FINANCIAL TOPICS

January 2004 Issue

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Estate Planning Considerations for Married Couples

Between the unlimited marital deduction (which allows married couples to leave any amount to their spouse without paying estate taxes) and rising estate exemption amounts, many married couples may not feel much need to plan their estates. Before reaching that conclusion, consider these items:

Estate taxes still need to be considered.  While the estate tax exemption amount is increasing (from $1,500,000 to $2,000,000 in 2006 to $3,500,000 in 2009) and the estate tax will be repealed in 2010, this amount will drop back to $1,000,000 in 2011 unless further legislation is enacted. Thus, individuals with estates over $1,000,000 still need to consider ways to utilize their exclusion amounts to minimize estate taxes. Those with large estates probably don't want to leave their entire estate to their spouse. While that will avoid estate taxes at the first spouse's death, estate taxes may be owed after the second spouse's death if the estate is larger than the estate tax exemption. While increasing estate tax exemption amounts can make it more difficult to plan, you should still consider leaving part of your estate to other heirs. If you don't want to make outright distributions to heirs in case your spouse needs the assets, you can set up a trust (commonly referred to as a credit shelter or bypass trust) to hold those assets. Your spouse can then use the income and even some of the principal, with the remaining assets distributed to your heirs after your spouse's death. This preserves the use of your exclusion amount.

Review whether you need a second trust. You may also want to control the remainder of your estate that is not placed in the bypass trust. Leaving the remaining assets to your spouse means he/she will control the ultimate distribution of those assets. Thus, if your spouse remarries, his/her new spouse may inherit some or all of those assets. Or, if you have children from a previous marriage, you may want to ensure those children receive a portion of your estate. Typically, a qualified terminable interest property trust (commonly referred to as a QTIP trust) is used in those situations. Any assets not placed in the bypass trust are placed in the QTIP trust, with income distributed to your spouse during his/her lifetime. This qualifies for the unlimited marital deduction, so estate taxes won't be assessed when you die. After your spouse's death, the principal is distributed to the heirs you designated.

Determine whether a disclaimer provision should be added to your estate planning documents. This provision details what happens if one of your heirs disclaims his/her inheritance. With the estate tax exemption amount fluctuating so much over the next several years, this provides a way for your heirs to decide after your death how much should be placed in various trusts. This leaves a great deal of flexibility with your heirs, so it should only be used if you trust their judgment.

Consider preserving your generation-skipping transfer tax amount. Leaving assets to wealthy children often means estate taxes will be paid when your children receive the assets and then again when your grandchildren receive the assets. Bequeathing those assets directly to the second or third generation can reduce estate taxes. However, the generation skipping transfer (GST) tax, which is set at the highest estate tax rate, will apply to amounts transferred in excess of your GST exemption. Starting in 2004, the GST exemption amount follows the estate tax exemption schedule. Again, if you don't want to make outright gifts to heirs, you can set up a trust so your spouse has access to the funds during his/her lifetime.

Check beneficiary designations and joint ownership of assets. Assets like life insurance, annuities, 401(k) plans, and individual retirement accounts will pass directly to beneficiaries, while joint assets, including bank accounts, will pass directly to the joint owner. Provisions in your will and other estate planning documents cannot change those designations. Thus, review beneficiaries and joint owners to ensure assets will transfer as you wish. Tax and estate planning considerations may make another individual a better choice. Once your spouse dies, be especially careful of joint ownership with just one of your children. While you may expect that child to share the asset with his/her siblings, that child may either not do so or may have to deal with gift tax implications.

Is Gifting Still a Valid Strategy?

An annual tax-free gifting program is often recommended to help reduce the size of a taxable estate. But changes in the estate tax laws may make you wonder whether this is still a valid estate planning strategy.

First, make sure you understand the tax laws regarding gifts. Under the marital deduction, you can leave any amount of your estate to your spouse without paying estate taxes. However, when making gifts to other individuals, including your children, two limits are set on how much can be gifted without paying estate or gift taxes:

Your annual tax-free gifts to any single individual are limited (in 2004, the limit is $11,000 or $22,000 if you split the gift with your spouse). The amount is adjusted annually for inflation, in $1,000 increments. An important exception allows you to make unlimited direct payments for medical and educational expenses for other individuals.

