Using Trusts to Protect Inherited IRAs

Many clients have large IRAs and retirement plan accounts and need special estate planning for these assets. A 2009 study by the Investment Company Institute found that retirement plans account for 34% of all household financial assets, up from 14% in 1978; IRAs alone account for more than 10% of all household financial assets; and 47 million U.S. households have IRAs.

Compare these numbers to the approximately 4,000 estate tax returns that will be required to be filed annually under the new “permanent” estate tax exemption of $5 million adjusted for inflation, and it is easy to see that planning for retirement accounts presents a more significant opportunity for the estate planning advisory team than does estate tax planning.

Clients want to protect their IRA and retirement plan assets for their families, but most do not understand what can happen to those accounts after they die. And, unfortunately, much of the information plan owners and beneficiaries receive from family members, other lay sources, and, surprisingly, even some advisors is outdated or incorrect.

Without proper planning, trillions of dollars in IRAs and qualified plans that are passed down to clients’ beneficiaries upon death could be exposed to the beneficiaries’ creditors and other beneficiary-associated risks. By using specially designed IRA trusts, the plan owner’s beneficiaries can be protected from creditors, predators, and the temptation inherent in “found” money and thus ensure that the beneficiary achieves the maximum tax deferral that the client intends.

In this issue of The Wealth Counselor, we will explain some of the rules about retirement plans that every member of the advisory team must know and how a properly prepared retirement plan trust (which we will here refer to as an “IRA trust”) can protect the plan assets after the owner’s death.

Problems with Inherited IRAs and Retirement Assets
Impact of Income Taxes
Unless the client’s retirement plan assets are in a Roth IRA or other Roth vehicle, income taxes must be paid whenever assets are withdrawn from these accounts. The top federal income tax rate is now 39.5% and state income taxes, where applicable, are in addition. (The 3.8% Medicare surcharge does not apply to retirement account withdrawals but the withdrawals from non-Roth accounts do get counted in determining if and by how much the taxpayer has exceeded the applicable threshold amount for the surtax.)

Impact of Income Tax Deferral
Different Levels of Protection for IRAs and Inherited IRAs
Qualified retirement plans, including SEP and Simple IRA plans, are protected under ERISA, but traditional, Roth, and inherited IRAs are protected under state laws, which vary greatly. For example, during the original IRA owner’s lifetime, protection can range from unlimited protection to a specified dollar amount or, as in California, to an amount reasonably necessary for the owner and any dependents. Protection for inherited IRAs may be different than that provided to the owner. This varies from state to state and is determined by the beneficiary’s state of residence when the protection question arises. Therefore, only the surest result is obtained through good, proactive planning.

Planning Tip: It is critical to understand how the laws in your state apply to an original owner and to someone who has inherited an IRA. You cannot assume that the beneficiary residing in another, often currently unknown state will have the same asset protection as the owner or a beneficiary residing in your state.

“Found” Money Is Extremely Slippery
We have all heard of the result of studies of how fast the average beneficiary goes through life insurance proceeds. Spending “found” money simply does not carry the significance of spending one’s own hard earned money. An IRA or other retirement account passing to an individual beneficiary is also “found” money and just as slippery.

IRAs and other retirement plans offer the substantial tax benefit of income tax deferral. Stretching out the inherited retirement plan’s distributions over a beneficiary’s actuarial life expectancy yields a much greater return than if the beneficiary cashes out the plan and pays taxes immediately on the full distribution plus on any future earnings on those assets.

Planning Tip: It can be very helpful to have a chart or calculator that illustrates to clients the benefits of income tax deferral based on his/her actual account balance, actuarial life expectancy, and beneficiaries’ ages.

Divorce and Unintended Beneficiaries
Although an inherited IRA is not a marital asset, it is “on the table” in a divorce because it can be transferred as part of a divorce settlement. Also, the beneficiary of an inherited IRA will make his/her own beneficiary designation in case of death before the account is depleted. Most clients do not want a child’s ex-spouse to get their IRA or a child’s new spouse to inherit because both carry the risk that the client’s grandchildren will be disinherited.

Loss of SSI/Medicaid
Any inheritance, including assets in an inherited IRA, are considered “resources” for determining SSI/Medicaid eligibility. At least temporary loss of SSI/Medicaid or other government benefits by a disabled beneficiary is hard to avoid if there is more than $2,000 in the inherited IRA.

Planning Tip: Assets held in a properly drafted IRA trust can provide much better protection and ensure maximum stretch out.

Basic Retirement Plan Concepts
A major advantage of qualified retirement plans and IRAs is that the income tax on plan earnings is deferred until withdrawal. With the exception of a Roth IRA or plan account, the account owner (referred to herein as “the owner”) must commence Required Minimum Distributions (RMDs) by his or her Required Beginning Date (RBD). The owner is never required by tax law to make withdrawals from any Roth account but the Roth account beneficiary is.

