On Estate Planning
My first rule of estate planning goes against the grain of our culture: you don’t need to leave any money to your heirs.
I say this because, generally speaking, children don’t deserve free money. They’re apt to blow it all on unnecessary downloads and overpriced lattes. Especially the way you raised them, those ungrateful punks. I’m sort of kidding about the punks part, but not the rule itself. Your concern in growing wealthy should be your own needs first. The most important legacy to leave your children is a strong character and set of values, experiences, plus unconditional love. That’s a legacy better than a pile of money in the bank.
My second rule of estate planning is that of course you should hire an attorney to professionally prepare a will, a power of attorney document, and a health proxy document. Why should you hire an attorney instead of downloading a cheaper version from the interwebs? For the same reason you should hire somebody else to do your taxes each year: you are apt to save money and avoid costly mistakes by hiring an expert who knows the specific rules that apply to your geography and financial situation.
My third rule of estate planning is: do it NOW.
When is a good time to prepare your first will? Now. Create a will as soon as you live on your own, not as a dependent. You might not have any real appreciable assets yet, but be optimistic. Remember the power of compound interest, the most powerful force in the universe. Steady accumulation, combined with an unwavering faith in risky assets, may create a large snowball of assets some day. You don’t owe the people who outlive you your money, but you do owe them clarity and simplicity. So save them the hassle and get it legally sorted. Again: Now.
So now that you know that you don’t need to leave money to heirs but you do need to create a will and end-of-life documents as soon as possible, what is there left to say?
Not much, except two important principles, and two specific life hacks, that follow naturally from those principles.
The first principle is KISS—keep it simple stupid. This should seem obvious at this point in the book, since it’s the same idea said many places and in many ways. Remember: Simple beats complicated almost every time. Low cost beats high cost. Avoid complexity. Be very skeptical if you’re doing something complex, just for the taxes.
For example, many wealthy people—more than you would expect unless you come from or live in that world—decide where to live throughout the year based on where income tax and estate taxes are the lowest. They and their accountants expend extraordinary effort to make sure not more than half of their days in any year (for example) are lived in a particular high-tax state. At the upper reaches of wealth and income of course this kind of attention to detail can be worth tens of millions of dollars, so naturally it’s the sort of thing accountants and lawyers suggest. But when you really think about it—if you have that kind of wealth, shouldn’t you be able to do and go and be whatever you damn well please? At a certain point, if you’re making major life choices (like where to spend your summers or winters and which neighbors and friends to spend them with) based on the taxes—I don’t know what to tell you except that you’re doing it wrong. That’s one example of what I mean about letting the taxes tail wag the life dog.
Similarly, complicated estate tax planning strategies—especially at the upper end of the wealth scale—may require you to go through elaborate schemes to pass on wealth with the minimal tax hit. These are all clever and great except that I’d urge deep skepticism about whether the cleverness—and the cost of the cleverness—are really worth it in the end. Should you be fortunate enough to qualify for high-end estate planning techniques, just remember the main lessons about simplicity, low cost, and not letting taxes dictate important life choices. So, again, KISS.
The second principle any good estate planner will tell you is that the heart of any plan must be your personal values. The key estate-planning question shouldn’t be about how to move the largest chunk of money to the next generation and philanthropies, but rather: What do I believe in? What do I stand for? What was it all for?
If you can make your personal values the center of your estate plan, then you’ve gone a long way toward a good plan.
Two Estate-Planning Life Hacks
Most of us will not need high-end estate-planning techniques, so I’ll just offer the two following estate-planning hacks that are super-duper simple and can help people of relatively modest estates. Eventually (of course, as a result of reading this book) you will have so much money and assets that you’ll be tempted to engage in complicated and expensive estate planning (resist that temptation!), but until then, you can feel clever with these two cheap and easy-to-manage ideas:
Let’s take these one at a time.
