Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with hosts Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Chuck: Welcome to Money Talk. I’m Chuck.

Ed: I’m Ed.

Chuck: Ed, we were going to talk about this book and then right before we started recording, you handed me five different articles. I guess we’re talking about those, right?

Ed: I’d like to talk. My favorite is what is this all-wealth distribution, income distribution about? I find it incredible. Let’s look at the numbers for just a second. I like numbers, not quadratic equations as you do, I’m sure. Differential. I didn’t do well. Differential equations.

Chuck: I think I did but I forgot all about them.

Ed: I don’t remember anything. Anyway, citing from information provided by the survey of consumer finance from the Federal Reserve, and this occurred in 2019. These are 2019 numbers. They’ll be updated in 2023. Now, this is the shocking part. The upper 1/10th of 1% has household value of $43 million, plus or minus a couple $100,000. The upper 1%, $11 million.

Chuck: $11 million. The current estate and gift tax exemption is $12,060,000 per person, so it’s actually double that per household.

Ed: Yes. In ’23, we go to $12,920,000. A total of $25,800,000. In other words, there’s all this business about wealth transfer planning and tra la la , and you got to see your lawyer before you get your clothes cleaned. It’s very Important that you do this estate planning and asset manipulation, but the reality of it is, tax, what, the 1/10th of the upper 1%?

Chuck: That is the estate and gift tax. If you looked at the ratio of the number of people who worry about estate tax versus the number of people who actually need to worry about the estate tax, I bet it’s 10 to 1, maybe 50 to 1.

Ed: I would say almost 100 to 1. I’ll do one better. Only because the issue so much isn’t the taxes, is how do I give this property away?

Chuck:   Right.

Ed: I give it to my outright? We’ve talked about this before, but it’s so recurring. I just can’t tell you the number of visits I’ll have that that’s the dominant characteristic.

Chuck:  Right. This actually just happened yesterday. I had a new client come in. One of the things he was concerned about, married couple, but the husband who was talking on this particular topic, and wanted to do something during his lifetime for a family member who was in some financial distress and was really very concerned. I think I got the impression the primary reason for the appointment, even though we were talking about estate planning, was he wanted to help this family member pay off a $70,000 mortgage on a house. This was an estate that was nowhere close to becoming taxable.

Ed: By that, you mean didn’t exceed the exclusion amount.

Chuck: Didn’t exceed the exclusion amount, and was–

Ed: Whoa, let me interrupt you. The exclusion amount is the amount that you can transfer gift and estate tax free.

Chuck: Right.

Ed: It’s like toothpaste, once you use it up, it’s gone.

Chuck: Right.

Ed: Go ahead.

Chuck: Far enough below this $12 million exclusion amount that there’s really no possibility that it would grow to become larger than the $12 million amount. Was in to see me primarily, I finally concluded, about how to help make this $70,000 gift to a family member without incurring all kinds of tax issues and was genuinely surprised to learn that you can just write a check, and it’s just fine. I’m starting to agree with your 100 to 1 ratio here.

Ed: The philosophy I seem to encounter is everyone’s afraid of the IRS. If you talk to someone who is foreign-born and afraid of being shipped back, they just go over the top about it. “The service, Ed, they called me.” So what?

Chuck: Right.

Ed: Just because you’re called and they claim X, Y, and Z, that doesn’t mean they’re right.

Chuck: Exactly.

Ed: The threat of punishment is just amazing. Okay.  Fine.

Chuck: Do you suppose the people who work there know that?

Ed: Yes.

Chuck: I think you’re right.

Ed:  Yes, I’m not suggesting that they’re bullies. Quite the contrary, there’s some five-star pros in the upper reaches of the Service. Those that aren’t, are inexperienced, tend to be a little more of in your face than is necessary. I don’t know what your experience has been but–

Chuck: Mine has been probably about 95% in the category of almost bending over backwards to be very careful and professional, and polite, and not overreach. Then with very few exceptions, and the exceptions are memorable.

Ed: They’re big time.

Chuck: Yes.

Ed: Typically, the larger engagement. You do a transaction that involves multiple millions of dollars, you must tell– we tell the client, look, you’re going to be audited. Why is that? Because there’s a lot of money involved, honey. It’s called money, honey.

