You don’t need to do a thing.

PlanLab^® was previously programmed to illustrate the laws as written for 2010, 2011 and beyond:

• No federal estate tax in 2010
• Limited step-up in basis for 2010 deaths
  • Step-up of $1.3 million in property from a decedent
  • Step-up of certain transfers to spouse up to $3 million but not available for all assets
• Gift tax maximum no greater than income tax highest rate
• Reversion to pre-2001 Tax Act in 2011
• These are just the main points, but all provisions are included.

If the first death occurs in 2010 and the spouse sells inherited property later, PlanLab^® with its true cash flow calculations will reflect the capital gains and subsequent estate taxes correctly. You can show the effects of the current legislation. PlanLab^® Analysis programs all illustrate true cash flow, including:

• Estate Tax Analysis
• Wealth Distribution Analysis
• Retirement Test Drive
• Financial Needs Analysis
• Financial Strategies
• Wealth Strategies

PlanLab^® Conceptual programs like Estate Tax Concepts and Family Limited Partnership illustrate the estate tax rates correctly but do not provide cash flow details.

You can count on your PlanLab^® illustrations to provide the proper estate taxes with certainty, even as Congress continues their uncertainty! And when new laws are signed, PlanLab^® will be among the first to provide updated illustrations.

What can you do with your 401(k) plan? A prior article has already discussed the advantages of continuing your contributions and taking advantage of the concept of “dollar cost averaging.” (“What Should I Do with My 401K?” October 11, 2008.) This article will consider the investments already in your plan. How can you be proactive with your 401(k) plan and still follow the current recommendations:

•    Always have a strategy that results in buying low and selling high
•    As long as time permits, sit tight on your plan so that you can experience the market recovery

First and foremost, continue making contributions. The tax advantages and any employer match allow you to acquire more low cost shares that can accelerate your plan’s recovery. The next step requires work on your part; after all, you wanted to be proactive. This proactive adjustment to your plan requires five steps.

1. Look at each asset class of investments allowed in your plan, and determine the dollar value you have in each class.

Hopefully, you have some diversification in your plan, perhaps having followed an asset allocation model based on your risk tolerances. Even if you have all your eggs in one basket and only have one investment, these steps may still be applied. Asset classes are nothing more than a grouping of investments with similar risks and expected returns. Some examples are fixed income, large company equities, small-cap or mid-cap equities, balanced funds, and international equities.

2. For each asset class in which you have some money, research all available investment choices in that class.

• Use all information provided by your plan
• Use on-line information available from mutual funds, Morningstar or other fund evaluation sources
• Compare the performances for the past 1 month, 3 months, 1 year, and 3 years as well as internal fees and expenses

3. Of the available choices in each asset class, decide which fund you would rank number 1 and number 2. Also, determine which fund you determine to be the most volatile – biggest swings over the same periods.

4. Using just the dollars already in an asset class, reallocate half of that amount to the fund you ranked number 1 in that class.

• If you are within 10 years of retirement, put the other half in the fund you ranked number 2 in that asset class.
• If you are 10 or more years from retirement, then put the other half in the fund you determined to be the most volatile in that asset class.

(Note: even though we may be changing investments, we are just shifting to a similar investment that probably has a better chance of recovering faster. We are not being stupid by selling low and buying high – we’re selling low and buying low.)

5. Determine the percentage of your investment in each fund, and reallocate to this percentage at least every three months.

• Be sure to check your plan’s rules for reallocating as sometimes fees may be charged. You want to be sure that the fees do not offset the gains in reallocating.
• Reallocating is nothing more than taking gains from the better performing funds whose prices are up, and shifting it to lesser performing funds whose prices are low. (A fancy process for continually buying low and selling high.)

What do these five steps accomplish? You have stayed within our rules: your strategy assures that you buy low and sell high, and that you give your investment the best chance possible of recovering. Although this may seem like a lot of work for just a little change, it is a strategy that combines almost all of the current financial advice in a proactive manner. You have the satisfaction of doing something about your retirement plan, and the confidence that you are not doing something stupid.

