic auto policy for auto-related liabilities • Protection against non-business-related personal injury claims, such as slander, libel, wrongful eviction, and false arrest • Legal defense costs for a covered loss, including lawyers' fees and associated court costs
What's not covered? Umbrella liability insurance typically provides extremely broad coverage. Furthermore, if something is not expressly excluded from coverage, it is covered. Exclusions vary from one insurer to another and from one policy to another, but the following are some items typically excluded from coverage:
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• Intentional damage caused by you or a member of your family or household • Damages arising out of business or professional pursuits • Liability that you accept under the terms of a contract or agreement • Liability related to the ownership, maintenance, and use of aircraft, nontraditional watercraft (e.g., jet skis, air boats), and most recreational vehicles • Damage to property owned, used, or maintained by you (the insured) • Damage covered under a workers' compensation policy • Liability arising as a result of war or insurrection
How big of an umbrella are we talking about? Determining how much liability coverage you need is not an exact science. You might think that you need only enough liability insurance to protect your assets, but a large judgment against you could easily wipe out your assets and put your future earnings in jeopardy. That's why you should also consider factors such as how often you have guests in your home, whether you operate a home-based business, how much you drive, whether you have teenage drivers in your home, and whether your lifestyle gives the impression that you have "deep pockets." Coverage limits vary, but a typical policy will provide liability coverage worth $1 million to $10 million. Of course, as your coverage limit increases, the premium will also increase. You need to decide both how much insurance you need and how much insurance you can afford. You'll want to have enough protection, but not too much. Look at it this way: Have you ever seen a five-year-old child walking under a big golf umbrella or a 300 lb. football player using a pocket-sized umbrella? One has too much protection and the other not enough. Your insurance agent can help you determine how much coverage you need.
Where can I buy an umbrella liability policy? Almost any insurer who writes auto and home insurance policies will also sell umbrella liability policies. In fact, you may be eligible for a multipolicy discount if you purchase an umbrella policy from your current insurer. Of course, it's important to shop around and make sure that you're getting the right coverage for your needs and the most coverage for your money. If you want to do some research on your own, try surfing the Internet, where you can get price quotes and answers to your questions in an instant.
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Estate Planning: An Introduction By definition, estate planning is a process designed to help you manage and preserve your assets while you are alive, and to conserve and control their distribution after your death according to your goals and objectives. But what estate planning means to you specifically depends on who you are. Your age, health, wealth, lifestyle, life stage, goals, and many other factors determine your particular estate planning needs. For example, you may have a small estate and may be concerned only that certain people receive particular things. A simple will is probably all you'll need. Or, you may have a large estate, and minimizing any potential estate tax impact is your foremost goal. Here, you'll need to use more sophisticated techniques in your estate plan, such as a trust. To help you understand what estate planning means to you, the following sections address some estate planning needs that are common among some very broad groups of individuals. Think of these suggestions as simply a point in the right direction, and then seek professional advice to implement the right plan for you.
Over 18 Since incapacity can strike anyone at anytime, all adults over 18 should consider having: • A durable power of attorney: This document lets you name someone to manage your property for you in case you become incapacitated and cannot do so. • An advanced medical directive: The three main types of advanced medical directives are (1) a living will, (2) a durable power of attorney for health care (also known as a health-care proxy), and (3) a Do Not Resuscitate order. Be aware that not all states allow each kind of medical directive, so make sure you execute one that will be effective for you.
Young and single If you're young and single, you may not need much estate planning. But if you have some material possessions, you should at least write a will. If you don't, the wealth you leave behind if you die will likely go to your parents, and that might not be what you would want. A will lets you leave your possessions to anyone you choose (e.g., your significant other, siblings, other relatives, or favorite charity).
Unmarried couples You've committed to a life partner but aren't legally married. For you, a will is essential if you want your property to pass to your partner at your death. Without a will, state law directs that only your closest relatives will inherit your property, and your partner may get nothing. If you share certain property, such as a house or car, you should consider owning the property as joint tenants with rights of survivorship. That way, when one of you dies, the jointly held property will pass to the surviving partner automatically.
Married couples Married couples have unique estate planning challenges and opportunities. On the one hand, you can transfer your entire estate to your spouse gift and estate tax free under the unlimited marital deduction. This will postpone taxation until the death of the surviving spouse. While this may be a good outcome for couples with smaller estates, couples with combined assets in excess of the estate tax exemption amount ($3.5 million per person in 2009) may wind up paying more in estate taxes than is necessary because they've wasted the exemption of the first spouse to die. Couples in this situation need to plan in advance to avoid this result (perhaps by using a "credit shelter" or "bypass" trust, or some combination of marital trusts, often referred as an "A/B or A/B/C trust arrangement"). Note: Funding a bypass trust with funds from a retirement plan could have adverse income tax consequences.
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Note: In the states that have "decoupled" their death tax systems from the federal system, using a formula provision to fund a bypass trust may increase the chance of having to pay state death taxes. Married couples where one spouse is not a U.S. citizen have special planning concerns. The marital deduction is not allowed if the recipient spouse is a non-citizen spouse (although a $133,000 annual exclusion, for 2009, is allowed). If certain requirements are met, however, a transfer to a qualified domestic trust (QDOT) will qualify for the marital deduction.
Married with children If you're married and have children, you and your spouse should each have your own will. For you, wills are vital because they can name a guardian for your minor children in case both of you die simultaneously. If you fail to name a guardian in your will, a court may appoint someone you might not have chosen. Furthermore, without a will, some states dictate that at your death some of your property goes to your children and not to your spouse. If minor children inherit directly, the surviving parent will need court permission to manage the money for them. You may also want to consult an attorney about establishing a trust to manage your children's assets in the event that both you and your spouse die at the same time. Certainly, you will also need life insurance. Your surviving spouse may not be able to support the family on his or her own and may need to replace your earnings to maintain the family.
Comfortable and looking forward to retirement If you're in your 30s, you're probably feeling comfortable. You've accumulated some wealth and you're thinking about retirement. Here's where estate planning overlaps with retirement planning. It's just as important to plan to care for yourself during your retirement as it is to plan to provide for your beneficiaries after your death. You should keep in mind that even though Social Security may be around when you retire, those benefits alone may not provide enough income for your retirement years. Consider saving some of your accumulated wealth using other retirement and deferred vehicles, such as an individual retirement account (IRA).
Wealthy and worried Depending on the size of your estate when you die, you may need to be concerned about estate taxes. Current federal estate tax law (1) increases the estate tax exemption from $2 million in 2008 to $3.5 million in 2009, (2) imposes a top estate tax rate of 45 percent, (3) repeals the estate tax for 2010 only, and (4) reinstates the estate tax in 2011, with an exemption amount of $1 million and a top tax rate of 55 percent. There is uncertainty about the exact form the federal estate tax system will take in future years. However, it appears that individuals with estates valued at under $1 million need not worry too much about federal estate taxes, those with estates between $1 million and $3.5 million should have some flexibility built into their plans, and those with over $3.5 million need to implement plans now to avoid having to pay federal estate tax. TWhether your estate will be subject to state death taxes depends on the size of your estate and the tax laws in effect in the state in which you are domiciled.
Elderly or ill If you're elderly or ill, you'll want to write a will or update your existing one, consider a revocable living trust, and make sure you have a durable power of attorney and a health-care directive. Talk with your family about your wishes, and make sure they have copies of your important papers or know where to locate them.
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Gift and Estate Taxes If you give away money or property during your life, those transfers may be subject to federal gift tax and perhaps state gift tax. The money and property you own when you die (i.e., your estate) may also be subject to federal estate taxes and some form of state death tax. You should understand these taxes and when they do and do not apply, especially since the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Tax Act). This law contains several changes that are complicated and uncertain, making estate planning all the more difficult.
Federal gift tax and federal estate tax--background Under pre-2001 Tax Act law, no gift tax or estate taxes were imposed on the first $675,000 of combined transfers (those made during life and those made at death). The tax rate tables were unified into one--that is, the same rates applied to gifts made and property owned by persons who died in 2001. Like income tax rates, gift and estate tax rates were graduated. Under this unified system, the recipient of a lifetime gift received a carryover basis in the property received, while the recipient of a bequest, or gift made at death, got a step-up in basis (usually fair market value on the date of death of the person who made the bequest or gift). The law substantially changed this tax regime.
