Bad Planning

Errold F. Moody Jr.

Master of Science in Financial Planning, Life and Disability Insurance Analyst

WWW.EFMOODY.COM

BASIS- A Mandatory understanding for proper investing

or

How to leave your kids the "same" amount of money in your estate, screw the whole thing up, and leave a legacy of resentment that can last another generation

BASIS- the amount within an investment or annuity that has already been taxed. When the asset is sold, this amount would escape additional income taxation (estate taxes are a separate issue).

Assume Dad has 6 investments- each worth $100,000 that goes to each of his six children. (This also keeps the limit under the $675,000 lifetime estate maximum). Assume each child has a combined state and federal tax bracket of 35%.

Child	Asset	Taxation while Dad is alive	Taxation for Child once Dad dies
Sue	Annuity/Pension plan/401(K)/ deductible IRA	Assume that all contributions were invested pre tax. The entire $100,000 is taxable as ordinary income. Every dollar is taxed as ordinary income	The entire $100,000 is taxed as ordinary income. Sue does get the $100,000 but will need to pay $35,000 in taxes
Bob	Annuity/Partially deductible IRA	Assume a $25,000 non deductible initial tax basis. If all pulled out, $25,000 remains untaxed and the rest ($75,000) is taxed as ordinary income.	The $25,000 remains untaxed. The remaining $75,000 is taxed as ordinary income. Bob will need to pay a tax of $26,250
Frank	Roth IRA	Assuming over 59 ½, etc. ZERO tax. Nada, Zilch, nothing	No tax Frank gets $100,000
Mary	Real Estate	Depreciate original basis (minus land) over time. When sold, take existing basis, add back in land, subtract from sales price and tax rest at capital gain. Assuming a $75,000 LTCG, the tax might be $15,000.	* Full Step Up in Basis at the Date of Death. No Tax Mary gets $100,000
Alex	Mutual Fund	Original Basis is purchase price. Adjusted basis is original price but all capital gains and ordinary income taxed per annual 1099's. Purchased for $25,000 + additional $10,000 of tax basis= 35,000 adjusted basis. $65,000 taxed at 20% LTCG= $13,000 tax	*Full Step Up in Basis at the Date of Death. No Tax Alex gets $100,000
Betty	Insurance	Assume $100,000 whole life with $25,000 cash value. Loan not exceeding basis is available with no current tax.	Assuming no current loans, Betty gets $100,000. No Tax

* Full Step Up in Basis: Certain assets are allowed by tax law to have their original or existing basis to be adjusted upwards to the value at the date of death. Many assets- obviously including real estate, mutual funds and stocks not in a qualified plan- get this step up at the date of death.

Annuities, 401(k)'s and other tax deferred qualified plans do NOT have such allowance. Therefore, the beneficiaries MUST pay tax on the asset as ORDINARY INCOME- which is much higher than the Long Term Capital Gains rate.

As a result, the children will net

	Remaining amount after tax
Sue	$65,000 (annuity)
Bob	$73,750 (partially taxed annuity)
Frank	$100,000 (Roth IRA)
Mary	$100,000 (Real Estate)
Alex	$100,000 (Mutual Fund)
Betty	$100,000 (Life Insurance)

While it is debatable that a decedent would leave each different asset, it is unquestionably true that many people have life insurance and a 401(k) plan. Therefore, just look at Betty and Sue. Betty gets $100,000 net and Sue gets $65,000 net. The $35,000 is very apt to cause a rift between the two children that may split the family forever- and it all initially looked "fine". Therefore leaving "equal" amounts to each child at death is almost irresponsible since the vast difference in net retained can cause animosity that can last for a generation or two.

Further, assuming Sue wanted Betty to give her part of her money to make the distributions equal, do you think she would do it? Even so, anything that she does give beyond $10,000 becomes a GIFT above the $10,000 annual gift limits and will require filing of federal tax forms (and additional cost for a CPA) and a reduction of her lifetime exemption.

Be very careful in your choice of investments while alive. Be equally cognizant of the distributions upon death. Your will or trust should account for these differences if you wish to avoid the financial conflict that will universally occur.

NOTE: Employer stock in a 401(k) or retirement plan have unique tax treatments that require far more planning than identified above. Make sure you see an advisor far before retirement or leaving your employer.