PlanLab News provides no investment advice nor does it offer any opinion with respect to the suitability of any transaction. Clients should consult their legal, tax, and/or financial advisor before taking actions based on this information.

“Yes, your finances are likely taking a beating this year. Which means it’s the perfect moment to transfer as many assets as you can.”

Stock values are depressed. Interest rates continue at historic low rates. Transfers are generally valued based on their market values – values that are very low today. For many types of transfers, especially those that delay the recipients’ use of the gift use prescribed IRS rates to determine the value and taxation. These IRS rates are adjusted monthly to reflect the current economic conditions – conditions today that produce very low rates.

Ms. Tergesen suggested a number of effective strategies to transfer wealth to your heirs that are advantageous when the transferred values are depressed. One such idea included establishing an intentionally defective grantor trust (IDGT). Even though IDGTs are complex and often expensive to establish, the rewards can be worth the extra efforts and expense. These trusts can provide a tax-advantaged way to pass assets to heirs, limit future taxation of the assets, and remove these assets from your estate. To better illustrate these benefits, a case study using PlanLab and its suite of financial tools is presented.

Case Study

Kevin and Rebecca Strangelove have been very successful in recent years. They have a daughter, a son-in-law, and a new grandson (named for his grandfather) with whom they want to share their fortunes. Their hopes are that it could benefit future generations as well. About two-thirds of their assets are in stocks. Stocks that were worth $15 million a few months ago, but due to the “melt-down” are worth only $10 million now. Kevin figures that the market will eventually recover, although it may take up to twenty years to do so.

The Strangeloves establish the trust. It will need some cash which should be at least 10% of its initial holdings. Since they plan to put $10 million of stock into the trust, they make a gift of $1 million cash. One million dollars is also the limit an individual may give away gift tax free during his lifetime. Since they want the trust to last for possibly generations, they must either pay generation-skipping transfer tax on the $1 million gift or use some of the $2 million credit for that tax. They will do the latter. (Gifts of more than $2 million may have generation-skipping transfer tax up to 45% of the additional amount.)

They then lend the trust $10 million using an installment note. In this case, a fifteen year interest only note is used. Interest is set at the Applicable Federal Rate for loans of more than 9 years which for October 2008 was 4.32%. The length of the note is usually long enough for the trust to accumulate enough funds to repay the note, but hopefully less than life expectancy of the grantor. Any unpaid balance of the note is included in the estate of the grantor. The trust then uses the loan to buy the $10 million of stock from the Strangeloves.

Being a grantor trust, income taxation to the trust is passed through to the grantors. Therefore, for income tax purposes, the Strangeloves “bought the stock from themselves” for tax purposes; thus, no capital gains tax due. Also, the interest paid by the trust for the installment note is not considered income to the grantors.

The Strangeloves wanted to use conservative assumptions throughout their plans. Previously for their long-term planning, they assumed the stocks would appreciate in value by 3.6%, doubling in value in 20 years. They assumed that the stocks would produce an average of 2.4% earnings or dividends each year. (Basically, they wanted to assume a total return of 6 %.) That assumption was decided prior to the recent market collapse. Since they felt the market would recover over the next 20 years, they increased their appreciation assumption to 5.7%. (The original value of $15 million growing at 3.6% for 20 years equals the depressed value of $10 million growing at 5.7% for 20 years.)

Advantages of the IDGT

• As a grantor trust, no capital gains tax was due when the stock was sold to the trust.
• No income tax is due on the interest payments from the trust for the loan.
• All appreciation in the trust is outside of their estate. (Only the balance of the unpaid installment note is included in their taxable estate.)
• The Strangeloves pay income tax on all income received by the trust. These tax payments further reduce their estate, but more importantly, allow the trust to appreciate faster since it does not have to pay the taxes.
• Life insurance on the grantor’s life owned by the trust, assures the grantor that the installment note could be repaid at the grantor’s death.

How will all of this work for the Strangeloves?

• The IDGT is established and the $1 million cash gift is made to it.
• A $10 million loan is made to the trust — a 15 year interest only installment note at a rate of 4.32%.
• The IDGT buys the $10 million stock from the Strangeloves.
• The IDGT purchases $10 million of life insurance on Kevin with a monthly premium of $4,000. The trust is the owner and beneficiary of the policy.