Estate Planning Life Hack 1: The Magical Roth IRA
As much as I kind of hate the idea of estate planning, I do get excited by the super-cheap, modest, intergenerational tax-free wealth transfer available through the Roth IRA.
The mechanics of a Roth IRA may change in the future, but as of now the Roth offers you—under specific circumstances—an unusually simple and cheap intergenerational wealth-transfer tool. It’s a life hack just for an older you, in your wealthy retirement.
Here are the three key ingredients to the magical Roth IRA life hack, which I’ll describe in more detail below the list.
Don’t Withdraw
Roth IRAs differ from a traditional IRA in that retirees are not required to take minimum distributions each year. Simply stated, if you had $100,000 in a traditional IRA and $100,000 in a Roth IRA, the IRS rules would require you to take out money from the traditional, but not the Roth, each year.
As mentioned in the last chapter, the amount you take out in required minimum distribution (RMD) is determined by an IRS table that tells you, at every age, what your expected remaining years of life are—and based on that, how much of your traditional retirement account you must withdraw that year. To take a simplified example, an 80-year-old man might have 10 years of “expected remaining life,” according to the IRS table, and therefore must withdraw at least one-tenth of his traditional retirement account. An 89-year-old may have 6 years of “expected remaining life” according to the IRS table and therefore must withdraw at least one-sixth of his traditional retirement account.
To repeat from above, the Roth IRA has no RMD, so a relatively wealthy person could die with a larger Roth IRA than a traditional IRA because of smaller, or zero, withdrawals in retirement years. If you have enough to live on in retirement without withdrawing from your Roth, then you’ll end up with a bigger amount to pass on to heirs. I mention all this in some detail because it forms step one of the magical Roth IRA life hack.
Tax-Free Income
Step two is that, as stated in Chapter 18, all income from Roth IRA distributions may be enjoyed tax-free. So any heir who withdraws money from a Roth account will pay no taxes on that income, ever. Depending on income tax rates, that makes the money between 20% and 40% bigger than it would otherwise be. Which is pretty sweet.
THE MAGICAL ROTH IRA: APPLYING COMPOUND INTEREST MATH
Using simple compound interest math from Chapter 4 we can see the long-term tax-free income potential of the inherited magical Roth IRA life hack.
Let’s say the fortunate great-grandchild inherited a $100,000 Roth IRA at age 12, and let’s further suppose the great-grandchild intends to only take the required minimum distribution for life, in order to maximize lifetime tax-free income. I’m going to further assume a 70-year life expectancy for the 12-year-old in the first year of inheritance. Finally, let’s assume the account earns 6% per year for the great-grandchild’s lifetime. How big does the account grow, and how much will the heir receive per year?
Under these assumptions, the account will grow from $100,000 at age 12 to approximately $578,000 by age 65. Annual distributions of tax-free income will grow from $1,400 in the first year to $34,000 by age 65. The total amount of tax-free income distributed between age 12 and age 65 will total approximately $557,000. Not a bad result from an initial $100,000 Roth IRA inheritance.
Step three takes advantage of the fact that you can designate the heir—or beneficiary—of your Roth IRA to be whomever you want. You as the original retiree could choose to forgo distributions from a Roth. However, your designated beneficiary must begin annual withdrawals, initially subject to an IRS life-expectancy table, when it comes to annual required minimum distributions.
Well, what’s the big deal there, you may skeptically ask? The big deal is that if you designate grandchildren or even great-grandchildren as heirs, then the life expectancy table allows that heir to take out only a small percentage of the account value each year from the Roth IRA. A 33-year-old heir, for example, might have 50 years of remaining life, so could choose to only withdraw one-fiftieth (or 2%) of the account value as income in the first year following inheritance. Even better, a 12-year-old heir might have 70 years of expected life remaining, so would withdraw only one-seventieth (or 1.4%) in the first year following inheritance.