Required Beginning Date (RBD)
Generally the RBD is April 1 in the year following the calendar year in which the owner reaches age 70 ½ or, for a qualified plan, the calendar year in which the owner retires from employment. There is a qualified plan exception for less than 5% owners. In each year beginning with the year of the RBD, the owner must withdraw at least the Required Minimum Distribution (RMD).

Calculating Required Minimum Distributions (RMDs)
RMDs are calculated by dividing the prior year’s 12/31 account balance by the applicable life expectancy factor as provided by the IRS.

Life Expectancy Factors
There are different life expectancy factors for different account holders. That from the Uniform Table is used for an owner’s lifetime distributions. (This table recalculates life expectancy every year so that even someone age 110 has a life expectancy and will not be required to empty the account.) However, if the owner’s spouse is the owner’s sole beneficiary and is more than ten years younger than the owner, the Joint & Last Survivor Table is used instead of the Uniform Life Table during the owner’s life. The Single Life Table is used by all qualified beneficiaries after the owner’s death.

Planning Tip: When working with a qualified plan, be sure to read the plan agreement and become aware of optional plan provisions. If the custodian is not willing to do what the client wants, consider changing to a new custodian where possible or rolling the account assets into an IRA.

Spousal Rollovers
Only a surviving spouse can rollover an IRA (or qualified plan) into his/her own IRA. Once rolled over, the IRA is treated as if all contributions to it had been made by the surviving spouse. In other words, the surviving spouse uses the Uniform Table to determine RMDs, which must begin by the surviving spouse’s RBD.

Planning Tip: A surviving spouse can defer a rollover indefinitely. If the surviving spouse is younger than 59 ½, rolling over before attaining age 59 ½ risks incurring the 10% early withdrawal penalty. In such cases, consider establishing an inherited IRA and rolling over when the surviving spouse attains age 59 ½. If the surviving spouse is the sole beneficiary, his or her RBD from the inherited IRA is the same as was his or her deceased spouse’s RBD.

Qualified Plan Rollovers by Non-Spouse Beneficiaries
A non-spouse beneficiary is now allowed to do a trustee-to-trustee rollover of a qualified plan to his or her own Inherited IRA.

NOTE: All inherited IRA accounts must be titled in the original owner’s name for the benefit of the beneficiary (e.g., Mary Smith, Deceased, IRA f/b/o Jim Smith). Anything else is considered a 100% taxable distribution.

Designated Beneficiary
If there is a designated beneficiary of the inherited IRA or plan account, the designated beneficiary’s life expectancy is used to determine RMDs in years following the year of the owner’s death. This allows the inherited account to be distributed over the beneficiary’s actual life expectancy, resulting in maximum stretch out and tax deferral.

*    If there is not a designated beneficiary and the owner died before his or her Required Beginning Date, the account must be completely distributed by the December 31 following the fifth anniversary of the owner’s death (the “five-year rule”).
*    If there is not a designated beneficiary and the owner died on or after his or her RBD, the RMD is determined using the Single Life Table as if the owner were still living (the “ghost life expectancy rule”).

A designated beneficiary (as defined by Treas. Reg Section 1.401(a)(9)-4):
*    Must be named a designated beneficiary under the terms of the plan or by an affirmative election by the employee;
*    Need not be specified by name but must be identifiable on the date of death;
*    May be a class of beneficiaries capable of expansion or contraction (e.g., my children or grandchildren);
*    Must be an individual alive on the date of the owner’s death;
*    May be a trust if all of its beneficiaries who have to be considered are individuals alive on the date of the owner’s death, the oldest of whom may be determined (a “qualifying” trust).

A designated beneficiary is NOT:
*    an estate;
*    a charity;
*    a non-qualifying trust;
*    any non-individual other than a qualifying trust; or
*    an individual born after the date of the owner’s death.

The IRA Trust
The advantages of using trusts in general include spendthrift protection, creditor and predator protection, beneficiary divorce protection, special needs planning, consistent investment management, estate planning, and exercising control over the trust assets after the death of the trust maker.

Disadvantages of trusts include greater complexity; legal, accounting and trustee fees; and for trusts that are not required to distribute all their taxable income, greatly compressed income tax brackets (the 39.5% top income tax bracket for individuals begins at $400,000, for such trusts it begins at $11,950).

To be a qualified trust, and thus qualify as a designated beneficiary of an IRA or retirement plan account, an IRA trust must:
1.   Be valid under state law;
2.   Be irrevocable not later than the death of the owner; and
3.   Have beneficiaries all of whom are individuals who are identifiable from the trust instrument when considered on September 1 of the year following the owner’s death.

In addition, the documentation requirement for a trust beneficiary must be satisfied.

