The "repeal" and looming reinstatement of the estate tax, with its lower exemption amount and higher rates in 2011, is complex – so much so that I get the sense that many affluent individuals are putting their heads in the sand and hoping more definitive laws will be enacted soon. This, of course, is no strategy at all for what is a vitally important part of Comprehensive Wealth Management.

The question all high-net worth individuals should be asking is, "How does this affect me?" I've asked a member of our expert team, Laura Wartner, an estate-planning attorney with Smith, Gambrell and Russell, LLP, to provide some guidance on how to navigate through the current confusion over the estate tax laws.

I hope that you will take a moment to read her commentary below and review your estate planning documents. If questions arise, please contact me and I will be happy to assist you in getting expert counsel on this complex issue. 

By Laura L. Wartner
Partner
Smith Gambrell & Russell, LLP

Much has been written about the failure of Congress to address the scheduled “repeal” of the estate and generation-skipping transfer (“GST”) taxes before 2010, thereby wreaking havoc on professional estate planners and their clients. We need not repeat the details, but a summary of how this came about is important.

Under 2001 legislation, the exemption for federal estate and GST taxation increased to $3,500,000 in 2009 and will drop to $1,000,000 in 2011. Under that same legislation, the tax rate for estate and GST taxation decreased to 45% in 2009 and will increase to a 55% maximum rate in 2011. During 2010, the 2001 legislation effectively repealed both estate and GST taxation. Because of the obvious inequity and poor national policy, it was widely believed that Congress would address these issues in 2009, but it did not.

The change in gift tax law is only slightly less confusing. The 2001 legislation allowed an effective gift tax rate of 45% in 2009, 35% in 2010 and 55% in 2011, while providing for a lifetime exemption of $1,000,000.

To compensate in part for the repeal of estate and GST taxes in 2010, the 2001 legislation provided for a “carry-over basis,” with some adjustments. Little has been written about the carry-over basis provisions, but statistics show that for decedents dying in 2010, over 70,000 estates will be negatively affected by the carry-over basis rules, while about 6,000 estates would benefit from a repeal of estate or GST taxation.

As though this situation is not complicated enough, there are two additional legislative movements that may provide more confusion. First, Congress may consider legislation to reinstate estate and GST taxation in 2010, which may be retroactive to January 1, 2010. Whether the retroactivity of such legislation would be constitutional remains to be seen. As a result, at the present time, no one can tell whether estates of decedents dying in 2010 will be subject to estate tax or not.

In addition, Georgia and other states are considering legislation which would influence the interpretation of estate planning documents for decedents who die when no estate or GST taxation is in effect, by causing the estate planning documents to be interpreted as though the law in effect in 2009 still existed.

Estate planning has never been so entertaining. The question which seems to be most pertinent to our clients is: “How does this affect me?”

There is no single or simple answer to that question, but you should review your existing wills and trusts (“Estate Planning Documents”), keeping some guidelines in mind:

1. If you are unmarried and your Estate Planning Documents leave specific bequests to children or other persons, either outright or in trust, in all probability your documents do not need to be revised.
    
2. If you are unmarried and you leave bequests to persons utilizing GST planning, you should consult with your estate planning counsel to see whether changes in your documents are warranted. If, in the review of your documents, you see the phrase “GST Exemption” or “Family Dynasty Trust,” your documents would fall into this category.
    
3. If you are married and your Estate Planning Documents leave all of your assets outright to your spouse, in all probability there is no need for any change.
    
4. If you are in your first marriage and your Estate Planning Documents create a Family Trust (to be funded with the amount of your estate tax exemption) and a Marital Share, your documents may or may not need revisions. Most estate plans which are constructed in this manner utilize a formula. In the absence of estate tax law, some formulas would cause all of the assets to pass into the Family Trust; other formulas may cause none of the assets to pass into a Family Trust, or may be unclear. If all of your assets would pass to the Family Trust and your spouse is the primary beneficiary of this trust with your descendents as secondary beneficiaries, passing all of your assets into the Family Trust may work well. But there are many exceptions. If there is any doubt about what would happen, you should have your documents reviewed immediately.
    