Federal gift tax The 2001 Tax Act increased the applicable exclusion amount for gift tax purposes to $1 million. The top gift tax rate is 45 percent in 2009 and 35 percent in 2010 (the top marginal income tax rate in 2010 under the 2001 Tax Act). In 2011, the gift tax rates revert to pre-2001 Tax Act levels. The carryover basis rules remain in effect. However, many gifts can still be made tax free, including: • Gifts to your U.S. citizen spouse (you may give up to $133,000 in 2009 tax free to your noncitizen spouse) • Gifts to qualified charities • Gifts totaling up to $13,000 (in 2009) to any one person or entity during the tax year, or $26,000 if the gift is made by both you and your spouse (and you are both U.S. citizens) • Amounts paid on behalf of any individual as tuition to an educational organization or to any person who provides medical care for an individual State gift tax may also be owed if you are a resident of Connecticut, Louisiana, North Carolina, Tennessee, or Puerto Rico.
Federal estate tax Under the 2001 Tax Act, the applicable exclusion amount for estate tax purposes is $3.5 million in 2009 (the applicable exclusion amount for gift tax purposes remains fixed at $1 million). The top estate tax rate is 45 percent in 2009. The estate tax (but not the gift tax) is repealed in 2010, but the estate tax applicable exclusion amount and rates revert to pre-2001 Tax Act levels in 2011. When the estate tax is repealed in 2010, the basis rules will be changed to those similar to the gift tax basis rules. The step-up in basis rules return in 2011.
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Federal generation-skipping transfer tax The federal generation-skipping transfer tax (GSTT) taxes transfers of property you make, either during life or at death, to someone who is two or more generations below you, such as a grandchild. The GSTT is imposed in addition to, not instead of, federal gift tax or federal estate tax. You need to be aware of the GSTT if you make cumulative generation-skipping transfers in excess of the GSTT exemption, which is $3.5 million (in 2009). A flat tax equal to the highest estate tax bracket in effect in the year you make the transfer is imposed on every transfer you make after your exemption has been exhausted. Some states also impose their own GSTT. Note: The GSTT exemption is the same amount as the applicable exclusion amount for estate tax purposes.
State death taxes The three types of state death taxes are estate tax, inheritance tax, and credit estate tax, which is also known as a sponge tax or pickup tax.
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Charitable Giving When developing your estate plan, you can do well by doing good. Leaving money to charity rewards you in many ways. It gives you a sense of personal satisfaction, and it can save you money in estate taxes.
A few words about estate taxes Current federal estate tax law (1) increases the estate tax exemption from $2 million in 2008 to $3.5 million in 2009, (2) imposes a top estate tax rate of 45 percent, (3) repeals the estate tax for 2010 only, and (4) reinstates the estate tax in 2011, with an exemption amount of $1 million and a top tax rate of 55 percent. Whether you are subject to federal estate taxes depends on the size of your estate and the year you die. Tax law changes only increase the need for careful planning, and charitable giving can play an important role in many estate plans. By leaving money to charity when you die, the full amount of your charitable gift may be deducted from the value of your taxable estate.
Make an outright bequest in your will The easiest and most direct way to make a charitable gift is by an outright bequest of cash in your will. Making an outright bequest requires only a short paragraph in your will that names the charitable beneficiary and states the amount of your gift. The outright bequest is especially appropriate when the amount of your gift is relatively small, or when you want the funds to go to the charity without strings attached.
Make a charity the beneficiary of an IRA or retirement plan If you have funds in an IRA or employer-sponsored retirement plan, you can name your favorite charity as a beneficiary. Naming a charity as beneficiary can provide double tax savings. First, the charitable gift will be deductible for estate tax purposes. Second, the charity will not have to pay any income tax on the funds it receives. This double benefit can save combined taxes that otherwise could eat up a substantial portion of your retirement account.
Use a charitable trust Another way for you to make charitable gifts is to create a charitable trust. There are many types of charitable trusts, the most common of which include the charitable lead trust and the charitable remainder trust. A charitable lead trust pays income to your chosen charity for a certain period of years after your death. Once that period is up, the trust principal passes to your family members or other heirs. The trust is known as a charitable lead trust because the charity gets the first, or lead, interest. A charitable remainder trust is the mirror image of the charitable lead trust. Trust income is payable to your family members or other heirs for a period of years after your death or for the lifetime of one or more beneficiaries. Then, the principal goes to your favorite charity. The trust is known as a charitable remainder trust because the charity gets the remainder interest. Depending on which type of trust you use, the dollar value of the lead (income) interest or the remainder interest produces the estate tax charitable deduction.
Why use a charitable lead trust? The charitable lead trust is an excellent estate planning vehicle if you are optimistic about the future performance of the investments in the trust. If created properly, a charitable lead trust allows you to keep an asset in the family while being an effective tax-minimization device.
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For example, you create a $1 million charitable lead trust. The trust provides for fixed annual payments of $80,000 (or 8 percent of the initial $1 million value of the trust) to ABC Charity for 25 years. At the end of the 25-year period, the entire trust principal goes outright to your beneficiaries. To figure the amount of the charitable deduction, you have to value the 25-year income interest going to ABC Charity. To do this, you use IRS tables. Based on these tables, the value of the income interest can be high--for example, $900,000. This means that your estate gets a $900,000 charitable deduction when you die, and only $100,000 of the $1 million gift is subject to estate tax.
Why use a charitable remainder trust? A charitable remainder trust takes advantage of the fact that lifetime charitable giving generally results in tax savings when compared to testamentary charitable giving. A donation to a charitable remainder trust has the same estate tax effect as a bequest because, at your death, the donated asset has been removed from your estate. Be aware, however, that a portion of the donation is brought back into your estate through the charitable income tax deduction. Also, a charitable remainder trust can be beneficial because it provides your family members with a stream of current income--a desirable feature if your family members won't have enough income from other sources. For example, you create a $1 million charitable remainder trust. The trust provides that a fixed annual payment be paid to your beneficiaries for a period not to exceed 20 years. At the end of that period, the entire trust principal goes outright to ABC Charity. To figure the amount of the charitable deduction, you have to value the remainder interest going to ABC Charity, using IRS tables. This is a complicated numbers game. Trial computations are needed to see what combination of the annual payment amount and the duration of annual payments will produce the desired charitable deduction and income stream to the family.
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Asset Protection in Estate Planning You're beginning to accumulate substantial wealth, but you worry about protecting it from future potential creditors. Whether your concern is for your personal assets or your business, various tools exist to keep your property safe from tax collectors, accident victims, health-care providers, credit card issuers, business creditors, and creditors of others. To insulate your property from such claims, you'll have to evaluate each tool in terms of your own situation. You may decide that insurance and a Declaration of Homestead may be sufficient protection for your home because your exposure to a claim is low. For high exposure, you may want to create a business entity or an offshore trust to shield your assets. Remember, no asset protection tool is guaranteed to work, and you may have to adjust your asset protection strategies as your situation or the laws change.
Liability insurance is your first and best line of defense Liability insurance is at the top of any plan for asset protection. You should consider purchasing or increasing umbrella coverage on your homeowners policy. For business-related liability, purchase or increase your liability coverage under your business insurance policy. Generally, the cost of the premiums for this type of coverage is minimal compared to what you might be required to pay under a court judgment should you ever be sued.
A Declaration of Homestead protects the family residence Your primary residence may be your most significant asset. State law determines the creditor and judgment protection afforded a residence by way of a Declaration of Homestead, which varies greatly from state to state. For example, a state may provide a complete exemption for a residence (i.e., its entire value), a limited exemption (e.g., up to $100,000), or an exemption under certain circumstances (e.g., a judgment for medical bills). A Declaration of Homestead is easy to file. You pay a small fee, fill out a simple form, and file it at the registry where your deed is recorded.
Dividing assets between spouses can limit exposure to potential liability Perhaps you work in an occupation or business that exposes you to greater potential liability than your spouse's job does. If so, it may be a good idea to divide assets between you so that you keep only the income and assets from your job, while your spouse takes sole ownership of your investments and other valuable assets. Generally, your creditors can reach only those assets that are in your name.
