In the next 20 years, about $10 trillion of value will pass from the generation born before World War II to the baby boomers. Also, some fortunate individuals work for companies who have offered stock options to their employees. If the company succeeded, the employees became wealthy, sometimes quickly.
While most anyone would welcome a windfall, it brings an entirely new set of decisions and challenges to your financial life. It can also impact your personal and social life, but in this column I will focus on the financial issues.
For retired individuals, these issues should be shared with your children, who may be facing them in a few years.
Income taxes
Prior to receiving windfall, the largest check most people write each year is to the mortgage company. With their new wealth, the largest payment will be to the Internal Revenue Service. The strategy will be to reduce or eliminate taxes on capital gains and dividends. Interest income is also fully taxed at their highest marginal rate.
The solution would be individual stocks that do not pay dividends or mutual funds that have a low turnover rate. Also, variable annuities, municipal bonds and qualified retirement plans can eliminate or defer the current income taxation.
Investment management
Suddenly, the newfound wealth carries responsibility. Many times the assets are heavily weighted toward one particular sector. An example would be an employee who has inherited a large amount of a single stock. The stock may have a low cost basis, therefore making it difficult to sell without significant tax consequences.
This is also true with heirs who inherit real estate. Heirs have an advantage, however, in that the property may carry a stepped-up cost basis if it has gone through a taxable estate. This stepped-up basis would allow them to sell the property without any tax consequences. The strategy would be to develop an asset allocation plan to diversify the portfolio and discover your risk tolerance level. This involves looking at your values, goals, investment time frame and your ability to withstand volatility in your investment program.
When it comes to investments, it is important to understand the difference between information and knowledge. It is important to consult with someone who has experience in developing an investment plan. Sometimes, amateur investors confuse a “bull market” with investment brilliance. This can lead to overconfidence and bigger mistakes down the road.
Estate taxes
Although there can be changes in the tax law, it is still important to have a plan to keep the IRS from becoming the largest beneficiary of your estate. There are other costs in settling an estate such as probate expenses, income taxes, debts and final expenses.
There are many tools to assist you in this planning. Legal and financial tools such as credit shelter trusts, annual gifts, charitable trusts and irrevocable life insurance trusts will allow more assets to pass to your family, escaping estate taxes. Implementing this plan will involve the selection of an attorney, trustees and personal representatives for your estate. It may also require the purchase of life insurance to fund a trust.
Burden of wealth
Surprisingly, many people who come to sudden wealth feel its burden as well as its benefits. You realize that the stock market can beat you and you don’t consider investing a game. You want to keep what you have, but you also want more. The best strategy is to determine the degree of professional help you need to lighten the burden and manage the risk.
There are legal, financial and tax issues to be dealt with. Trying to become an “expert” in all of these areas will be all-consuming and will make this wealth own you instead of the other way around. Most wealthy individuals use a combination of managing their wealth themselves with the help of a professional team.
Legacy
Having received substantial resources, most people want to use them in a way that makes their wealth count for something. They realize that they have the opportunity and responsibility to use their wealth for the advancement of their fellow man. Again, it is important to develop a plan of philanthropy, family relationships, business ventures and pursuing their dreams. Some of the tools that are available would be family foundations, education funds for children and/or grandchildren, charitable giving and outright gifts.
Sudden wealth can be a blessing or a burden, depending on how it is handled. It must be guarded carefully, or it will be lost through improper spending, poor investments or excess taxation. A confident financial adviser can provide experience, judgment, accountability and a face-to-face relationship. These can be invaluable for maximizing the benefits of suddenly acquired wealth.