The thing we miss aside from the exclusion amount and that sort of business, and how to give it away, when to give it away, why to give it away. Are you going to destroy a lifestyle? You’re going to make someone who otherwise competent, incompetent, and not taking advantage of the journey? Which is the destinations I’ve suggested. We talk about tax. The federal tax, transfer tax, after you pay the income tax and payroll taxes, and whatever, is something that’s almost discretionary. It’s almost voluntary. Then we get to the question of the state tax. That’s where the rubber hits the road.

Chuck: You’re talking about individual states imposing their own taxes.

Ed: That’s right. For example, Illinois has pretty interesting rate on the exclusions of over $4 million. You have a $12 million federal exclusion

Chuck: Right.

Ed: and a $4 million Illinois exclusion,

Chuck: Right.

Ed: so most of your time planning is with respect to the–

Chuck: To the Illinois. People truly do not understand that tax because it’s very strange the way it’s administered. The only way you can explain it is with historical reference to how the law came about. Otherwise, it just makes no sense.

Ed: Typically want to know, how much is it? Simple as that.

Chuck: Right.

Ed: In Illinois, you can make annual gifts that don’t count, but any taxable gift that is amount in excess of annual gifts, medical gifts, charitable gifts, political gifts, becomes what’s called an adjusted taxable gift and that’s added back in. Without getting too technical about that, you have to look at the quality of life, the state and local taxes, the effective property tax rate, and income tax collections per capita. The range is significant.

All I’m saying is you cannot look at merely income and transfer taxes. You’ve got to consider the real estate. For example, real estate taxes. I have a friend who has a nice home here in this city, and the real estate taxes on a very nice home of 5,000 square feet are less than the real estate taxes on a condo in Fort Worth of 1,200 square feet. It’s remarkable. The point is, don’t get bamboozled by the idea of, oh, there’s no income taxes in Alaska. What’s the sales tax? What’s the property tax? What portion is deductible?

I think the focus should be on the quality of life rather than on these itsy-bitsy, I’ll call them taxes. The big issue that I’m seeing, and challenge me and see what you say, is the IRA balances, the amounts that we’ve talked before about a cash balance pension plan, a profit sharing 401(k) plan, stuff it real early, the result is a significant amounts in an IRA.

Chuck: Right.

Ed:   How do you deal with that? Let me give you some numbers. There are 314 taxpayers in the United States that have an IRA balance of $25 million or more. 314.

Chuck: Wow.

Ed: That’s a lot of money but there’s only 314 of them.

Chuck: Isn’t that amazing? When you think about it, it is something that very few people take advantage of the mechanisms that are available that would allow you to end up with a significant IRA like that.

Ed: Why?

Chuck: First of all, you almost have to have one of two things happen. Either you get something into the IRA early on that’s a stock of a company that just explodes, and you essentially get lucky, or you are a small business owner, you have a cash balance pension plan and you’re able to put a significant portion of your net income into an IRA or into the cash balance pension plan for a period of time, which then rolls over into an IRA. It has substantially more in it than a typical qualified retirement plan. Those are really the two primary mechanisms. You and I have been through this about how few people will actually put together a cash balance pension plan in aggressively funded.

Ed: Simplified employee pension plan, SEP IRA, or a simple, now they’re gone, but no longer can you establish one. This deferral self-gratification is intriguing to me more than anything. I’m really a first-generation folks here, individual of this country, and having a job was wow. If you had two jobs, even better. Let’s get back to this IRA. 98.5% of the taxpayers in the US, again there’s those numbers, have $1 million or less.

 Chuck: I believe that.

Ed: Then you go to 1% or 336,000 have account balances of $3 million to $5 million, which is pretty incredible too.

Chuck: Right.

Ed: That’s 36,000 out of how many millions of people and how many taxpayers?

Chuck: Now I wonder how those statistics were gathered, if those are the balances of a single IRA or if those are for an individual, the total balances of all their qualified plan assets. Because there are plenty of people who have maybe three or four, or five, or six different vehicles that add up.

Ed: I don’t know, but I’ll tell you, these are old numbers. Given what’s occurred except for this year in stock market, it could be much different. These are 2014 numbers. Last ones I can get a hold of.

Chuck: It’s been a huge amount of growth.