Planning Tip: A single revocable living trust would meet requirement #2 because it becomes irrevocable upon the trust maker’s death. However, unless it contains a “conduit” provision, discussed below, a single RLT is unlikely to satisfy requirement #3. A joint revocable living trust would not satisfy requirement #2 because it continues to be revocable until the death of the second spouse. For these and many other reasons, a specialized IRA trust is a preferable IRA beneficiary.

Planning Tip: The documentation requirement is fairly easy to satisfy, but it is vital not to miss the documentation deadline. The trust document must be provided to the account custodian by October 1 of the year following the owner’s death.

Types of IRA Trusts
Conduit Trust
The IRS regulations for IRA trusts provide an example that is commonly referred to as a “conduit” trust. This is a trust in which all distributions from the IRA are required to be immediately distributed to the trust’s beneficiary(ies). With a conduit trust, identification of countable beneficiaries and qualifying the trust as a designated beneficiary is easier because “downstream” and contingent beneficiaries are not considered. On the other hand, because all distributions, including RMDs, must be immediately distributed to the beneficiary(ies), those distributions are not asset protected as they would be if they could stay in the trust.

Accumulation Trust
An accumulation trust is one in which distributions from the inherited IRA may be kept within the trust rather than being distributed to the beneficiary(ies). That way, the trust assets have more protection against creditors and predators. This also more easily allows the beneficiary(ies) SSI/Medicaid eligibility to be preserved. On the other hand, an accumulation trust is a separate taxpayer and is subject to the compressed income tax brackets for undistributed income. Plus, the risk of the trust not being a designated beneficiary (and thus able to take advantage of the stretch) is greater because all beneficiaries have to be considered except those who are “mere potential successor” beneficiaries.

Example: The owner’s child is the primary beneficiary and a charity is the contingent beneficiary. With a conduit trust, the charity would not be counted and the child’s life expectancy would be used to determine the trust’s RMDs, which would produce maximum stretch out and tax deferral opportunity. With an accumulation trust, the charity would be counted and the trust would not be a “designated beneficiary.” That would cause the trust’s RMDs to be determined using the five-year rule or the owner’s ghost life expectancy, depending on whether the owner’s death occurred before or on/after his or her RBD.

In PLR 100537044, the IRS permitted a one-time “toggle” from conduit to accumulation trust. Having such a provision could be important if there is a change in circumstances of a beneficiary (disability, drug problems, etc.) between the time the owner set up the trust and September 1 of the year following the owner’s death. In the “toggle,” any general power of appointment given to a beneficiary must be converted to a limited power of appointment, which can create a Generation-Skipping Transfer Tax issue.

Planning Tip: Consider giving the Trust Protector the “toggle” power in any IRA trust to provide flexibility to deal with possible future events.

Separate IRA Trust vs. Trust in a Revocable Living Trust or Will
A separate IRA Trust is more likely to qualify as a designated beneficiary than is either a non-conduit RLT or trust established under a will.

Commonly encountered issues with using RLTs and trusts in wills as IRA/retirement plan beneficiaries include the possible adverse effects of formula funding clauses; pecuniary clauses and recognition of income; powers of appointment (can expand the class of potential beneficiaries); adoption effect clauses; provisions for payment of debts, taxes and expenses; apportionment language/firewall provisions; older or unidentifiable contingent beneficiary(ies), and non-individual remote contingent beneficiaries.

Drafting Issues and Beneficiary Designations
Revocable vs. Irrevocable
A revocable IRA trust allows for changes to be made easily, but it may open the IRA to the account owner’s creditors at death. See, Commerce Bank v. Bolander, 2007 WL 1041760, Kan. App. 2007. Making the IRA trust irrevocable will protect against the Commerce Bank case problem. Making the IRA trust irrevocable does not have to be a final decision by the IRA owner. While an irrevocable trust may not be changed by its maker, a competent IRA owner can always create a new IRA trust and make a new beneficiary designation pointing to the new IRA trust.

Beneficiary Designations—Separate Shares
If an IRA is payable to an IRA trust rather than the separate beneficiaries’ shares of the trust, the trust’s RMD will be determined by the life expectancy of the oldest trust beneficiary (problematic if one beneficiary is age 60 and another beneficiary is age 2). By contrast, if multiple sub-trusts of an IRA trust are allocated shares of an IRA in the beneficiary designation form, the IRA share of each sub-trust will be paid over the life expectancy of the oldest beneficiary of that sub-trust.

Disclaimer Planning
IRA trusts can contain credit shelter and QTIP trusts for the benefit of the surviving spouse. Proper structuring of the beneficiary designation allows for disclaimer planning for the spouse and other beneficiaries. Note that no further stretch is allowed after the death of the spouse with regard to IRAs not rolled over to the surviving spouse’s own IRA by instead going to a credit shelter or QTIP trust established by the IRA owner.