Business entities can provide two types of protection--shielding your personal assets from your business creditors and shielding business assets from your personal creditors Consider using a corporation, limited partnership, or limited liability company (LLC) to operate the business. Such business entities shield the personal assets of the shareholders, limited partners, or LLC members from liabilities that arise from the business. The liability of these owners will be limited to the assets of the business. Conversely, corporations, limited partnerships, and LLCs provide some protection from the personal creditors of a shareholder, limited partner, or member. In a corporation, a creditor of an individual owner is able to place a lien on, and eventually acquire, the shares of the debtor/shareholder, but would not have any rights greater than the rights conferred by the shares. In limited partnerships or LLCs, under most state laws, a creditor of a partner or member is entitled to obtain only a charging order with respect to the partner or member's interest. The charging order gives the creditor the right to receive any distributions with respect to the interest. In all respects, the creditor is treated as a mere assignee and is not entitled to exercise any voting rights or other rights that the partner or member possessed.
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Certain trusts can preserve trust assets from claims People have used trusts to protect their assets for generations. The key to using a trust as an asset protection tool is that the trust must be irrevocable and become the owner of your property. Once given away, these assets are no longer yours and are not available to satisfy claims against you. To properly establish an asset protection trust, you must not keep any interest in the trust assets or control over the trust. Trusts can also protect trust assets from potential creditors of the beneficiaries of the trust. The extent to which a beneficiary's creditors can reach trust property depends on how much access the beneficiary has to the trust property. The more access the beneficiary has to the trust property, the more access the beneficiary's creditors will have. Thus, the terms of the trust are critical. There are many types of asset protection trusts, each having its own benefits and drawbacks. These trusts include: • Spendthrift trusts • Discretionary trusts • Support trusts • Blend trusts • Personal trusts • Self-settled trusts Since certain claims can pierce domestic protective trusts (e.g., claims by a spouse or child for support and state or federal claims), you can bolster your protection by placing the trust in a foreign jurisdiction. Offshore or foreign trusts are established under, or made subject to, the laws of another country (e.g., the Bahamas, the Cayman Islands, Bermuda, Belize, Jersey, Liechtenstein, and the Cook Islands) that does not generally honor judgments made in the United States.
A word about fraudulent transfers The court will ignore transfers to an asset protection trust if: • A creditor's claim arose before you made the transfer • You made the transfer with the intent to defraud a creditor • You incurred debts without a reasonable expectation of paying them
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Trust Basics Whether you're seeking to manage your own assets, control how your assets are distributed after your death, or plan for incapacity, trusts can help you accomplish your estate planning goals. Their power is in their versatility--many types of trusts exist, each designed for a specific purpose. Although trust law is complex and establishing a trust requires the services of an experienced attorney, mastering the basics isn't hard.
What is a trust? A trust is a legal entity that holds assets for the benefit of another. Basically, it's like a container that holds money or property for somebody else. You can put practically any kind of asset into a trust, including cash, stocks, bonds, insurance policies, real estate, and artwork. The assets you choose to put in a trust depend largely on your goals. For example, if you want the trust to generate income, you may want to put income-producing securities, such as bonds, in your trust. Or, if you want your trust to create a pool of cash that may be accessible to pay any estate taxes due at your death or to provide for your family, you might want to fund your trust with a life insurance policy. When you create and fund a trust, you are known as the grantor (or sometimes, the settlor or trustor). The grantor names people, known as beneficiaries, who will benefit from the trust. Beneficiaries are usually your family and loved ones but can be anyone, even a charity. Beneficiaries may receive income from the trust or may have access to the principal of the trust either during your lifetime or after you die. The trustee is responsible for administering the trust, managing the assets, and distributing income and/or principal according to the terms of the trust. Depending on the purpose of the trust, you can name yourself, another person, or an institution, such as a bank, to be the trustee. You can even name more than one trustee if you like.
Why create a trust? Since trusts can be used for many purposes, they are popular estate planning tools. Trusts are often used to: • Minimize estate taxes • Shield assets from potential creditors • Avoid the expense and delay of probating your will • Preserve assets for your children until they are grown (in case you should die while they are still minors) • Create a pool of investments that can be managed by professional money managers • Set up a fund for your own support in the event of incapacity • Shift part of your income tax burden to beneficiaries in lower tax brackets • Provide benefits for charity The type of trust used, and the mechanics of its creation, will differ depending on what you are trying to accomplish. In fact, you may need more than one type of trust to accomplish all of your goals. And since some of the following disadvantages may affect you, discuss the pros and cons of setting up any trust with your attorney and financial planner before you proceed: • A trust can be expensive to set up and maintain--trustee fees, professional fees, and filing fees must be paid
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• Depending on the type of trust you choose, you may give up some control over the assets in the trust • Maintaining the trust and complying with recording and notice requirements can take up considerable time • Income generated by trust assets and not distributed to trust beneficiaries may be taxed at a higher income tax rate than your individual rate
The duties of the trustee The trustee of the trust is a fiduciary, someone who owes a special duty of loyalty to the beneficiaries. The trustee must act in the best interests of the beneficiaries at all times. For example, the trustee must preserve, protect, and invest the trust assets for the benefit of the beneficiaries. The trustee must also keep complete and accurate records, exercise reasonable care and skill when managing the trust, prudently invest the trust assets, and avoid mixing trust assets with any other assets, especially his or her own. A trustee lacking specialized knowledge can hire professionals such as attorneys, accountants, brokers, and bankers if it is wise to do so. However, the trustee can't merely delegate responsibilities to someone else. Although many of the trustee's duties are established by state law, others are defined by the trust document. If you are the trust grantor, you can help determine some of these duties when you set up the trust.
Living (revocable) trust A living trust is a special type of trust. It's a legal entity that you create while you're alive to own property such as your house, a boat, or mutual funds. Property that passes through a living trust is not subject to probate--it doesn't get treated like the property in your will. This means that the transfer of property through a living trust is not held up while the probate process is pending (sometimes up to two years or more). Instead, the trustee will transfer the assets to the beneficiaries according to your instructions. The transfer can be immediate, or if you want to delay the transfer, you can direct that the trustee hold the assets until some specific time, such as the marriage of the beneficiary or the attainment of a certain age. Living trusts are attractive because they are revocable. You maintain control--you can change the trust or even dissolve it for as long as you live. Living trusts are also private. Unlike a will, a living trust is not part of the public record. No one can review details of the trust documents unless you allow it. Living trusts can also be used to help you protect and manage your assets if you become incapacitated. If you can no longer handle your own affairs, your trustee (or a successor trustee) steps in and manages your property. Your trustee has a duty to administer the trust according to its terms, and must always act with your best interests in mind. In the absence of a trust, a court could appoint a guardian to manage your property. Despite these benefits, living trusts have some drawbacks. Assets in a living trust are not protected from creditors, and you are subject to income taxes on income earned by the trust. In addition, you cannot avoid estate taxes using a living trust.
Irrevocable trusts Unlike a living trust, an irrevocable trust can't be changed or dissolved once it has been created. You generally can't remove assets, change beneficiaries, or rewrite any of the terms of the trust. Still, an irrevocable trust is a valuable estate planning tool. First, you transfer assets into the trust--assets you don't mind losing control over. You may have to pay gift taxes on the value of the property transferred at the time of transfer. Provided that you have given up control of the property, all of the property in the trust, plus all future appreciation on the property, is out of your taxable estate. That means your ultimate estate tax liability may be less, resulting in more passing to your beneficiaries. Property transferred to your beneficiaries through an irrevocable trust will also avoid probate. As a bonus, property in an irrevocable trust may be protected from your creditors.
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There are many different kinds of irrevocable trusts. Many have special provisions and are used for special purposes. Some irrevocable trusts hold life insurance policies or personal residences. You can even set up an irrevocable trust to generate income for you.
Testamentary trusts Trusts can also be established by your will. These trusts don't come into existence until your will is probated. At that point, selected assets passing through your will can "pour over" into the trust. From that point on, these trusts work very much like other trusts. The terms of the trust document control how the assets within the trust are managed and distributed to your heirs. Since you have a say in how the trust terms are written, these types of trusts give you a certain amount of control over how the assets are used, even after your death.
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How can I figure out my net worth? Question: How can I figure out my net worth?