In addition to the IDGT strategy, several other techniques were recommended. Their wills needed to be revised to take advantage of the large available estate tax exemptions. Annual exclusion gifts could be used to provide additional cash for estate settlement. There are many additional techniques and strategies that could be applied, but the Strangeloves preferred just the basic ones.

Results

PlanLab’s suite of tools allows us to see the results in various situations. For these results, (See Executive Summary from Estate Tax Analysis) it was assumed:

• No additional changes were made
• The markets recover over the next 20 years
• Change their wills to leave an amount equal to any applicable exclusion amount to a Family Trust
• Kevin dies in year 2028
• Rebecca survives him for 5 years

The net value to the heirs at Rebecca’s death in 2033 would be $40 million.

Adding the IDGT as described above, the net to the heirs in 2033 would be $57.1 million.

• Establish an irrevocable life insurance trust (ILIT) to acquire a survivorship policy and make annual exclusion gifts to the trust for the premiums
• ILIT purchases $20 million of survivor life on Kevin and Rebecca for $8,000 monthly premium.

The net value to the heirs in 2033 would be $85.8 million.

When this strategy was analyzed with Wealth Distribution Analysis, (See Planning Impact) the Strangeloves would have their new worth reduced by 38% but would have doubled the net to heirs or an increase of 102%. This was possible while meeting all lifestyle expenses.

Risks associated with this strategy

Neither the tax code nor case law specifically addresses IDGTs. The IRS has been known to challenge them on occasion. Establishing the trust with a cash gift some time before selling the assets is thought to reduce the chance of a challenge.

The biggest risk is for the trust to run out of income. Income is needed to make the interest payments on the loan and to pay the premiums on any life insurance it acquires. Gift taxes and possibly generation-skipping transfer taxes may be due, if the trust cannot meet its interest payment. Testing the cash flow arrangements of the trust is essential to avoid this costly problem. (See Trust Ledger from PlanLab)

In addition to the illustrations shown above, PlanLab effectively can illustrate all aspects of this case study. PlanLab’s Estate Tax Analysis shows how the proposed strategy would work. (See Estate Flow Chart) Since there is uncertainty as to what estate taxes might be in the future, “Needs over Time” graphs can be printed that show the current law and a hypothetical illustration assuming the 2009 limits and rates are extended (which is similar to the proposals of both Presidential candidates). (See Needs Over Time Compared)

PlanLab’s Wealth Strategies or Retirement Test Drive can consider the Strangelove’s strategy from different vantage points. Both of these tools can perform extensive Monte Carlo Simulations to determine the likely results when all variables fluctuate in accordance with their historical results. The year-by-year results and likely range of results can give the clients confidence that their strategy will work. (See Likely Net Worth)

PlanLab’s suite of financial tools help the advisor make “lemonade” out of the “lemons” of our present economy.

Photo credit: Adrian MB

Other than these unusual times, what could cause a credit crunch for businesses? Often, available credit is based on personal relationships between an employee and the creditor. The creditor may consider an employee to be responsible for the profits that will enable the business to repay any loans. Although this personal relationship is often with an owner or senior executive, it is sometimes based on others – a star salesperson, an organized and efficient office manager, an inspiring supervisor or foreman, or an employee who is a respected community worker. Various employees may provide that key relationship that reassure the creditors of a business.

When valuing key employees, employers sometimes take the employee’s contribution to business credit for granted. As today’s crisis is teaching everyone the necessity of good and available credit, the value of an employee to business credit lines must be considered. If a key employee suddenly died or became disabled, would the business’s creditors hesitate to continue credit? How much cash would be needed to bridge the difficult time following the employee’s loss to reassure creditors?

One of the first principles of financial planning for both individuals and businesses is to protect your existing assets and newly acquired assets. Credit relationships are a valuable asset. They are difficult to acquire, and when acquired, should be protected. Key person insurance can protect businesses from the loss of a key person. Businesses usually consider the effects of a key person on sales or profits, but often neglect to consider the key person’s loss on the business’s credit availability.