Planning Tip: The general treatment for disclaimer planning is 1) spouse; 2) if spouse disclaims, IRA trust (for funding of credit shelter/QTIP); 3) if spouse is deceased, to the separate IRA sub-trusts for descendants, per stirpes. Also, children can be given the power to disclaim so that IRA distributions can be stretched out over the owner’s grandchildren’s lifetimes.

Custom-drafted beneficiary designations are required to allow proper disclaimer planning and separate share treatment. (See planning tip above.) However, some IRA custodians will not accept custom beneficiary designations and insist on using their own forms, especially for “smaller” accounts (those under $500,000). In such cases, giving the custodian a choice between losing the account to a more reasonable custodian and accepting the proposed custom beneficiary designation may produce the desired result.

Naming a separate IRA trust as designated IRA or retirement plan beneficiary is preferable to naming beneficiaries outright. It ensures that the client’s goals are carried out, including that the client’s beneficiaries will use the IRA stretch out potential. It provides asset protection against predators, the beneficiaries’ creditors and loss upon divorce. It can provide bloodline protection, preventing unintentional beneficiaries and disinheriting of descendants. It provides for beneficiaries who have or later develop special needs without jeopardizing their valuable government benefits. And it can even keep the IRA assets under the client’s current advisor’s management.

Each client’s situation is different. For IRA trust planning, individual, case-by-case analysis with input from all advisors is essential.

With so much outdated and incorrect information about IRAs and IRA planning being tossed around, current and knowledgeable advisors will stand out and prove invaluable to both clients and the other members of the advisory team.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer’s particular circumstances.

Income Tax Planning with Alaska Community Property Trusts

The Internal Revenue Code (“IRC”) provides substantial income and estate tax benefits to the married residents of the nine “community property” states. A tenth state – Alaska – allows married couples to opt in to the community property regime and reap these benefits. In addition, Alaska offers the married residents of the other 40 states a way to reap these benefits by using its community property law.

This simple income and capital gains tax planning trust strategy is one that advisor teams in those 40 states can use to distinguish themselves from other advisors and bring real value to their clients.[1] While this strategy has been underutilized in the 15 years since the Alaska Community Property Act was passed, the recent changes in income and capital gains tax rates have made it especially valuable.

In this edition of The Wealth Counselor, we will review the 2013 changes to the federal income and capital gains tax laws, explain community property law basics and tax benefits, explain how an Alaska Community Property Trust works, and identify some appropriate applications.

The Problem of Capital Gains Tax
Clients hate to pay capital gains tax to the point that they sometimes put themselves at risk to avoid this tax. Portfolios become unbalanced or over-weighted in one or two stocks because clients refuse to sell. Elderly clients are tired of managing rental real estate but won’t sell the property because of the capital gains tax.

Current Capital Gains Tax Rates
Under the Taxpayer Relief Act of 2013 and the Patient Protection and Affordable Care Act of 2010, the capital gains problem is much worse in 2013 for high income taxpayers. Here are the 2012 and 2013 capital gains tax rates for married couples filing jointly:

Adjusted Gross Income                            2012 Rate        2013 Rate
$250,000 to $450,000                               15%                 18.8%
Over $450,000                                          15%                 23.8%

Add State Capital Gains Tax
Several states now have their own capital gains tax. For example, Iowa’s is 8.98%; Hawaii’s is 11%; New Jersey’s is 8.97%. Alaska does not currently have a state capital gains tax.

Add Recapture of Depreciation
For depreciated property, a 25% tax rate will apply to recaptured depreciation. The 3.8% Medicare surtax will also apply to recaptured depreciation if the couple has adjusted gross income of more than $250,000.

Example: John and his wife Mary own an apartment building in Illinois that they purchased for $1 million in 1978. It is now worth $10 million. If they sell it, they will have a gain of $9 million. The property has a depreciated basis of zero, so they will also have $1 million of depreciation recapture. They have more than $450,000 in other income. Here’s what will happen if they sell their apartment building and why they may not want to:

20% Federal capital gains tax (on $9 million)       $1,800,000
25% Depreciation recapture tax (on $1 million)         250,000
3.8% Medicare surtax (on $10 million)                      380,000
5% Illinois capital gains tax (on $10 million)              500,000
Total Tax                                                              $2,930,000

The Hold Until Death Strategy
IRC Section 1014 provides that the basis of property acquired from a decedent that is included in the decedent’s estate for estate tax purposes is its fair market value at 1) the date of the decedent’s death or 2) optionally in a few cases, six months after the date of the decedent’s death. Generally, this results in a “step up” in basis as most property appreciates in value over time due to the effect of inflation. (A “step down” in basis occurs if the market value goes down instead of up between acquisition and death.)