Answer: To figure out your net worth, add up the current value of all of your assets, then add up the current amount of all of your liabilities. Subtract your total liabilities from your total assets. The amount you end up with is your net worth. Assets can include cash, checking accounts, certificates of deposit (CDs), mutual funds, stocks, bonds, IRAs, 401(k) plans, automobiles, and real estate. Liabilities can include debt from credit cards, student loans, mortgages, home equity loans, 401(k) loans, and car loans. If you are married, take this a step further. List your assets and liabilities under the name of the owner, so you can then calculate net worth values for you, your spouse, and the two of you as a couple. The first step in the financial planning process should be to calculate your net worth. Once you determine your net worth, you will know exactly what you have and what you owe, enabling you to begin mapping out your financial future. Keep in mind that your net worth constantly changes. As a result, you should calculate your net worth annually and make adjustments as needed to ensure that you are meeting your financial goals.
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Should I invest my extra cash or use it to pay off debt? Question: Should I invest my extra cash or use it to pay off debt?
Answer: To answer this question, you must decide how your money can work best for you. Compare the money you might earn on other investments with the money you would pay on your debt. If you would earn less on investments than you would pay on debts, you should pay off debt. Let's assume that you have $1,000 in a savings account that earns an annual rate of return of 4 percent. Meanwhile, your credit card balance of $1,000 incurs annual interest at a rate of 19 percent. Your savings account thus earns $40, while your credit card costs $190. Your annual net loss is 15 percent, or $150, the difference between what you earned on the savings account and what you paid in interest on the credit card balance. It's even worse when you consider the tax effect. The interest on the savings account is taxable, and you have to use after-tax dollars to pay your credit card bill. In this instance, it would be best to use your extra cash to pay down the high-interest debt balance. The same principle would apply if you were to invest your extra cash in a certificate of deposit (CD), mutual fund, or other investment. Now, let's look at another example. Say you have a student loan of $1,000 that you are repaying at an annual interest rate of 5 percent. Instead of paying off the debt, you invest $1,000 in a CD earning a 7 percent average rate of return. Here, your best strategy would be to keep the loan and invest the extra cash, because your net gain will be 2 percent annually, or $20--the difference between what you earned on the investment, less what you paid on the debt.
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What will happen if I die without a will? Question: What will happen if I die without a will?
Answer: Some people leave instructions about who gets what property in a legal document known as a will. If you do not have a will, you leave no legal instructions about how your property is to be distributed to your heirs. The state then steps in and dictates how your property will be distributed. The state does this by following laws known as intestacy laws. Each of the states has adopted its own intestacy laws, so the pattern of distribution varies from state to state. However, a typical pattern may be that half of the property goes to the spouse, and the other half is split equally among the children. The major disadvantage of this is that your property may not be distributed according to your wishes. There are other drawbacks to this situation, as well. Instructions about other special matters, such as who will settle the estate or who will take care of minor children, are also left in a will. If you do not have a will, these matters will also be determined by the state. Although the state will do what it thinks is in the best interest of your family, its actions may not be consistent with what you would have wanted.
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How can I minimize taxes on my estate? Question: How can I minimize taxes on my estate?
Answer: This question may seem simple, but the answer is not so easy. In fact, there are experts who make their living answering just this question. Estate tax liability depends on the year in which you die and the value of your estate when you die (see the following chart). Year of Death
Value of Estate on which Estate Tax May Be Imposed (estates in excess of the applicable exclusion amount)
2009
$3.5 million or more
2010
Estate taxes will not be imposed on any estate
2011 and thereafter $1 million or more Thus, you can minimize estate tax by reducing the value of your estate until it is below the applicable exclusion amount. There are many ways you can accomplish this. The best way(s) for you may not be the best ways for others and vice versa. (Note: We're discussing only federal estate tax here. Your estate may also be subject to state death taxes. See a tax attorney for more information about state death taxes.) One way is to make lifetime gifts. Be aware, however, that certain lifetime gifts may trigger gift tax (Note: Though estate taxes will not be imposed in 2010, the gift tax remains in effect.). Gifts that do not trigger gift tax include the following: • Gifts made to U.S. citizen spouses and certain charities • Gifts of $133,000 or less made to non-U.S. citizen spouses (in 2009) • Certain payments made for tuition or medical expenses on the behalf of others • Gifts up to the annual gift tax exclusion amount of $13,000 (in 2009) • Gifts made that fall under the gift tax applicable exclusion amount of $1 million (Note: Any portion of the gift tax applicable exclusion amount used for lifetime gifts effectively reduces the applicable exclusion amount that will be available for estate tax purposes.) See a tax attorney for more information about federal and state gifts taxes. Another common technique to minimize estate taxes is to transfer assets to an irrevocable trust. Such a transfer may be subject to gift tax on the value of the assets at the time of the transfer, but the assets, plus any future appreciation, are removed from your gross estate. There are many types of irrevocable trusts, each created for a specific purpose. Be aware, however, that as the name implies, an irrevocable trust cannot be revoked or amended. This is just a brief glimpse of some of the techniques used to minimize estate taxes. For more information, or to discuss how these techniques might apply to your own situation, you should consult a qualified tax attorney.
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Do I need an attorney to prepare my will? Question: Do I need an attorney to prepare my will?
Answer: Legally, no. Practically speaking, yes. A will does not need to be prepared by an attorney for it to be legally effective. A will that you draft yourself, or even a preprinted will form purchased in an office supply store, will be legally effective if you are of legal age in your state (i.e., 18), are mentally competent, and execute the will properly. This means the will must be acknowledged and signed by you in front of witnesses. The required number and age of the witnesses varies from state to state, though two witnesses who are at least age 18 is typical. In addition, the witnesses should not be anyone who will benefit under your will. Some states also require that a will must be notarized to be legally effective. However, most people feel uncomfortable with a do-it-yourself will. They generally have some questions that should be addressed by an experienced estate planning attorney. In addition, some people have more than just basic concerns or are in complex situations where drafting the will properly is vital. Legal assistance can help ensure that your intentions are clearly communicated and no questions exist at the time of your death. You should also seriously consider professional assistance if your personal situation includes concerns such as: • You have minor children, children from a prior marriage, or a beneficiary with special needs • You own significant assets and are concerned about minimizing estate taxes at your death • You want to achieve certain goals, such as controlling the management and distribution of your property after your death • You have heirs you wish to disinherit, or there is a chance your will may be contested after your death
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I just made a gift. Do I have to file a gift tax return? Answer: A federal gift tax return must be filed if any gifts you made during the calendar year were other than: • Gifts to your U.S. citizen spouse • Gifts to a political organization for its own use • Gifts to qualified charities, if no other interest has been transferred for less than adequate consideration or for other than a charitable use • Gifts totaling $13,000 or less to any one individual, unless you and your spouse are "gift-splitting" • Amounts paid on behalf of any individual as tuition to an educational organization or to any person who provides medical care for an individual However, you may want to file a gift tax return in certain circumstances even if the rules do not require it. For example, you should consider filing whenever you sell hard-to-value assets, such as real estate or stock in a family business, to a relative. This is because the IRS can claim that transactions between family members were actually gifts in disguise. Disclosing such transactions on a gift tax return means that the IRS has only three years to challenge the value. If you file a federal gift tax return, you must use Form 709 and file by April 15 of the year following the year in which the gift was made. The federal gift tax rules are complex. If you believe you have made gifts that might be subject to gift tax, you should consult an experienced tax specialist. Check with your state about its own rules regarding gifts, too.
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What makes up my taxable estate? Question: What makes up my taxable estate?
Answer: Your gross estate for federal estate tax purposes includes: • All property that you own at death (e.g., real estate, investments, business interests, personal property, mortgages held by you) • Property you have given away while retaining a lifetime interest in the income from the property, the use and enjoyment of the property, or the right to determine who ultimately receives the property • Gifts that don't take effect until you die • Property that you own jointly with another person except to the extent the other party contributed to the purchase price of the property • Property over which you possess a general power to appoint the property to yourself or others • Life insurance policies owned by you or in which you retained the right to change the beneficiary, cancel the policy, or make policy loans • Your one-half interest in community property • Annuities, pensions, and profit-sharing plans From your total gross estate, your estate may take deductions for funeral expenses, administration expenses (e.g., executor's fees, court costs, attorney's fees, appraiser's fees), certain debts and income taxes, state death taxes paid, and property left to your U.S. citizen spouse or to qualified charities. The net amount may be subject to estate taxes, if estate taxes are imposed in the year in which you die. However, the amount of taxes payable on your taxable estate may be reduced by the applicable exclusion amount (formerly known as the unified credit), and a credit for foreign death taxes.