PlanLab has a Key Person module that helps to guide business owners through the process of considering the impact and value of a key person to the business. It helps the business owners consider all aspects of the employee’s effect on the business, including the relationship with creditors. 2008 has been a difficult year for businesses, and everyone needs to learn from the experience. One lesson is the value of available credit and the necessity to protect the business’s credit by considering a key person’s effect on the business’s credit.

Photo credit: absoblogginlutely

The answers must consider individual situations, but a few basic concepts should always be considered before making decisions to each question.

Should I take my money out of my 401K Plan?

If you take your money out of your plan, it is subject to income taxes. Paying taxes on the decreased values will increase your losses. If you are under 59 ½ you may pay an additional 10% penalty tax. You can avoid the taxation by rolling over to an IRA, but that generally provides no advantage to leaving it in the 401K. Unless the money is immediately needed for another reason, you should not take it out of the plan.

Should I change investments in my 401K?

If you are close to retirement, say within five years, you definitely want to reexamine your asset allocation to be sure you are not too heavily invested in stocks. If you are already retired, you want to be sure that the portion, from which you are taking your retirement income, is in very conservative investments. In most cases, if your investments are diversified, you should consider leaving them as they are. If you move them to a low risk investment now, they will not be able to recover. The more time you have between now and retirement, the longer you can wait for the values to recover.

Should I continue to make contributions to my 401K?

Yes. First, you always want to take advantage of any employer match—it is free money. For example, if the employer matches $.50 for each dollar you contribute, that’s like earning 50% after taxes for each matched dollar. Regardless of economic conditions, you should always contribute up to the amount that the employer will match.

The other reason that you want to contribute is called dollar-cost-averaging. This principle always works to your advantage, but it is especially advantageous when the market is down— like it is now! Here’s how dollar-cost-averaging works. My making monthly contributions, you purchase shares based on their value each month. If the price per share goes up, you get a few less shares that month. If the price goes down, you get a few more shares. Proportionately, you get more additional shares when the price goes down than you give up when the price goes up. Consider the example in the chart below.

$100 is contributed each month. The first month the price per share is $5, so 20 shares are purchased. The price goes up the next month to $6 per share. The $100 buys 16.667 shares. The third month, the price is back to $5 and 20 shares are purchased. The next month the price drops to $4 per share, so you receive 25 shares. If the price returns to $5 the next month, 20 more shares are purchased. You now have a total of 101.667 shares worth $5 per share for a total of $508.33. It is easy to see that the average price paid per share was $5. Had all $500 invested been invested at the average price, you would only have had 100 shares worth $500. Systematic purchasing with varying prices allows you to do better than the average.

Let’s continue the prior example, but this time let the prices go really low. This time, the price continues to decline to $1 per share. It would be easy to get discouraged when the price has fallen so low and values so low, but continuing to contribute each month until the market has reversed, provides substantial gains. In this example, dollar-cost-averaging has produced 30% more value than would have been earned buying the stock each month at the average price.

If we had lost our nerve when the price reached $1 and quit making monthly purchases, we would have only had $1,325 when the market had recovered.

For someone who is a number of years from retirement and has time to let the market recover, dollar-cost-averaging can make this economic crisis a “blessing in disguise.”

Photo credit: m kasahara

Companies and advisors, who used Retirement Road Map from Impact’s PlanLab®, last year, can reassure their clients that their retirement plans are fine. Retirement Road Map recommends time horizon investments by retirement phases. The two images are pages from Retirement Road Map that explain investing by phases and time horizons (click to see full size).

Investing by Phases

Investment Time Horizons

Consider the case of Sam and Sara. They retired October 2007 when they were both age 65. They wanted to know how much should be invested, and how it should be invested to provide their desired retirement income.

Retirement Road Map Assumptions:

On the first anniversary of their retirement in October 2008, the country was in for a big shock. Sam and Sara found that there very conservative investments, from which they were withdrawing their retirement income was just about what was expected. But, the conservative investments had lost 10% of their value, their moderate investments had lost 20% of their values, and the aggressive investments had lost 30% of their values.