You can also gift an additional $1,000,000 during your lifetime without paying any gift taxes. Lifetime gifts over $1,000,000 are subject to gift taxes, with the maximum gift tax rate equal to the maximum estate tax rate through 2009 and then equal to the maximum individual income tax rate.

Consider an annual gifting strategy if you plan to leave assets to your heirs and your estate will be subject to estate taxes. Your estate is taxable if it exceeds $1,500,000 in 2004 and 2005, $2,000,000 in 2006, 2007, and 2008, and $3,500,000 in 2009. In 2010, there will be no estate tax, but your estate will again be taxable in 2011 and later years if it exceeds $1,000,000.

Over a number of years, an annual gifting program can remove a substantial amount of assets from your estate. For example, if you have two married children and four grandchildren, you and your spouse can make annual gifts of $176,000 ($22,000 to each of your children, their spouses, and your four grandchildren). After 10 years, you would remove at least $1,760,000 from your estate. You can make gifts to any number of individuals, even those not related to you.

Consider gifting noncontrolling interests in businesses, farms, real estate, and other assets during your lifetime, which may allow you to assign a minority interest discount to the gift's value.

Individuals with substantial wealth may also want to consider using their $1,000,000 lifetime gift exclusion. When doing so, gift property that has the potential to increase in value, but has not already done so. Gifts received after death are stepped up to market value on the date of your death (unless you die in 2010), while lifetime gifts retain your original basis. Thus, to the extent possible, you should make lifetime gifts of assets whose market value is close to your basis, while distributing assets with large capital gains after your death.

Except in rare situations, you probably don't want to make taxable gifts until the ultimate fate of the estate tax is determined.

Make sure you are comfortable with the fact that you are permanently removing gifted assets from your estate. You don't want to gift so much of your estate that you have difficulty making ends meet later in life.

Back to Basics: Building Your Portfolio

After the huge market declines of the past four years, it's difficult to decide how you should invest. Maybe it's time to go back to basics and review principles for building your portfolio.

1. Identify your investment goals. This will determine how much money you need to accumulate and how long you have to do so. You're likely to find that your goals need to be altered. With large declines in your investment portfolio and more modest expectations for returns going forward, you might not have enough time to accumulate the funds you need for your financial goals. At the very least, you'll probably find that you need to save significant sums to reach those goals.

2. Determine your tolerance for risk. After the large stock declines, you're liable to find that your tolerance for risk is not as high as you originally thought. You will probably have to take some risk to reach your goals. Investing all your money in a bank savings account probably won't be sufficient to reach your goals. But you still need to invest in assets with a level of risk you can comfortably tolerate. Make sure you thoroughly understand the potential downside as well as upside for any investments you're interested in.

3. Review investment alternatives. Don't confine yourself to investments you currently own. Investigate all options, including cash equivalents, bonds, stocks, precious metals, international investments, rental real estate, limited partnerships, collectibles, and other choices. You should understand the basic aspects of each, examining the types of risk they are subject to as well as their historical rates of return.

4. Determine an appropriate asset allocation mix. Your asset allocation strategy represents your personal decisions about how much of your portfolio should be allocated to various investment categories. Within those broad categories, you should also make allocation decisions for each category. Not only will each individual's allocation strategy vary, but your strategy will vary over time.

5. Compare your current investment portfolio to your desired asset allocation. Calculate how much of your current investment portfolio is invested in each investment category. Since you'll probably need to make adjustments to your portfolio, take a fresh look at each investment you own, making sure the reasons you chose to initially invest are still valid. Determine if you can simplify some of your investments. You may find you own several stocks within one industry or several investments with similar objectives. It may make sense to own only the strongest performers, reducing the number of investments to monitor.

Determine what changes need to be made to your portfolio so it will reflect your desired asset allocation. If you must make significant changes, you should probably do so over a period of time.

6. Monitor your portfolio periodically. You should review your portfolio at least annually, making adjustments as needed. If certain portions of your portfolio have been successful, they may make up a larger percentage of your portfolio than you originally planned, requiring adjustments to get the percentages back in line. You may also find you need to sell certain investments that are not performing well. As time goes on, your goals or feelings regarding particular investments may change, which will require changes in your overall asset allocation.