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What is the applicable exclusion amount? Question: What is the applicable exclusion amount?
Answer: The applicable exclusion amount (formerly known as the unified credit) exempts a certain amount of gifts made during your life from federal gift tax and exempts a certain amount of your estate from federal estate tax. In other words, if you are a U.S. citizen or resident, you will be able to leave a certain amount of your property free from gift tax or estate tax. The gift tax applicable exclusion amount is $1 million. Here is the current table for the estate tax applicable exclusion amount: Estates of those who die during: The applicable exclusion amount is: 2009
$3.5 million
2010
Estate tax is scheduled to be repealed
2011 and thereafter
$1 million (estate tax is scheduled to be reinstated)
Keep in mind that the applicable exclusion amount for gift tax purposes is $1 million even though the applicable exclusion amount for estate tax purposes is $3.5 million in 2009. Any portion of the applicable exclusion amount used for gift tax purposes effectively reduces the applicable exclusion amount that will be available for estate tax purposes. In addition, although estate tax is scheduled to be repealed in the year 2010, the gift tax will remain in effect. It is especially important for spouses to understand the applicable exclusion amount. Without advance planning, the applicable exclusion amount of the first spouse to die may be lost. It is wise to seek advice from an experienced estate planning attorney so that each spouse can make maximum use of the shelter that the applicable exclusion amount provides.
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How will estate taxes be paid if I leave no provision in my will? Question: How will estate taxes be paid if I leave no provision in my will?
Answer: The IRS places an automatic lien against your estate for any estate taxes that may be due. If your will leaves no specific provision about how these taxes are to be paid, state law generally controls how the burden of paying the taxes will be distributed among your beneficiaries. As a result, your beneficiaries may end up paying taxes out of their own pockets or selling some of the property that you left to them to meet this obligation. Most state apportionment statutes impose the tax payment liability only on those assets that contributed to the tax imposed. Thus, your spouse will not be responsible for any taxes if he or she received all your property free of tax under the unlimited marital deduction. Likewise, charities that received property free of tax under the charitable deduction will not have to carry any of the tax burden. In addition, most state apportionment acts divide up the tax burden on a prorated basis. For example, if your taxable estate was evenly split between two beneficiaries, each beneficiary would be responsible for 50 percent (one-half) of the taxes due. Beneficiaries who received the taxable portion of your estate must pay their share of the taxes owed when they are due--generally nine months from the date of your death. They may have to sell their inheritances to get the cash. If their inheritances are already spent, however, they still must pay the taxes, and the IRS can go after any of their other assets to satisfy the lien.
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How often do I need to review my estate plan? Question: How often do I need to review my estate plan?
Answer: Although there's no hard-and-fast rule about when you should review your estate plan, the following suggestions may be of some help: • You should review your estate plan immediately after a major life event • You'll probably want to do a quick review each year because changes in the economy and in the tax code often occur on a yearly basis • You'll want to do a more thorough review every five years Reviewing your estate plan will not only give you peace of mind, but will also alert you to any other changes that need to be addressed. There will be times when you'll need to make changes to your plan to ensure that it still meets all of your goals. For example, an executor, trustee, or guardian may change his or her mind about serving in that capacity, and you'll need to name someone else. Other reasons you should do a periodic review include: • There has been a change in your marital status (many states have laws that revoke part or all of your will if you marry or get divorced) or that of your children or grandchildren • There has been an addition to your family through birth, adoption, or marriage (stepchildren) • Your spouse or a family member has died, has become ill, or is incapacitated • Your spouse, your parents, or other family member has become dependent on you • There has been a substantial change in the value of your assets or in your plans for their use • You have received a sizable inheritance or gift • Your income level or requirements have changed • You are retiring • You have made a change in your estate plan (e.g., you created a trust or executed a codicil to your will)
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Is jewelry or art covered under my homeowners policy? Question: Is jewelry or art covered under my homeowners policy?
Answer: Your homeowners policy provides coverage for your personal property, which should include your jewelry and works of art. However, personal property coverage is usually limited to 50 percent of the coverage amount for your home. In addition, most policies set dollar limits for certain types of personal property (e.g., jewelry, furs, silver). And some items will be covered only for theft. You'll have to read your policy to determine your coverage limits. If you feel that the value of your jewelry or art exceeds the coverage limits on your policy, you can increase your coverage by purchasing either an endorsement or floater. Or, you can purchase a stand-alone policy designed to cover specific pieces of jewelry or art. Keep in mind, though, that in order to obtain additional coverage for your jewelry or art, your insurer will require you to have a professional appraisal. The appraisal establishes an objective value for your property, which may be significantly different from what you think it's worth.
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How can I find insurance for my sailboat? Question: How can I find insurance for my sailboat?
Answer: You might want to start with your insurance agent, because you may be able to save money by insuring your sailboat with the same company that carries your auto, life, or homeowners insurance. You can also search for marine insurance in the yellow pages or on the Internet, or ask your insurance agent for a referral. Hundreds of insurance companies specialize in marine insurance. Before you begin your research, though, make sure you know what type of policy you'll need. You'll find that pleasure boats are categorized according to size and type for insurance purposes: • Pleasure boats 16' to 25'11": Boats of this size, and valued at $3,000 or more, are eligible for boatowners insurance (territorial limits are normally imposed) • Pleasure boats 26' or longer: These boats, which include most cruisers and sailboats (and some sportfishing vessels), are eligible for personal yacht insurance Boatowners insurance policies typically provide coverage for personal liability and physical damage. Some policies also include legal defense protection, medical payments coverage, and uninsured boater coverage. Personal yacht policies also provide personal liability and physical damage coverage, as well as optional coverage for legal defense, medical payments, and uninsured boaters. In addition, you may be able to purchase a hurricane endorsement. Yacht insurance generally does not have specific territorial limits, but may have cruising limits as defined in the policy. Here are some questions you may want to ask your insurance agent before buying insurance for your sailboat: • Will I be covered for both inland boating and ocean boating? • Are boating supplies covered? • Which boat operators are covered? • Are discounts available if I complete a safety training course?
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My cleaning person is bonded and insured. Is that important? Question: My cleaning person is bonded and insured. Is that important?
Answer: When hiring a cleaning person, it's a good idea to hire someone who is bonded and insured. When a company claims that its employees are bonded, it's agreeing to be responsible if an employee steals from you. Insured, on the other hand, usually means that the company has liability, property damage, and/or workers' compensation insurance. If you haven't already done so, ask to see the company's insurance certificates to verify the exact type of coverage it has. Is your cleaner a solo act? Here's an important fact you should know. Courts often find that hiring an individual directly to come into your home and follow your instructions may make you the employer. In this case, you'll have different insurance needs (e.g., workers' compensation insurance). Review your policies and talk to your insurance agent. If you're not sure what to do, contact an attorney who specializes in labor or employment law.
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How do I insure my coin collection? Question: How do I insure my coin collection?
Answer: If your coin collection is valuable, you'll certainly want to take steps to insure it. The first place to look is your existing homeowners/renters policy. Most policies provide at least some coverage for collectibles, although the total amount of coverage is usually capped at a specific dollar limit. If you read your homeowners/renters policy and find that it provides some coverage for collectibles, you'll want to understand how you'll be reimbursed in the event of a loss. There are two options: actual cash value coverage or replacement cost coverage. The most common type is actual cash value coverage. Under this type, if your coin collection is stolen or destroyed, you'll be reimbursed in an amount equal to the value of your collection minus depreciation. In other words, the amount will be what you could have received if you sold your collection to a willing buyer. With replacement cost coverage, you'll be reimbursed for what it would cost you to replace your collection in full, without considering depreciation. In other words, you'll receive what it would cost you to go out and buy the exact same collectible on the market today. The catch is that many policies don't offer replacement cost coverage on items more than 25 years old. You'll need to shop around. If you need more coverage than your homeowners/renters policy can provide, you can purchase a floater on your existing policy or a new stand-alone policy specifically designed for collectible items. A floater will increase the coverage limit on your coin collection under your existing policy. The stand-alone policy will provide additional coverage for your coin collection in an amount you designate. For either option, you'll probably need to have your coin collection appraised by a professional.