5. If you are in your first marriage and your Estate Planning Documents create a “Family Trust,” a “Family Dynasty Trust,” a “Generation-Skipping Trust,” or other language suggesting the use of GST planning, your documents should be reviewed, because the GST tax planning will, in all probability, not be effective.
    
6. If you have children by a prior marriage, and your estate plan utilizes a “Family Trust” and a “Marital Share,” your documents should be reviewed immediately. It is possible that the formula would cause all of your assets to pass into the Family Trust, which may or may not include your spouse as a beneficiary.
    
7. If your Estate Planning Documents include a trust to carry out charitable bequests, such as a Charitable Lead Trust or a Charitable Remainder Trust, you should have your documents reviewed immediately, as the formula amounts that are used to determine the value of property passing into these trusts may not produce the results you anticipate.
    
8. If you are married and you own assets that have unrealized gain in excess of $1,300,000, you should review your situation carefully, as there are special new rules that allow a basis increase for certain assets passing to or in special types of trusts for the benefit of a surviving spouse, up to a maximum $3,000,000 basis adjustment. This special basis adjustment will be lost unless your estate planning documents are properly prepared.

There are several approaches to address these issues. One approach is to write provisions into your Estate Planning Documents which set out alternative provisions for your estate if death occurs when there is no applicable Federal estate or GST tax law in existence. Another approach is to add a provision that interprets your Estate Planning Documents as if the estate and generation-skipping laws that existed on December 31, 2009 are still applicable. It is important for you to contact your estate planning counsel to determine whether you need to do anything and what approach is best for you.

Roth IRAs have been around since 1998, yet most of our clients don’t have a Roth IRA. The reason is that the ability to contribute or convert traditional IRAs to Roth IRAs has been limited to taxpayers with relatively low Adjusted Gross Incomes (AGI).

Despite this limitation, you will be hearing more and more about the opportunity to convert traditional IRAs to Roth IRAs in 2010. The reason for this renewed interest is that the income phase-out to convert traditional IRAs to Roth IRAs, which used to be set at $100,000, will be eliminated in 2010. In addition, Congress has permitted the income recognition on these conversions in 2010 to be recognized in 2011 and 2012. Therefore, the financial press and Wall Street are cranking up their marketing machines to encourage investors to consider a Roth IRA conversion. But, just because you can convert to a Roth IRA does not mean you should.

As a refresher, the primary difference between Roth IRAs and traditional IRAs is that Roths are funded with after-tax contributions instead of pre-tax contributions. As a result, Roths have two big advantages over their traditional cousins:

1. Earnings on contributions grow tax-free in Roth IRAs vs. tax-deferred in traditional IRAs (tax-free treatment requires five-year holding period and attainment of age 59½).

2. Roth IRAs do not have the Required Minimum Distribution (RMD) at age 70½ provisions that traditional IRAs have. In other words, if you don’t need the money in your IRAs to live on and want to leave an income-tax-free Roth IRA to your heirs for gift and estate planning purposes, Roth IRAs make a great deal of sense.

So if Roth IRAs make so much sense, why would you not convert your traditional IRA to a Roth? That answer is that Roth IRA conversions require you to pay the tax now (or, with the new rules, in 2011 and 2012). And, since you don’t want to use money from the IRA to pay the tax (which would greatly diminish the size of your IRA and thus the amount of compounding your portfolio would be able to do), you would need to pay the tax out-of-pocket. For a large IRA, this can be a sizeable chunk of money. For example, converting a $500,000 traditional IRA to a Roth would result in a tax bill of around $205,000, depending on your state’s income tax rate.

Still, even though you have to pay current income tax on the amount you convert to a Roth IRA, it may make sense for some people. Here is a decision matrix for you:

The conversion rules do allow for a partial conversion which may allow you to capture some of the benefits of conversion without wiping out your cash reserves. In addition, some taxpayers may find themselves in low tax brackets due to the economic slowdown and a partial conversion may make sense to the extent you can pay tax on the conversion amount at lower rates.

Keep in mind that even the opportunity to delay and spread the income recognition to 2011 and 2012 may not be a benefit because the tax act that reduced the top marginal rate at 35% is set to expire at the end of 2010, after which the highest marginal rates will go up in 2011 and 2012. Thus, if a conversion makes sense, you may be better off paying the entire tax in 2010.