You can tell Sam and Sara that they should continue to make their regularly scheduled withdrawals. A plan that invests by phases and time horizons is design to allow market recovery over an entire phase. Even after what were larger first years loses than ever anticipated, they don’t have to make any immediate changes. With a few simple calculations, you determine that if the very conservative investments continue to earn 2%, and each of the other classes of investments average earning an extra 1 ¼ %, then their plan will continue to support their planned income through age 100. Their retirement plan allows for slow recovery, so there is no need for drastic adjustments.

Retirement Road Map uses conservative assumptions that are about half of the twenty year averages. Assuming slight increases in the assumptions are reasonable. Combining conservative assumptions with investing by phases and time horizons makes retirement plans secured. Plans don’t require major adjustments while in retirement – even when the completely unexpected happens.

Don’t your retirement clients deserve to have a retirement plan that takes advantage of the market and higher returns, but in a way that minimizes frequent adjustments and retirement income worries? They deserve a retirement plan made with Retirement Road Map.

It’s helpful to understand how the credit market works, especially at the bank level.

When a dollar is deposited into a bank, the bank keeps a portion as a reserve so that it has cash to meet day-to-day business needs. This is called its reserve. Let’s assume that regulations require that 20% be kept by the bank. That means that the bank can use 80% for their usual business of making loans—loans that are the bank’s primary source of profits. The 80% used for loans results in additional deposits, which result in additional loans.

For example, if $1000 is deposited, $200 is kept in reserve, and $800 is used for new loans. The $800 in loans is deposited in banks. The banks kept 20% or $160 in reserve and loan $640 to other people and businesses. The $640 new deposits allow 80% to go to additional loans of $512. This process is continually repeated until $1000 is held in bank reserves, and $5000 of new loans has been made. Thus, for every $1000 of new deposits, the bank can make $4000 of new loans.

If the reserve requirements were 5% instead of 20%, as is the case in some home mortgages, then a $1000 deposit (or home collateral) could provide loans of $19,000.

When the public and banks have confidence in their loans, the system works great. The bank has cash reserves to mean day-to-day demands, and makes a nice profit on the loans. The loans mean that we can buy new homes and cars without having to pay for them in cash. We can send our children to college and spread the payments out to make them affordable. Business can expand and develop new products, whose profits will provide the repayment of the development costs. Businesses can expand and build new offices and factories and create new jobs. Many businesses use a line of credit to be sure that payrolls can be met each week, regardless of cash flow.

But what happens when a loan goes bad? If a loan defaults, then the whole process is reversed. For example, if a loan for $1000 defaults, the bank has to use its reserves to cover it. As we saw in the above example, if the reserve requirement were 20% then $4000 of available credit would be lost; if the reserves were 5%, then $19,000 of available credit would be lost. Not only does the bank lose its reserves and available credit, confidence is lost and people and businesses are afraid to make additional deposits. Thus, available credit becomes even less.

What happens when the banks lose almost all of their available credit? Remember that it is the available credit that is the “product” banks use to make a profit. Without credit, a bank is like a car dealership without cars—no product to sell.

But, banks have a large amount of unused, available credit in the form of credit card limits. Your credit card bill is $3,000 but you have $10,000 available credit, so you don’t think twice about buying your liquid gold, I mean gas, and paying for it with your credit card. However, if banks cannot find available credit elsewhere, they may reduce your credit card limit in order to have credit for larger clients such as businesses. If your limit were reduced to $3,000, your card will no longer be accepted until you pay some of your bill.

The credit crisis is now personal—your credit cards don’t work, your employer may need to defer your paycheck, as developments, buildings, and expansions stop your employer may need to lay off employees. Your bills and expenses continue as your sources of cash and credit have suddenly evaporated. This is why the credit crisis today should be seen as a personal crisis.

Today’s financial crisis has many dimensions, not just the credit issues. However, it is the collapse of the credit markets that is likely to have the most immediate effect on your personal finances. Correcting the collapse of the credit market and the resulting personal crisis in the lives of most Americans is imperative. Why it has happened, who is responsible, or how we solve this problem are not the important issues: the important issue to every American is that confidence in our financial systems is restored, and credit markets return to normal to prevent individual personal financial crisis on “Main Street, America.”

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