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I'm going on a cruise. Do I need trip interruption insurance? Question: I'm going on a cruise. Do I need trip interruption insurance?
Answer: Trip interruption insurance reimburses you for losses associated with your trip being cut short (e.g., emergency flight home, unused prepaid expenses). Whether you should purchase trip interruption insurance depends primarily on whether you can afford to absorb those losses yourself. Other factors may come into play, though, such as your health status, the location of your trip, and how comfortable you are with risk. Trip interruption insurance coverage varies, depending on the type of policy you buy. However, most policies provide coverage if you get sick (although policies often exclude pre-existing conditions) or have some kind of emergency (e.g., death in the family). Some even provide coverage if your trip is interrupted by bad weather (e.g., hurricane). However, most cruise contracts give the cruise company the right to change the ship's itinerary if there's severe weather. So don't expect reimbursement from your trip interruption insurance for missing a scheduled port of call. Be sure to read your trip insurance policy carefully to understand exactly what is and isn't covered. To get a premium quote, call your property/casualty insurance agent or your travel agent.
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I've just bought a pair of expensive skis. Will they be covered under my homeowners insurance? Question: I've just bought a pair of expensive skis. Will they be covered under my homeowners insurance?
Answer: In general, yes. Your homeowners insurance policy covers the theft, damage, or destruction of your personal property, including your skis. But it won't provide coverage in all situations. Depending on the value of your skis and where you take them, you may need extra coverage. For instance, if you want to recover the full value of your skis rather than their depreciated value should you have to file a claim, you need to purchase a replacement cost floater. If you want to ensure that your skis are covered no matter where you take them, you should add a personal effects floater to your homeowners policy. And if you want to protect your skis against all risks, even ones typically excluded from coverage under a homeowners policy, you may want to purchase an open perils floater. Of course, all of these optional coverages will increase your homeowners insurance premium, so you'll have to decide if the extra coverage is worth the cost. Talk to your insurance agent or broker about your options.
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Are hunting rifles covered under my homeowners insurance? Question: Are hunting rifles covered under my homeowners insurance?
Answer: Yes. Hunting rifles, like personal stereos, VCRs, and other personal property, are covered under your homeowners insurance for loss, theft, or damage. The standard policy typically provides up to $2,500 for such claims. But if you're a collector, the value of your firearm collection may exceed this limit. Ask your insurance agent about adding a floater to your homeowners policy that will provide additional coverage. If you accidentally injure someone on your premises, your homeowners insurance will cover some or all of the damages (e.g., medical bills, property damage, and liability claims). For additional coverage, you can buy a specialized policy, such as sporting firearm insurance, collectors firearm insurance, or gun club liability insurance, to meet your needs. Ask your insurance agent or broker for more information.
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I'm planning on living in Europe for several months. Do I need special health insurance? Question: I'm planning on living in Europe for several months. Do I need special health insurance?
Answer: Unless you're in the military or working for an American company abroad that has a health plan in place, you'll need to make sure that your health insurance will cover your needs--and don't wait until you're already sick or injured to do it. If you're planning to travel overseas, be aware that your health insurance plan may not cover you at all. Most managed care plans, such as health maintenance organizations (HMOs) or preferred provider organizations (PPOs), will cover emergency treatment. But HMOs may pay nothing if you see an out-of-network health-care provider for routine care, while PPOs will pay only part of the cost. So before you set foot on foreign soil, check the limitations of your policy and call your insurer's customer service department if you have any questions. If you're going to be away for less than six months, a short-term supplemental health insurance policy may be sufficient for your needs. These policies are available from insurance companies or travel agents, and they offer accident and sickness coverage. However, read the policy carefully because the coverage is often limited. If you'll be out of the United States for more than six months, you may want to purchase expatriate health insurance. Underwritten by large insurers such as Lloyd's of London, these policies offer standard emergency and routine care coverage, and can be customized to meet your specific needs. Be sure to check for pre-existing condition limitations, including pregnancy. Options available include maternity coverage, acupuncture, chiropractic services, language translation and foreign currency exchanges, and even emergency evacuation coverage. The application process for expatriate health insurance can be detailed and extensive; you'll have to list any health problems you've had in the past 10 years. The cost of a plan will depend on several factors, such as your age, state of health, sex, and travel itinerary.
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Should I invest in mutual funds or individual securities? Answer: Mutual funds offer many advantages that are particularly attractive if you have a small amount to invest (i.e., $25,000 or less), or if you don't have the time, experience, or inclination to manage your own investment portfolio. If you invest in an actively managed mutual fund, you get the benefit of the fund manager's professional expertise without the expense of hiring your own investment advisor (although you'll pay mutual fund fees and expenses). Money invested in a mutual fund is fairly liquid. With some qualifications, you can generally sell your shares back to the issuer at any time if you need cash. Also, the typical mutual fund holds dozens and often hundreds of different securities. If you purchase shares of a mutual fund, you benefit from instant diversification at a relatively low cost. For instance, if you buy into an asset allocation fund, your investment dollars will automatically be spread across multiple asset categories, even if you invest only a few hundred dollars. Even with a mutual fund that invests in only one type of investment, you still have a small stake in many different securities. It would require a much larger initial outlay of cash to purchase a portfolio of individual securities as diverse as most mutual funds. Remember, though, that diversification doesn't guarantee a profit or ensure against a loss. Note:Before investing in a mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which are included in the prospectus available from the fund. Read it carefully before investing. However, investing in individual securities also has its advantages. You can time the purchase and sale of securities to minimize the tax consequences. You can hold securities long enough to avoid short-term capital gains treatment and realize your losses at a time when you are in the best position to claim them as a deduction. As a mutual fund investor, you give up that control--fund managers do not consult with shareholders before making transactions. Finally, although you may spend more time and money building a portfolio of individual securities, you'll be able to customize your portfolio so that it truly serves your needs. You can invest only in companies you are comfortable investing in, with the level of diversification you desire and degree of risk you're willing to take.
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What is a mutual fund prospectus and how do I read it? Answer: A mutual fund prospectus is a pamphlet or brochure that provides information about a mutual fund. Mutual fund companies must give potential investors a prospectus, free of charge, before they invest. You can get a prospectus by calling the mutual fund company directly or by visiting the fund's website. Before investing in a mutual fund, read the prospectus thoroughly so you can carefully consider the fund's investment objectives, risks, fees, and expenses. The prospectus will include information about the fund manager's objectives and practices. When reviewing a prospectus, you'll want to look at the kind of securities the fund holds and the kind of transactions it makes and how often. Make sure the fund operates in a way that's consistent with your own needs, investment goals, and tolerance for risk. For instance, if you need to invest for income and preservation of capital, and the prospectus describes the fund's investment policy as aggressive and growth oriented, then you haven't found a good match. The prospectus will also tell you about expenses and fees. It will disclose specifics about sales charges and fees for management, distribution (12b fees), redemption, reinvestment, and exchange transactions that may be charged to you as a shareholder. It will also disclose the minimum required investment amounts and whether the fund is a load or no-load fund. Before you invest, gather this information from the prospectus so that you understand the cost of investing in the fund.
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How can I gauge my risk tolerance? Answer: Risk tolerance is an investment term that refers to your ability to endure market volatility. All investments come with some level of risk, and if you're planning to invest your money, it's important to be aware of how much volatility you can endure. Your tolerance for risk affects your choice of investments and the overall makeup of your portfolio. If you are attempting to gauge your own tolerance for risk, consider the following factors: • Personality: Are you able to sleep at night knowing that you've put a portion of your hard-earned dollars at risk in a particular investment? Remember, it might be easy to tolerate a high-risk investment while it is generating double-digit returns, but consider whether you'll feel the same way if the market takes a downward turn with your investment leading the way. It's best to invest at a level of volatility that you are comfortable with. • Time horizon: If you will need your investment dollars to make a down payment on a house in 2 years, your risk tolerance is lower than if you're investing for retirement in 20 years. If you can keep your money invested for a long period of time, you may be able to ride out any downturns in the market (though time alone is no guarantee of higher returns). In general, the longer you can wait, the higher your risk tolerance. • Capacity for risk: How much can you afford to lose? Your capacity for risk depends on your financial position (i.e., your assets, income, and expenses). In general, the more you have to fall back on, the higher your risk tolerance. In addition to the above, think about taking a risk tolerance test. Any number of risk tolerance tests can be found on the Internet and in books about investing. Most require that you answer a series of questions, and generate a score based on your answers. The score translates into a measure of your risk tolerance and may be matched with the types of investments that the author deems appropriate for someone with your risk profile. Although these tests may be helpful as a reference, an honest self-analysis and advice from a trusted professional financial advisor are still the best ways to determine what investment choices are best for you.