Ed: Yes. I’m understating what’s going on here. I’d rather under than overstate. The one vehicle that I find to be most productive in the case of these IRAs, bearing in mind that we have the exclusions from the amount of the federal tax. We’ve got the estate tax to worry about, estate inheritance tax or estate tax. Then the income tax, because when you take these funds out, you’re going to pay a tax. Now, several states exempt distributions from pension plans like an IRA. What are the alternatives? I think we share this, the favorite is the charitable remainder trust.

Chuck: Absolutely. Especially for larger IRAs. Of course, they don’t have to be $25 million IRAs, but just the larger IRAs where the risk there is that the required distributions, because of the accelerated rate under the Secure Act that those distributions now have to be taken out by someone who inherits the account. It really does make these charitable remainder trust far more valuable because this effectively allows you to stretch that IRA over the lifetime of the beneficiary rather than what’s now the default rule is to have to take the entire IRA balance within 10 years of the death of the original owner.

Ed: Let’s revisit that for a second. It’s very important because a lot of folks have these IRAs floating around. Specifically, the default rule is that when the ancestor dies, the owner of the IRA, you, the beneficiary, have this ten-year distribution period, but it’s been changed. Specifically, the required minimum distribution of the ancestor who died after the required beginning date, you’ve got to take at least that much out.

Chuck: Right. Right. You can’t wait 10 years and then take the whole thing. You have to continue with those payments for the first nine years and then empty the account on year 10.

Ed: The government reacted late on this. So, we have all kinds of amendments and not going to have a penalty. It’s crazy what these things do, but the amount of money in these IRAs, I can’t believe it.

Chuck: Now, I have to say that I’ve seen a number of practitioners who express surprise about that. This “change” in posture from the IRS on that. If you look, it seems like the statute was always relatively clear.

Ed: The service didn’t say that.

Chuck: The statute itself was– I don’t know. I just thought–

Ed: Chuck, who reads the legislation? Right. You remember in law school. Everyone wanted to read. Not everyone. Many people wanted to read what someone had to say about the statute rather than reading it.

Chuck: Right.

Ed:  Just read it and maybe you have to outline it.

Chuck: In defense of that comment, there are plenty of times when you read typically where the IRS is being more aggressive, and then you turn and you look at the statute and say, “Where on earth did they get this?”

Ed: Then you know that if the agent comes calling and tells you X, Y or Z, and it’s A, B, and C, you say, “Hey, read the legislation.”

Chuck: Right.

Ed:  I found if you give them that, they back off. The idea is read the primary source.

Chuck: Right.

Ed: Let’s get back to the IRA and the charitable remainder trust. We have several clients that have Roth IRAs that they’ve paid the tax, and now they’ve got– one guy, $20 million in a Roth IRA.

Chuck: Right.

Ed: I don’t know what he is going to do with that money, but that’s not my issue. My dog, Jack, would receive some. In any event, we talk about this charitable remainder trust. That basically is a situation where you can be your own trustee of a charitable of remainder trust.

At your death though, so you got to get someone else. The amount of your IRA then current balance of your IRA, less whatever, $100,000 charitable distributions you may have, and you should have made during the course of the year that offsets your required minimum distribution. This amount is poured into this charitable remainder trust in a lump sum and then doled out over the life expectancy of the beneficiary or a period of fixed number of years. Then the estate receives a charitable deduction for the present value of the amount other than the passing to a charity.

Chuck: Right.

Ed: Chuck, some percentages. You can vary those depending upon the age of the beneficiary, right?

Chuck: Correct. It’s basically the older the beneficiary is, the shorter their life expectancy, the greater the charitable deduction. The charitable deduction is basically the actuarial value of the amount that you anticipate going to charity. For instance, if the beneficiary is someone who is post-retirement age, I’ve seen these where the charitable deduction is 50% or higher of the value of the account.

Typically for younger beneficiaries, it’s more like 20% to 30% of the value of the account, is what you get for the charitable deduction. Then because of the fact that you need to, in order for these trusts to qualify, in order for them to not fail under the rules of the Internal Revenue Code, you have to have at least a 10% value that’s assigned to the charity. That effectively means, can’t remember if it’s age 30 or 31, but it’s right around age 30 is about the minimum age that you can have the beneficiary if you want this spread out.

Ed: Put in another way, the charitable remainder of the younger person, the amount passing to the charity actuarially, the younger the person, the less that’s passing to the charity.

Chuck: Right.

Ed: If you have a charitable remainder trust with a two-year term, or someone who’s 95 when it’s funded, the charitable deductions much greater.

