Mick Jagger is among the most successful entertainers of our time. But despite his wealth, Jagger tells his eight children that they’ll need to make their own way. Similarly, Shaquille O’Neal tells his children that they can earn some of his millions, but it won’t necessarily be given to them. Actor Jeff Goldblum puts it more bluntly: “Row your own boat,” he’s said. Other public figures have echoed a similar theme.
Why do these wealthy folks take such a seemingly uncharitable view? One likely reason: They want their children to have the opportunity—and the satisfaction—of succeeding on their own. Counterintuitive as it may seem, by withholding a large inheritance, they may feel they’re doing their children a favor.
Decisions like this aren’t easy and require delicate trade-offs. Much of estate planning, in fact, is about trade-offs. If you’re building a plan for your own family, here are other key trade-offs to consider.
Cost. While estate planning strategies can be effective in reducing estate taxes, they can be costly to set up and to maintain. How to strike the right balance?
With the Federal estate tax at 40%—and many states levying their own estate or inheritance taxes on top of that—folks with assets above the lifetime exclusion amount often conclude that it’s worth spending virtually any amount on legal fees in an effort to defray that tax.
Suppose, for example, you have assets $1 million over the threshold. At today’s rates, that would result in a tax of $400,000—a hefty number. While legal fees can be costly, it’s unlikely that an estate planner would charge even one-tenth of that amount to put a new strategy in place. Seeing this likely return on investment, many families are happy to incur significant legal and accounting fees.
That’s one point of view, and it’s certainly logical—but not everyone agrees. Other families look at it this way: If their estate is large enough for the estate tax to apply, then by definition, their heirs will receive a healthy sum regardless of how much estate tax is paid. Through this lens, other families decide to spend little or nothing on estate tax strategies. They accept that their estates might—and likely will—end up facing a larger tab at the end of the day but would still prefer that to spending large sums on legal fees today.
Complexity. The reality of estate tax strategies is that the most effective strategies also tend to introduce the most complexity. To see why, let’s look at a common structure known as an irrevocable trust.
Suppose Jane and Joe are 50 years old and have a net worth of $10 million. They’re concerned that if their assets continue to grow, their family will face estate tax exposure down the road. To get in front of this, Joe sets up an irrevocable trust for the benefit of Jane and their children and moves $500,000 of stocks from his brokerage account into this newly-created trust.
At the time that Joe makes this gift, the $500,000 is deducted from his lifetime exclusion, so there is no immediate benefit. But if Joe lives another 40 years, and the stock appreciates at 7% per year, then it would be worth $7.5 million at the end of his life. That’s when the benefit would be realized. The $7 million of appreciation above Joe’s original $500,000 would be free of estate tax.
The benefit, in other words, could easily reach into the millions. The downside, however, is that irrevocable trusts introduce complexity. Drafting the documents and making the initial gift is actually the easy part. On an ongoing basis, however, the trust will require its own tax return each year, and Joe will need to decide on a trustee or trustees, who may also ask to be paid. This all entails additional complexity each year, and that’s for the most straightforward type of trust.
For even greater potential tax savings, some families move illiquid assets, such as their homes or shares in a family business, into irrevocable trusts. But moves like this dial up the complexity level further. Suppose a family moves its home into a trust. Over time, this could deliver a tax savings, but in the meantime, the result is that this family will no longer own its own home. The trust will. To continue living in the home, then, the family will need to pay rent to the trust each year, and all of the home’s expenses will need to be paid by the trust. This can take a fair amount of bookkeeping, which is why many high-net-worth families decide that this complexity is more trouble than it’s worth.
Flexibility. Let’s continue with the above example in which Joe moved $500,000 into an irrevocable trust. If everything goes according to plan, Joe’s heirs will realize a significant tax savings. But suppose Jane and Joe have a change of heart and would instead like to use that $500,000 toward another goal—perhaps to pay for college or to help their children purchase a home. If a trust is well designed, it will allow for distributions during Joe’s lifetime, but it isn’t so simple. Irrevocable trusts aren’t truly irrevocable as long as the donor is still living, but for the most part, they are, and this is another key trade-off when constructing a plan.
Control. Establishing an irrevocable trust requires a few additional leaps of faith. Specifically, the donor needs to feel comfortable with the distribution provisions written into the trust, and also needs to feel comfortable with the trustee. This too requires a delicate trade-off. On the one hand, establishing a trust sooner rather than later provides more time for the assets to appreciate, as described above, increasing the opportunity for tax savings. But that also means there are more years during which a divergence might emerge between the provisions written into the trust and the donor’s current preferences.
Equity. A final trade-off to consider: If you have children, how should you approach the question of equity? Imagine a family with two children, one of whom is a schoolteacher and the other a brain surgeon. If you were the parent, would you leave equal shares to each, or would you leave more to the schoolteacher? There are good arguments for each approach.
On the one hand, the surgeon is more likely to be self-sufficient and might be happy to see a greater share go to his schoolteacher sibling. But on the other hand, as I often say, brain surgeons have feelings too. Though he might have a higher income, he might feel that it’s a matter of principle for children to be treated equitably by their parents.
There is no “right” or “wrong” on any of these questions—they’re personal decisions—but it can be a valuable exercise to think them through before creating your own estate plan.