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How do I construct an investment portfolio that's right for me? Answer: Generally, you should leave the construction of an investment portfolio to your professional investment advisor, especially if you are investing a significant percentage of your total wealth, or if you're relying solely on the success of your portfolio to meet your future financial goals. However, whether you or your advisor designs your portfolio, consider a few of these well-recognized guidelines. The term "time horizon" refers to how long you plan to keep your money invested. Your time horizon affects your portfolio design because the longer you plan to keep your money invested, the easier it may be for you to ride out dips in the market. You may be able to tolerate more volatile investments, with potentially higher returns (though time alone is no guarantee of higher returns). Your personal risk tolerance also affects your portfolio design. Can you sleep at night knowing that a sudden downward shift in the market could cost you a significant portion of your principal? If not, a portfolio that holds a high percentage of aggressive growth stocks, for example, is not right for you. You should match investments to your personal level of risk tolerance. Your personal liquidity needs may eliminate some investment choices. If you periodically need access to your investment dollars, it makes no sense to design a portfolio dominated by assets that can't be readily sold or whose value can fluctuate dramatically. Instead, you'll need investments that can be converted to cash easily and quickly.
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What is asset allocation and how does it work? Answer: Asset allocation is a technique used to spread your investment dollars across several asset categories. The investment categories may include cash and cash alternatives, bonds, stocks, real estate, mutual funds, insurance products, or any other investment category imaginable. The general goal is to minimize volatility while maximizing return (though asset allocation alone can't ensure a profit or eliminate the risk of a loss). The process involves dividing your investment dollars among asset categories that do not all respond to the same market forces in the same way at the same time. Though there are no guarantees, ideally, if your investments in one category are performing poorly, you will have assets in another category that are performing well. The gains in the latter will offset the losses in the former, minimizing the overall effect on your portfolio. The number of asset categories you select for your portfolio and the percentage of portfolio dollars you allocate to each category will depend, in large part, on the size of your portfolio, your tolerance for risk, your investment goals, and your time horizon (i.e., how long you plan to keep your money invested). A simple portfolio may include as few as three investment categories, with a percentage of total dollars divided among, for example, cash alternatives, bonds, and stocks. A more complex portfolio may include many more asset categories or break down each of the broader asset categories into subcategories (for example, the category "stocks" might be further divided into subcategories such as large cap stocks, small cap stocks, international stocks, high-tech stocks, and so on). Generally, the asset allocation that best suits your needs is determined with the help of a financial professional. (Instant asset allocation can be achieved by investing in an asset allocation mutual fund.) Whether you hire a financial professional or not, be sure to periodically review your portfolio to ensure that the mix of investments you have chosen still serves your investment needs.
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Should I work with a stockbroker to buy individual stocks? Question: Should I work with a stockbroker to buy individual stocks?
Answer: This is almost a trick question, because in order to buy an individual stock on an exchange, you must always go through a brokerage house that is a member of that exchange, and the transaction will be completed by a registered broker. Perhaps the more important question is whether you should use a full-service broker, a discount broker, or some combination of the two. If you have more money than time to manage it, you may find the full-service broker well worth the additional expense. Full-service brokers typically charge a fee or commission but provide research, individual planning assistance, and investment advice. Many full-service brokers also offer the option of using mutual funds for some part of your investment portfolio. Typical discount brokers may provide little or no investor services but can charge much less to complete whatever transactions you desire. Competition for market share and advances in technology have given rise to a whole host of brokerages that combine the elements of these two extremes. Most notable are the Internet brokers that feature on-line research and assistance, as well as low-cost, per-trade, flat rates. Whatever broker you choose to work with, make sure you know what you are getting and how much you are paying for it, before you invest.
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Who do I call if I have a complaint about my stockbroker? Question: Who do I call if I have a complaint about my stockbroker?
Answer: First of all, you'll have to act promptly. By law, you have only a limited amount of time to take legal action. You'll need to contact your broker first and give him or her the chance to correct the problem. If the broker can't or won't help you, you'll need to take further steps. You should review the documents you signed when you opened your account. They should describe your appeal process. You should contact the broker's branch manager or regional office manager. Often they will have the authority to intervene and resolve the matter. If not, write to the compliance department of the firm's main office. Explain the problem clearly and tell them how you want it resolved. Ask for a written response within 30 days. Keep thorough notes on each of your conversations, including dates and who you contacted. It is also a good idea to follow up a phone call with a letter. If you still get no satisfaction, you may want to contact any of the regional or district offices of the United States Securities and Exchange Commission (SEC) to get information about how to file a complaint with any of the offices that oversee the securities industry. The SEC has offices in New York, Boston, Philadelphia, Miami, Atlanta, Chicago, Denver, Fort Worth, Salt Lake City, Los Angeles, and San Francisco. You can also file complaints on-line at the SEC's website (www.sec.gov) or by writing to the SEC Complaint Center, Securities and Exchange Commission, 450 Fifth Street NW, Washington, DC 20549. Finally, if all other efforts have failed, contact your attorney. Your problem may involve criminal behavior or require a securities specialist.
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How much of my portfolio should I keep in stocks? Question: How much of my portfolio should I keep in stocks?
Answer: Financial professionals advise that if you are saving for retirement, the younger you are, the more money you should put in stocks. Over the long term, stocks are more likely to provide favorable returns and capital appreciation than other commonly held securities. As you age, you have less time to recover from downturns in the stock market. Therefore, many planners suggest that as you approach and enter retirement, you should begin converting more of your volatile growth-oriented investments to fixed-income securities such as bonds. A simple rule of thumb is to subtract your age from 100. The difference represents the percentage of stocks you should keep in your portfolio. For example, if you are age 40, 60 percent (100 minus 40) of your portfolio should consist of stock. However, this estimate is not a substitute for a comprehensive investment plan, and many experts suggest modifying the result after considering other factors, such as your age, risk tolerance, financial goals, and the fact that individuals are now living longer and may have fewer safety nets to rely on than in the past. For example, if you accept an early retirement package at age 57, it's feasible that you'll be living off your retirement fund for as long as 30 years or more. You'll have plenty of time for your portfolio to recover from any unexpected downturns in the markets, and with inflation and the rising costs of medical care, you will need more growth than most fixed-income securities typically deliver. You may want to keep a portion of your portfolio invested in stocks well into your retirement years. If you're investing for something other than retirement, the simple rule of thumb probably doesn't apply. If you'll need access to your investment dollars within a few years (e.g., to purchase a home or to pay your child's tuition), you should consider investing more of your portfolio in less volatile securities, such as money market or short-term bond mutual funds, rather than in stocks. If your investment goals are short term (e.g., two to five years), you won't have time to recover from a downward swing in the markets, and you risk that your investment dollars may not be there when you need them.