Formulating an investment strategy is a difficult process that requires evaluating many factors. But the process is well worth the effort - it will give you the means to help achieve your long-term goals in a manner you are comfortable with.

Invest or Pay Off Debts?

Trying to decide what to do with some extra cash? Assuming you're looking for ways to help improve your financial situation (i.e., you don't want to spend the money), the basic choices are to invest the money or use it to pay off debt. Which is the better alternative?

The decision typically centers around the potential return you can earn on the investment and the interest rate you are paying on your debt. For instance, if you're going to invest in a bond earning 5% and you are paying 12% interest on your credit card debt, you should probably pay off your credit card debt. When making this analysis, look at after-tax, not pre-tax, rates. For instance, in the above example, you'll have to pay federal income taxes on interest income from corporate bonds. If you're in the 25% tax bracket, that 5% interest rate will net you 3.75%. On the other hand, any credit card interest is not tax deductible, so interest is paid from after-tax money. Thus, a 12% interest rate equates to a 16% pre-tax rate.

There are some situations, however, where you should consider other factors, including:

When your employer matches 401(k) contributions. Many employers match contributions to 401(k) plans, which is money you lose if you don't contribute. Those matching contributions can significantly affect your decision about whether to invest or pay off debt. For example, assume your employer matches 50% of contributions up to 6% of salary. If you're making $50,000, a 6% contribution would equal $3,000 with your employer making a $1,500 matching contribution. Thus, you should typically ensure you receive all matching contributions before using money to pay down debt.

When you are paying down your mortgage rather than other debts. Psychologically, you may prefer paying down your mortgage to build equity in your home. However, that is usually the last debt you should pay off, since interest rates are typically lower than other forms of debt and the interest is tax deductible. If you're trying to pay down debt, make a list of all your debts, the interest rate, and whether the interest is tax deductible. Start paying off the debt with the highest nondeductible interest rate. Once that debt is paid in full, move down to the next highest.

When you're using money from your retirement savings to pay off debt. Many 401(k) plans allow loans at relatively low interest rates. Thus, you may be tempted to take out a loan and use the proceeds to pay off your high interest rate credit card debt and auto loans. One of the dangers of this strategy is you'll start to think of your retirement savings as a piggy bank you can dip into whenever you need money. It's typically better to leave retirement savings alone so the money can continue to compound for your retirement. Also, you don't want to take out a loan, pay off your credit cards, and then start running up the balances again. If you use retirement savings in this manner, make sure your spending is under control.

Understanding the Basics of Earnings

When evaluating a stock, you'll typically look at a variety of historical figures. One of the most important is earnings, which is also used as a basis for several other important statistics.

From an accounting standpoint, earnings are calculated by subtracting operating costs, taxes, and preferred-stock dividends from revenue. Those earnings are typically divided by common stock shares outstanding to come up with earnings per share, or EPS. EPS is a convenient way to compare earnings over a period of years so upward or downward trends can be identified.

The price/earnings ratio, or P/E ratio, is calculated by dividing the stock's price by its EPS. It's one of the most common measures of stock value, both for individual stocks and the overall market. It basically indicates how much investors are willing to pay for a dollar of the company's earnings. P/E ratios can be calculated using different earnings numbers. Trailing P/E ratios, which are typically reported in newspapers, use earnings per share for the most recent four quarters, while forward P/E ratios use forecasts of future earnings per share.

For individual companies, investors' expectations regarding future earnings affect the P/E ratio. Confidence that a company will improve its profitability or remain profitable generally results in a higher P/E ratio. If profits are threatened or weak, the P/E ratio is likely to drop. Higher forward P/E ratios indicate investors regard the company more highly and expect the company to have good future prospects. P/E ratios for the overall market change based on broad market conditions and investors' views about how desirable stocks are compared to other investments. P/E ratios can fluctuate significantly over time and among companies and industries.

A company's growth prospects can be evaluated using the price/earnings growth, or PEG, ratio, which is calculated by dividing the P/E ratio by the company's projected earnings growth rate. A PEG ratio of one is considered standard, meaning its growth rate is incorporated in the stock's price. A PEG ratio higher than one means the stock is trading at a premium to its growth rate, while a ratio less than one may mean the stock is undervalued.

Copyright © 2004. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

FR2003-0923-0052