Planning Tip: Many people are tempted to hold onto appreciated property until they die so their children will get the step up in basis.

Example Variation #1: Assume that John is the sole owner of the apartment building and leaves it to Mary upon his death in 2013. Under IRC Section 1014, Mary receives a “step up” in basis to $10 million, the fair market value of the property. If Mary then sells, there is no tax on the gain or depreciation recapture – a tax savings of more than $2.9 million.

Example Variation #2: Assume John and Mary own the building jointly and John dies. IRC Section 1014 provides Mary a “step up” in basis on John’s half of the property to $5 million. Added to Mary’s basis on the other half, that results in a new basis for Mary of $5 million. Upon sale by Mary at $10 million, capital gains tax and recapture is still over $1.4 million.

Community Property
Community property states have marital property laws that were derived from Spanish or French law whereas the “common law” states’ marital property laws were derived from English law. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In 1998 Alaska adopted a law that allows a married couple to opt in by written agreement to the community property regime.

Each state’s community property law is slightly different from those of the other community property states, but, in general, a community property regime is similar to a partnership. Each spouse has a one-half undivided interest in the community property, so the property is held as a whole and cannot be divided into his/her shares.

Death Basis Adjustment of Community Property
IRC Section 1014 also provides a special rule for any community property owned by the decedent and the decedent’s spouse. For such property, the IRC Section 1014 basis adjustment applies to both the decedent’s interest in the property and the “property which represents the surviving spouse’s one-half share of community property held by the decedent and the surviving spouse under the community property laws of any state or possession of the United States.”

Here’s how that works:

Example Variation #3: Assume John and Mary own the building as community property. When John dies, the property will receive a full “step up” in basis for Mary to fair market value of $10 million. If she sells it at $10 million, there will be no capital gains tax. Community property treatment thus saves about $1.4 million in capital gains tax. If Mary doesn’t sell, she can depreciate the property’s improvements at its new basis of $10 million minus the value of the land.

Planning Tip: The result is that appreciated real estate, marketable stocks or family businesses held as community property can avoid all capital gains tax upon sale after the death of the first spouse.

The Alaska Community Property Trust
In our example, John and Mary do not have to move from Illinois to a community property state (and there enter into an agreement converting their marital property into community property) to achieve the result of Example Variation #3. Instead, they can, while remaining Illinois residents, establish an Alaska Community Property Trust and transfer the appreciated property to it while converting it to community property.

An Alaska Community Property Trust thus allows John and Mary to take advantage of Alaska’s community property laws and have their Chicago apartment building characterized as community property.

How It Works
Under the Alaska Community Property Act, Alaska resident married couples may “opt in” to the community property regime, thereby converting some or all of their marital property to community property by written agreement. Under the Alaska Community Property Act, married couples who are not Alaska residents also may “opt in” to Alaska’s community property regime by creating an Alaska Community Property Trust. Such couples may also specify which trust assets they want to become community property.

An Alaska Community Property Trust is a joint revocable living trust. However, the Alaska Community Property Act imposes certain conditions on it. It must have an Alaska trustee, which can be a bank or trust company that exercises trust powers in Alaska or an individual whose true and permanent home is in Alaska. Also, the Alaska trustee must have at least certain specified powers or responsibilities regarding the trust, which do not have to be exclusive. Thus the trustmakers may serve as co-trustees to manage the property and assets held in the trust, and to take the income and, upon the death of the first spouse, have the trust assets “pour over” into the spouses’ home state revocable living trusts.

Planning Tip: Assets transferred to the Alaska Community Property Trust will be titled in a way similar to: “John and Mary Smith, Trustees, and ABC Trust Company, Administrative Trustee, of the John and Mary Smith Alaska Community Property Trust dated ____________.”

Planning Tip: Asset accounts can continue to be managed by the current advisor. An additional statement will need to be provided to the Alaska trustee.

Planning Tip: An Alaska bank or trust company’s annual trustee fee for the minimum services and responsibilities required by the law is likely to be around $2500 per year. Fees are not fixed by law and so a trustee may charge less, especially if the client has another relationship with the bank or trust company. The client can determine if the benefits exceed the costs by comparing the trust creation and maintenance fees over the oldest client’s life expectancy to the amount of capital gains tax that having the trust will avoid.

What to Look for When Evaluating Clients for this Strategy
Clients who are good prospects for establishing an Alaska Community Property Trust are married couples who are not community property state residents and who have one or more of these characteristics:
*    They are in a long-term, stable marriage;
*    They own (or one of them owns) highly appreciated property, stocks, real estate or business interests;
*    Their financial portfolio is over-weighted in one or two stocks that they refuse to sell because of exposure to capital gains tax;
*    They have rental real estate that the likely survivor does not want to manage;
*    They are older or at least one has a reduced life expectancy.