It is important to recognize that the primary reason for this rule change was to accelerate the collection of income taxes that might have otherwise been locked up in traditional IRAs for decades to come. Therefore, I don’t believe that we will see an enormous amount of people take advantage of the 2010 Roth conversion opportunity.

The bottom line is that if you don’t need the assets in your retirement accounts in your lifetime you should take a look at a Roth conversion. Otherwise, take a look at the matrix above and if you’re a “Likely Candidate,” or somewhere close, feel free to call me if you want to take a closer look at your unique set of facts and circumstances.

The notion of a “wealth manager” is relatively new in the financial services field. The term evolved to differentiate an advisor who primarily offers investment advice (the vast majority of advisors) from an advisor who is dedicated to helping clients achieve all of their financial goals through a consultative process.

To help us describe our concept of wealth management at Capital Directions we use a specific formula:

WM = IC + AP + RM

Wealth Management = Investment Counsel + Advanced Planning + Relationship Management

^{(Note: These components and the consultative process we use to implement wealth management are described more fully at www.capdir.com/individuals.php.)}

One thing this formula does not capture, however, is one of the most important roles for any wealth manager: managing client emotions.

The six-month period from mid-September 2008 to mid-March 2009 was an incredibly challenging time for investors to stay the course and stick with their long-term investment strategy. There were been numerous times where investors were tempted “to take a time out until things calm down.”

Industry data is now showing that many (if not most) investors blinked at the market bottom and cost themselves thousands if not millions of dollars. One industry data point that provides a glimpse into investor behavior is the net mutual fund cash flows compiled by the Investment Company Institute. The chart below shows weekly cash flows into and out of mutual funds and then overlays the value of $1 invested in the S&P 500.

Clearly, most mutual-fund investors panicked at the market bottom in March and fled the market in droves. By comparison, it is very interesting to contrast the cash flows of those retail funds with those of Dimensional Fund Advisors – the funds we use extensively to construct our portfolios at Capital Directions. DFA funds are only offered through approved advisors who adhere to a buy-and-hold philosophy, advocate diversification and focus on wealth management.

DFA recently provided me with the following chart that compares their cash flows to industry cash flows during the recent market turmoil, and the difference is striking:

Note the steady orange line at the top representing net cash flows to DFA (+$8 billion) compared with the net $272 billion that flowed out of the rest of the fund industry. DFA attributes this disparity to their advisors/wealth managers who were focused on keeping clients invested during the turmoil. This is illustrated in the next two charts which highlight quarterly cash flows in the retail fund industry (first chart) compared to DFA (second chart):

The differences are striking. While most investors were pulling assets out of domestic and international stock funds and locking in their losses, advisors who use DFA funds were keeping their clients invested and rebalancing their portfolios by trimming fixed income and adding to equity on the significant market dips we experienced in 2008-09. And that is what being a good wealth manager is all about.

The events of the past year were disconcerting to all of us. We’ve seen home prices plummet, the bankruptcy of major corporations, and the inability of business owners to access credit. The list goes on and on. In response to these historic events the federal government has undertaken an incredible amount of intervention in the economy, including forcing companies to merge, enacting unprecedented amounts of fiscal stimulus and even taking ownership in private companies.

In my conversations with clients, family and friends over the past few months I have heard a recurring theme about this: The belief that all of this government intervention has to bad for future stock returns. The argument goes that the United States’ economy is the world’s strongest because it was built on free-market principles, so therefore more government intervention has to mean our economy – and, hence, stock prices – will suffer.

The leap in the argument that gives me pause is that more government intervention HAS to be bad for stock prices. The reason for my pause is that history has often told a different story. The fact is there are numerous examples in the past when massive government interventions were followed by periods of strong gains in the stock market. And stock return data by country shows little correlation between the degree of government intervention and that country’s stock market performance.

Weston Wellington of Dimensional Fund Advisors provides an excellent history lesson on this in the three-minute video linked below. I hope that after watching this short video you will agree that, while government intervention is certainly a major factor in the economy, it is just one factor among many affecting stock returns.

http://www.dfaus.com/library/videos/governme/