The “remaining expected life” for the heir then reduces by one for every year thereafter. Our theoretical 12-year-old must withdraw one-seventieth in the first year, then one-sixty-ninth in the second year, one-sixty-eighth in the third year, and so on.
So why is that a good thing as a wealth transfer? That’s good because, invested properly (see again, Chapters 13 and 14) the inherited Roth IRA probably continues to grow throughout the lifetime of the heir, to become significantly larger than it was when first inherited, generating an increasing amount of tax-free income for the heir. If you only take out 1.4% or 2% of the account value each year, it should be possible for an heir to enjoy an increasing legacy of tax-free income. That’s the life hack.
Alternatively, you may feel free to ignore all of this semi-complicated life hack for the simple principle stated above, that children—and especially grandchildren—do not deserve free money. It’s up to you.
Estate Planning Life Hack 2: Donor-Advised Funds
Brokerage firms that advise wealthy families report two big problems in estate planning. First, many families decide to pass on assets to heirs and charities only after they die. Second, a majority of wealthy families worry about the negative effects of passing on money to heirs.
Traditionally, a wealthy family with philanthropic intentions could set up a charitable foundation, reaping tax benefits while at the same time doing good work in the world. The costs of setup and maintenance of foundations, however, traditionally make them sensible above, say, $25 million. That’s a lovely solution for certain families but isn’t so practical or relevant for 99% of us.
And that’s why donor-advised funds (DAFs) offer a super-cheap, practical, life hack.
DAFs address the problems in a low-cost, simple way at a scale that works for the rest of us. I’ll explain how DAFs are the solution to many estate-planning problems, one at a time.
The problem of passing on money to heirs and charities after you die, rather than before, is multifold. First, it’s more tax efficient to pass on money before your death. I know, I know, in Chapter 10 I talked about how unimportant taxes were. I don’t mean to disregard taxes completely. I just mean don’t do something simply to save on taxes. The second, and more important, reason to pass on money and assets before you pass on is that you can better express your values with your money while you’re still alive.
What do I mean by that? I mean, when you give money to a charity while you are alive, you get to participate in the mission of the charity. Becoming a donor while you’re still alive means you can watch the organization make use of your funds. Is it accomplishing the goal? Is it a good steward of your funds? Are there equally good or better ways to accomplish the philanthropic mission you care about most?
Giving money while you’re alive also lets you be thanked by the organizations you’ve helped. Philanthropic groups would rather thank you personally than pay homage to a tombstone.
Just as importantly, if you’re interested in passing on your values to your children, the DAF lets you select other trustees to join you in the giving process. Trustees, such as, your kids. Joining your children as fellow trustees in turn provides the platform, I believe, for addressing the key estate-planning questions: “What do we believe in? What do we stand for? What was it all for?”
So let’s talk about the mechanics of a donor-advised fund. Plenty of large brokerages offer DAFs, at reasonable cost, no hassle, and low-minimum account sizes.
The ones I looked at from a few well-known brokerages charged 0.6% management fees, which seems reasonable to me, and when combined with an index mutual fund fee keeps money management costs below 1% of assets. A few required $5,000 to open an account, while another one had a $25,000 minimum, but in either case these are within reasonable range of middle-class donors rather than the multi-million-dollar fortunes generally needed to open up a charitable foundation. The average DAF account was a little less than $300,000 in recent years, but clearly we can open up and maintain these accounts for a lot less than the average.
When you find a charity you want to give to, you contact the brokerage with your instructions, they verify the legitimacy of the charity, and release funds within a day or two.
When you contribute to a DAF you:
A DAF solves a whole bunch of estate-planning problems—values, children, tax efficiency, timing, appropriate (including small) scale—all in one neat package. Check it out.
When you’ve set up a simple will, possibly incorporating these two life hacks—a Roth IRA and a DAF—that’s when you’ll know you’re pretty close to being wealthy. The end of this book discusses what it means to be wealthy, by my own definition. See if you agree.