Couples Less Likely to Benefit from Using this Strategy
Clients who are not good prospects for establishing an Alaska Community Property Trust are those with one or more of these characteristics:
*    They have a recent marriage, especially one where property is kept separate;
*    They have an unstable marriage;
*    They have limited low basis property;
*    They are in a second (or subsequent) marriage with prior-marriage children where property is kept separate.

Planning Tip: Advisors in community property states should also be aware of this strategy for their clients who have relocated to a non-community property state.

Alaska Community Property Trusts Benefit Clients and Advisors
The Alaska Community Property Trust is value-added planning for your clients and is only a part of a more comprehensive plan. It can provide substantial tax savings for the right clients and particularly benefits the surviving spouse more so than the children. It can empower a surviving spouse to diversify their portfolio by removing the capital gains tax exposure. For example, a surviving spouse who has not been involved in the management of rental properties can sell them without paying any capital gains tax.

The financial advisor can continue to manage accounts while the property is in the Alaska Community Property Trust and increase capital under management when non-managed property is sold following the death of the first spouse. The advisor who begins to actively promote these trusts has an opportunity to distinguish himself or herself in the community.

Educating the Client and Advisors
The Alaska Community Property Trust is not a well-known strategy and is underutilized by many estate planning lawyers and CPAs. It is often confused with the Alaska Domestic Asset Protection Trust, which is completely different.

Here are some suggestions to help you get started:
*    Identify clients with appreciated property.
*    Calculate their current capital gains tax exposure, including recapture of depreciation.
*    Calculate their capital gains tax exposure if the surviving spouse sells and receives a “step up” in basis on half of the property.
*    Demonstrate the real tax savings potential to clients who would benefit greatly from using the technique.
*    Estimate the costs, including legal and trustee fees, over the life expectancy of the spouse who is expected to die first.
*    Compare those costs to the estimated tax savings at the time of sale (and don’t forget to factor in anticipated asset appreciation to the first death).
*    Team with a WealthCounsel attorney who is familiar with drafting Alaska Community Property Trusts, and who can discuss this strategy with clients and other advisors as needed.

Planning Tip: The Alaska Community Property Trust works well with assets that have been placed in a Limited Liability Company or Family Limited Partnership. (The Alaska Community Property Trust will simply hold a membership interest in the LLC or limited partner interest in the FLP.) It also can work well with buy/sell agreements for family businesses.

The Alaska Community Property Trust offers an exceptional opportunity for the advisory team to collaborate to provide powerful tax savings for their clients. In addition, when an asset is sold without having to pay capital gains tax, the client will have more capital available for additional planning, such as dynasty trusts, and money management for the investment advisor.  Therefore, Alaska Community Property Trusts offer a true win-win for clients and the advisors who recommend this strategy.



[1] The Alaska Community Property Trust is a completely different vehicle than the Alaska Domestic Asset Protection Trust.


Financial Planning Goals

As people make financial plans, serious consideration need to be given to unanticipated cash flow needs that may arise in the future. It can be helpful to have reminders of the types of financial needs that are common, to help us remember they types of things to plan for.

Examples of Items to Consider

  • Retirement Living Expenses—Projections should be based on the pre-retirement budget but should remove items that will no longer be expenses at that point—such as monthly debt payments for loans that will already be paid off by retirement.
  • Cars—A new car should reasonably last for about 10 years. If you own two cars, plan to buy one every 5 years. It is reasonable to assume that a new car will cost between $25k and $35k, but if it a more expensive car is anticipated, a higher price range should be used.
  • Major Home Repairs—This is not the same as remodels (which should also be separately considered). Over a 30-year cycle certain things will need to be replaced: roof, water heater, furnace, etc. It is safe to assume about $25k in major repairs every 10 years. For those living in a condo or communal setting that number would be lower. For assisted living, that number would be $0.
  • Travel—This is good to treat separate from living expenses because travel is very discretionary and flexible (be sure to reduce living expenses by this amount to avoid doubt-counting expenses). Note that the ability to travel usually declines as individuals reach the later chapters of their lives. Also to be accounted for are any unusually expensive “big” trips that don’t fit within annual travel plan budgets.
  • Education—This would include funds set aside for self, spouse, children, grandchildren, etc.
  • Weddings and Celebrations—This may include funds reserved for weddings, major birthday parties, extravagant anniversary plans, etc.
  • Gifting—This may be to family (assistance to elderly family members, down-payment on children’s first home, etc.), friends, or charities (such as a church).
  • Other Financial Goals—Such items may include, self-funded church or community service, philanthropy, charitable work, etc.

There really is no end to the list of possibilities that could be considered, but these ideas should help to get financial planning underway.