Chuck: Correct. Of course, the larger there’s a unitrust payment, the percentage each year that goes to the lifetime beneficiary, and the larger that payment is, then the lower the charitable deduction.

Ed: Yes. The idea is to grow it. If you’re looking at a charitable remainder unitrust, a percentage, say 5%, you hope that the IRA when a lump sum enter the charity remainder trust, that investment grows, so the greater the annual distribution.

Chuck: Right, seems like most of these we’ve seen that unitrust amount, that’s the annual amount to the lifetime beneficiary has been between 5% and 10%, seems pretty rare. I’m having a hard time remembering examples where we’ve gone above that.

Ed: All the ones I’ve done with you, it’s been 5%.

Chuck: Yes.

Ed: That seems to be different.

Chuck: That’s what allows it to grow.

Ed: Right.

Chuck: You do want it to last the person’s lifetime, so keeping that number small is beneficial.

Ed: The other side is when it’s going to charity. Eddie, it’s going to a charity. Wait a minute, I’m charitable, not that charitable. What’s the alternative? We’ll discuss this in more detail perhaps later, but this ushers in the private foundation.

Chuck: Right.

Ed:  Not during your lifetime, this is at death. The balance of your IRA is payable to your own private foundation, staffed by members of your family, and they can be compensated only at a reasonable rate. All sorts of restrictions on self-dealing, but nonetheless, the identity of the charities can be in the hands of the charitable foundation members.

Chuck: Makes a lot of sense. You know, we’ve talked on this podcast in the past about donor-advised funds. Those have kind of , in more recent years, gotten a little bit of a bad rap. I don’t know if your thinking is veering more back to the value of these private foundations or how you weigh one versus the other.

Ed: I am a very strong supporter of the private foundation. Why? It’s the ability to allow descendants to participate and emulate your desires as to charitable distributions for some amount of compensation reasonable, but most importantly, they’ve got to get together.

Chuck: Right.

Ed: That’s overstated. The negative, “Oh, we don’t want those, they can’t get along.” Wait a second. It’s the money that their parent has accumulated. If they’re charged with the responsibility to manage those funds, the minimum cost, and we’ll talk about friction costs, and know what mom and dad wanted as to charitable distributions, it’s a fantastic device for keeping a family together.

Chuck: I’ve seen some really great examples of this, by the way. The friction costs can really be fairly reasonably controlled, it seems to me. When you have to file an annual report, that’s not a big deal.

Ed: No. Oftentimes states have reports you have to file, but it’s overstated complexity. A lot of authors are typically of the donor-advised funds for the financial institutions. The big investment houses have their own. They want to trap the money, so you got to consider the source, and we’ve talked about that. Who’s giving you the opinion and why?

Chuck: Right.

Ed:  That’s where I suggest the private foundation with the name of the family and managed by the descendants, typically not their spouses. That’s a matter of preference, with a succession plan in place and an ultimate distribution to selected charities if it’s not working. I don’t know, Chuck. I am a little old-fashioned but keeping it in the family is a way of keeping the family together. Not because they’re nice to each other, they’re probably not going to be nice to each other, but if there’s money involved and there’s a honey pot there, they will get along. How do you feel about that?

Chuck: This is kind of unique because it’s not money that they can use for themselves. Right?

Ed: Yes.

Chuck: They’re managing money for someone else with really, other than committing crimes, there’s no opportunity for them to fight with each other over the money because it’s not their money.

Ed: You’ll see all kinds of fights with respect to trusts. Generations skipping trust that we’ve talked about where these exclusion amounts can allow a trust to grow substantially. Then some unknown heir who didn’t know you from the guy that used to pump gas has this windfall of x millions of dollars and no training on asset management or distributions, and you ruin lives.

Chuck: Right.

Ed:  Money is a funny thing in the sense that what it cures and what it causes.

Chuck: Right.

Ed:  Not always the same. That’s about it for today. I wish we could– no, I don’t wish we could spend more time. I think that we’ve covered it. We know the issues, the accumulating process is the art of managing money, managing debt. The distribution process sucks.

When do you give it away, to whom, and why? Any number of clients have said to me, “Ed, this has been a lot of fun getting it together, but a real pain in the ass to decide how to give it away.”

Chuck: I’ve heard the same thing.

Ed: I said, “My, dog Jack.” That’s it. Talk to you next time.

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