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How long should I hang on to an investment? Answer: You'll want to hang on to an investment as long as it meets your investment objectives, and you think it is likely to continue to perform as well as or better than comparable investments. Evaluating your investments once or twice a year will help you make that determination. To evaluate your investments, you'll have to determine whether a particular investment is still appropriate for your age, risk tolerance, and financial goals. For example, perhaps you have been investing for retirement and have recently decided to purchase a home later this year. If a large part of your current investment portfolio is in a growth company stock fund, you should consider moving at least part of that investment to a less volatile investment. Your investment goal has changed, and you'll need access to your investment dollars sooner rather than later. You certainly don't want to risk losing the down payment for your new home because of a sudden downturn in the markets. A common mistake among investors is to hold on to an investment because it has fallen in value, hoping to earn your losses back before moving on. A good rule of thumb is that if you aren't willing to buy more of that investment at the lower value, it may be time to sell it. Just because the markets have historically gone up over time doesn't mean that an individual stock will go back up in value. Aside from changes in your financial goals, a good time to re-evaluate an investment is when changes occur in the management of a mutual fund or company in which you own stock. You generally have no way of predicting what effect new management may have on the value of the securities. The additional risk or a change in investment objective, if any, may lead you to reconsider holding on to your shares. Whenever you contemplate selling an investment, you may want to speak with a tax professional about the tax impact of the sale. You may decide to sell an investment that has performed poorly to offset gains in a given tax year. In contrast, you may want to hold on to an investment because selling it now may result in short-term capital gains treatment, whereas holding it for longer than a year will allow you to qualify for more favorable long-term capital gains treatment.
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How do I protect my assets in the event of a divorce? Question: How do I protect my assets in the event of a divorce?
Answer: If protecting your assets means that you want to keep all of your money, property, and possessions out of your soon-to-be ex-spouse's hands, you're probably out of luck. Any assets acquired during marriage are considered marital property and must be divided according to state law. If you live in a community property state (i.e., California, Texas, or one of eight other states), you and your spouse must split any marital assets equally. However, in all other states, assets must be divided equitably (fairly) rather than equally. Your best protection is to make sure that your interests are represented. Hire an experienced attorney who will help you negotiate a fair settlement. Don't shortchange yourself by overlooking hidden assets. For instance, you may know your joint savings account balance and what possessions you must divide, but do you know the balance of your spouse's pension plan? Does your spouse own a prepaid life insurance plan? Does your spouse have retirement funds (e.g., 401(k), IRAs) in his or her own name? These things will be considered marital assets as well. Finally, don't forget about debt. In general, you'll be responsible for any debt acquired during the marriage, even if you didn't run up the debt yourself. Make sure that the divorce settlement states who will be responsible for paying off all debts, and close all joint accounts.
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Should I sign a prenuptial agreement to protect my assets when I remarry? Question: Should I sign a prenuptial agreement to protect my assets when I remarry?
Answer: Even if you never thought about signing a prenuptial agreement the first time you married, it's wise to consider it now, because marriage is often more complicated the second (or third or fourth) time around. You may have more assets now, or you may own a business or have children to protect. And because you've been through it before, you may be worried about the financial consequences of divorce or widowhood. A prenuptial agreement can ease your mind by spelling out what assets and liabilities each partner is bringing into the marriage, and by determining how money or property brought into the marriage or acquired during the marriage will be divided if the marriage ends either in death or divorce. A prenuptial agreement addresses some or all of these points: • Assets and liabilities: What assets are you each bringing into the marriage? How much are they worth, and who owns them? Which ones will become marital property, and which ones will continue to be owned individually? Will gifts and inheritances be shared or separate? What liabilities do you have (e.g., back taxes or other debt)? • Divorce: If you divorce, how will you divide assets brought into the marriage or acquired during the marriage? Will either spouse receive a lump-sum cash settlement or alimony? • Estate planning: What will go to your children from previous marriages? What will go to children you have together? • Special contributions of partners: If one spouse contributes to the marriage in a special way (e.g., limiting his or her career for the benefit of children or the other spouse), will that spouse be provided for? What if one spouse brings more liabilities to the marriage than the other? Because it's difficult to write an ironclad prenuptial agreement, don't try doing it yourself. Instead, you and your future spouse should hire separate attorneys to help you negotiate an agreement that will protect your financial interests without causing mistrust between the two of you.
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What's the best way to handle a financial windfall? Question: What's the best way to handle a financial windfall?
Answer: First, put the money into a safe, liquid investment such as a money market fund, and take stock of your situation. Don't spend or invest your windfall until you have a chance to: • See a tax professional and analyze the tax consequences--you may need a big portion of what you have received to pay taxes • Consider how the windfall affects your overall financial situation • Create a budget • Speak with a financial professional to help you decide the best way to invest • Consult with an estate planning attorney to create or update your will and other necessary documents You should also guard against those who offer get-rich-quick schemes or otherwise want to share in your windfall. If you have hired an attorney or other professional to help you manage your new wealth, it might be a good idea to refer all of the requests that you receive to that person. Often a wise financial move, no matter the size of your windfall, is to pay off high-rate loans such as credit card balances. Then, only after you have carefully considered how your circumstances have changed, indulge yourself with something you've always wanted. Spend wisely, though. Most people who get a windfall spend the entire amount within five years. If you plan well and control the urge to spend lavishly, however, your good fortune could provide you with financial security for many years to come.
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When I play the lottery, I have to choose between a lump sum and annual payments. Does it matter? Question: When I play the lottery, I have to choose between a lump sum and annual payments. Does it matter?
Answer: With hard-to-beat odds of winning the average lottery game, it probably doesn't matter. Should you beat those odds, however, choosing between a lump sum and annual payments does make a difference and depends largely on your personal needs and goals. In either case, you'll pay federal taxes and in some cases state and local taxes, according to the prize amount and your existing financial status. With a lump-sum disbursement lotteries pay out a percentage of the jackpot in a lump-sum (typically 40 to 50 percent of the jackpot amount). Depending on the state and lottery rules, your payout option may be selected before or after your win. If you select the lump-sum option, you'll receive a large chunk of cash for your immediate use. You may spend or invest it as you like. There are big benefits to taking the cash in a lump sum. Used judiciously, it can improve your finances by eliminating debt and improving your lifestyle. If invested wisely, it can potentially grow dramatically and become the basis for a significant estate. Of course, you'll need to consider the inherent risks of investing and get some professional assistance. The annual-payment option invests the value of the estimated present cash value of the advertised jackpot amount in securities over a period of years (usually 20 to 30 years). Using this option you will receive more money by the time you receive your final payout, but your spending power will actually have decreased due to inflation. It also gives you less money that can currently be put to work. Even if you invest a large part of your annual payout, the growth will be limited by the size and incremental nature of each investment. The annual-payment structure, however, offers the possibility of a budget-based approach to your winnings. You'll be less able, and therefore less likely, to spend it all in one extravagant spree. Depending on your goals and financial position, this can be the safer option. With discipline, you can create a solid estate as well.
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What is my tax bracket? Answer: Generally, a tax bracket is the income tax rate at which you are taxed for a certain range of income. The income ranges vary, depending on your filing status: single, married filing jointly (or qualifying widow(er)), married filing separately, or head of household. Brackets are expressed by their marginal tax rate, which refers to the rate at which your next dollar of income will be taxed. There are six marginal tax rates: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent. Year 2010 federal income tax rates for single taxpayers are as follows: If Taxable Income Is:
Your Tax Is:
Not over $8,375
10% of taxable income
Over $8,375, but not over $34,000
$837.50+ 15% of excess over $8,375
Over $34,000, but not over $82,400
$4,681.25 + 25% of excess over $34,000
Over $82,400, but not over $171,850
$16,781.25 + 28% of excess over $82,400
Over $171,850, but not over $373,650 $41,827.25 + 33% of excess over $171,850 Over $373,650
$108,421.25 + 35% of excess over $373,650
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What is the alternative minimum tax? Question: What is the alternative minimum tax?
Answer: The alternative minimum tax (AMT) is a separate tax computation that affects only certain taxpayers. The purpose of the AMT is to ensure that taxpayers with substantial income will not escape taxation entirely by employing certain exclusions, deductions, and credits. The tax law affords preferential treatment to certain types of income and allows special deductions and credits for some kinds of expenses. Taxpayers who benefit from these tax advantages have to pay at least a minimum amount of tax through an additional tax--the AMT. You may have to pay the AMT if your taxable income for regular tax purposes, plus certain adjustments, is more than a specified exemption amount. More specifically, tax benefit items, known as adjustments and preferences, are added to your income to arrive at alternative minimum taxable income (AMTI). A special exemption amount is then subtracted from AMTI, and the result is multiplied by the applicable AMT rate. If the AMT calculation results in a higher tax liability than the regular income tax, the difference is reported as an additional tax on Form 1040. While the taxes are reported separately on your return, in effect, you would be liable for the AMT or the regular tax, whichever is higher.
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