Healthcare Cost Lifecycle

Healthcare costs vary widely from person to person, and from household to household. While this is the case, there still exists a general cycle of healthcare expenses that follows the overall life cycle of many individuals. For financial planning purposes, this is very helpful to consider when estimating future cash-flow needs and retirement expense projections

During the earliest phase, full-time employees are often covered by their employer’s health insurance plan. Normally the employer does not cover the spouse or children of the employee. The expense of providing health insurance and care for these family members falls on the family. In this phase, a financial shock, such as loss of employment would have two effects. First, it would increase family healthcare expenses by the cost of insurance and care for the terminated employee (since employer would no longer be providing coverage as a benefit). Second, lost income here would be likely to strain the ability of the family to continue to pay for family coverage.

In the next phase, kids grow older and begin to leave to home. If they go obtain their own full-time employment, they will likely be covered by their employer’s health insurance plan, and will no longer be a health expense for the family. If, alternatively, they go off to college, they may remain on the parental/family health insurance plans. In California, there is a special health insurance program for college students. Upon graduating or upon obtaining their own employment, their healthcare expense burden will be shifted onto the children themselves (or onto their employers).

In the final phase, working adults are usually covered by employer plans and kids are out of the house. As the empty nesters age, they will usually see increasing personal healthcare needs. When they are old enough to qualify for Medicare, some healthcare expenses will be offset. Since only two, and eventually, only one person in the household will need healthcare, this phase often actually requires even less expense than in previous phases. Naturally, near the time of death, healthcare expenses often are significantly higher for a given person than at any previous period of their individual life. Careful planning in earlier years can allow for the retirement income needed to provide coverage for healthcare and even long-term care needs.

Overview of Inflation


It can almost always be found in some corner of the financial news. Several economic reports are released on a monthly basis to advise the public of inflationary trends. Most people have heard stories, or personally remember stories, of hyperinflation in foreign countries. There comes to mind an imagery of people carting around large buckets of cash that has become nearly worthless through sudden inflation. Many economists study it. Governments try to regulate it within modest ranges. Many scholars say there needs to be some healthy amount of inflation.

So, what is inflation?

Simply put, inflation is the growth in prices of goods and services. When demanding dollars exceed supply of a good or service, inflation occurs. In other words, when there are more dollars than goods, the dollars compete for the more scarce goods by bidding up the price. This process of competing consumers demanding a finite amount of goods and services is the essence of the capitalist pricing machine. If goods get scarce, their price goes up. If dollars become more abundant the price of goods goes up (shortage of goods relative to dollars demanding). Either increasing demand or decreasing supply can cause the dollar-goods mismatch that leads to inflation in the U.S.

Historically, inflation has occurred in the U.S. at the long-term average rate of 2.3% per year. Of course, that degree of inflation has rarely been achieved in a single year, but the annual highs and lows have averaged out at about 2.3%. As a point of comparison, the cost of healthcare and education have followed a higher inflationary trend, at closer to 6.0%!

Social Security payments are indexed to inflation. They increase whenever cumulative inflation surpasses 1.0%. So if inflation was only 0.5% one year, no adjustment to payments would be made. But if the in the next year, the inflation rate was 0.6%, the resulting cumulative inflation would be greater than 1.0% (0.5% + 0.6%) and the payments would be increased to match inflation. At that point the inflation “measuring stick” would be reset to zero and annual measurements of inflation would start over.

In concept, if someone had $100k saved, and did not invest their savings, such that at the beginning of the next year they had the same $100k saved, inflation would deteriorate their spending power. Say inflation was 3% that year. That means that prices went up by about 3%. That means this person’s savings could buy about 3% less goods than in the preceding year. This illustrates the danger of saving cash for long periods of time. Without any investment returns the buying power of savings declines each year. Basically, the value of the dollars goes down each year, even though the number of dollars remains the same. If your investments don’t keep up with inflation, you are actually losing value (even if you are not losing dollars) each year!

“Real Return” refers to the rate of return a person has on their investments after accounting for the degree of current inflation.

For example, if Joe earned 10% on his investments in a year with 3% inflation. His “real return” would be about 7%. When you factor in the costs of investing (commissions, fees, etc.) and taxes, it becomes very important to maintain some degree of consistent investment performance in order to pay for all of this and still come out with a positive return to the investor.

Inflation hurts creditors (who are generally owed fixed dollar amounts), but helps debtors (who generally owe fixed dollar amounts). If annual income remains unchanged in an inflationary environment, the value of the pay actually declines over time, just like in the case of savings (above), even if the amount paid is constant.

Planning for inflation and properly investing to overcome its negative effects on buying power are essential components of financial security and retirement well-being.

Life Insurance Policy and Retirement Plan Loans

Whole life insurance policies and retirement plans both permit contributed funds to accumulate tax-deferred. (In the case of whole life policies, only the growth of the cash value component is tax-deferred).

Withdrawal of funds from either source triggers income taxation. In the case of a retirement plan, early withdrawal (before age 59 1/2) additionally incurs an sharp 10% excise tax penalty.

Accessing Funds without Taxation

One way a person can access tax-deferred funds without prematurely incurring income tax, is by taking out a policy or plan loan (if such is permitted by the policy or plan).

Life Insurance Policy Lapse

If there is an outstanding loan balance when an insurance policy lapses, when an insurance company pays the maturity value of the policy to the insured, the loan value is deemed taxable income (to the extent it exceeds taxpayers basis).

If the insurance company repays the loans from the maturity value and only distributes the difference, all of the maturity value is still taxable (to the extent it exceeds taxpayer basis in the policy). There is no economic difference between receiving a full distribution and then repaying the amount owed and the insurance company retaining the amount owed and only paying out the difference.

Default on Repayment of Retirement Plan Loans

There are often term-limits on the amount of time that a loan can be held outside of a retirement plan. Failure to repay the loan in by the end of the term may result in income tax liability and triggers the early distribution penalty.

When to Take Social Security Benefits

When a person should take Social Security benefits depends on considerations of one’s personal health and history of family longevity.

General rules of thumb:

  • If someone expects to live longer than 80 years old, they should delay taking Social Security until the maximum start age (70). Account for family history of longevity (is it longer?).
  • If someone expects to live to less than 80 years old, they should take Social Security as early as possible (this age depends on when you were born). Account for family history of longevity (is it shorter?).
  • If one has adequate financial resources, they may consider delaying their benefits.

Of course the above guidelines may be modified by one’s personal health status.

Avoiding Probate is NOT the Same as Avoiding Estate Tax

In the realm of estate planning often things are spoken of as being “excluded” from the gross estate or “excluded” from probate. Occasionally, some confusion arises about these two things. They are very different.

Exclusion from the gross estate is a tax matter. Exclusion from the gross estate is usually a matter of ownership. If property is owned it is in the estate. If not owned, it is not part of the gross estate.

Exclusion from probate is an administrative matter. If property is excluded from probate it is still part of the gross estate.

Both can save money, but for different reasons.

Probate is a court process whereby property is legally transferred from an estate to a beneficiary. This process does not avoid tax, it simply changes ownership.

Why might someone want to avoid probate?

Like many court matters, probate can be very expensive. In some states, such as California, there are statutory probate fees for attorneys who guide the estate through probate. These fees can be very high, taking a large bite out of assets that could otherwise be given to beneficiaries. To avoid probate, property can be arranged to pass outside of court altogether–by using trusts, titling of assets, and beneficiary designations on certain accounts.

Exclusion from the gross estate reduces the value of the taxable estate and ultimately can reduce estate taxes. One cannot simply decide property should be excluded from his estate, upon death. The gross estate essentially includes all property that is owned. To be excluded, it must not be owned. Property given away is no longer owned. Property sold is no longer owned (though the proceeds of sale ARE owned). Funds spent in consumption are no longer owned. In short, property that is permanently transferred to another, such that it is no longer controlled or owned or directed in its use, is generally excluded from the gross estate.

Take-home message: Property that is excluded from probate is still subject to the estate tax system. But, such property is distributed to it’s ultimate beneficiary by a means other than through the probate court process. If property is excluded from the gross estate, it will not be subject to probate (court supervised property transfer) because such property has already been permanently transferred to a new owner.

How is the Estate Tax Calculated?

Compared to the income tax, the estate tax is fairly straightforward.

Although this is a bit of an oversimplification, the estate tax is determined as follows:

  1. Value the gross estate.
  2. Value deductions and exclusions.
  3. Determine net taxable estate.
  4. Apply the tax rate.

In more depth, the estate tax can be calculated as follows:

  1. Gross Estate – Deductions = Adjusted Gross Estate. **These deductions include: administrative expenses, burial costs, uninsured casualty losses between death and settlement of the estate, and debts.
  2. Adjusted Gross Estate – (Gifts to Charity and Spouse) = Taxable Estate.
  3. Taxable Estate + Taxable Gifts During Life = Tentative Tax Base.
  4. Estate Tax Brackets Apply to Calculate Tax on this Amount.
  5. Tentative Tax – Tax Already Paid on Lifetime Gifts = Estate Tax Owed.
  6. Estate Tax Owed – Individual Estate Tax Credit = Estate Tax Liability.

The tax amount that is owed on an individual’s estate is due within nine months of death. The value of the estate used to calculated the tax may electively be either market value at date of death, or alternately, the value 6 months from the date of death.

While this may not seem terribly complex, many challenges and many planning opportunities lie in definitions of ownership (and thus inclusion in or exclusion from estate) and in determinations of valuation of property.