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Bequest Allocation and Bequest Location

In financial planning we talk a lot about asset allocation — what portion of your portfolio is allocated to US stocks, international stocks, bonds, etc. And we talk about asset location as well, which is the idea that you can achieve tax savings by making sure your least tax-efficient assets are in retirement accounts rather than in taxable accounts where they’ll generate considerable tax costs each year. (For example, if you own a high-yield bond fund or actively managed stock funds with high turnover, it’s best not to own them in taxable accounts.)

I would like to propose the terms bequest allocation and bequest location as well.

Your bequest allocation is what portion of your assets will go to which parties, upon your death (or upon the second death of you and your spouse).

And the bequest location concept is analogous to asset location. That is, after deciding your bequest allocation, it’s wise to take some time to think about which assets should be used to satisfy which parts of your bequest allocation.

For example, imagine that you are a grandparent and you have decided that you want your bequest allocation to be 40% to your children, 10% to your grandchildren, 50% to charity.

And imagine that your assets are roughly broken down as: 40% tax-deferred accounts, 25% taxable accounts, 15% Roth IRA, 20% real estate (your home).

How should you divvy up those accounts to meet the desired bequest allocation? Many people might default to simply taking a pro-rata approach, but there’s a much better solution.

First things first: tax-deferred accounts are the ideal asset for giving to charity, because the charity doesn’t have to pay any tax on the money, whereas any individual would have to pay tax as distributions are taken from the account.

And for the opposite reason, the Roth accounts should go to a human rather than to charity. That is, a charity has no reason to prefer Roth dollars over tax-deferred dollars, whereas your kids (or grandkids) definitely would prefer Roth dollars.

So should the Roth IRA go to your kids or grandkids? Back when Roth IRAs could be stretched over a beneficiary’s lifetime, it often made sense to leave them to the youngest people, to get tax-free growth for as long as possible. Today though, they often have to be distributed over 10 years regardless of whether they’re going to kids or grandkids. So now it often makes sense to leave the Roth dollars to the generation that has the highest marginal tax rate. (Note though that if the grandkids are under 18 or under 24 and full-time students, the kiddie tax could cause your grandkids to have a marginal tax rate that’s the same as their parents’ rate anyway.)

Taxable assets work well for either party. Again, any assets are tax-free to a tax-exempt charity. And any humans who inherit taxable assets will receive a step-up in cost basis, thereby allowing them to sell the assets immediately (if desired) and incur little to no tax.

So in the above example, the ideal bequest location would probably be:

  • The tax-deferred assets (40% of the total assets) go to charity,
  • A portion of the taxable assets (10% of the total assets) goes to charity,
  • Another portion of the taxable assets (10% of the total assets) goes to your grandkids,
  • The rest of the taxable assets (including the home) as well as the Roth IRA go to your kids (40% of the total assets).

In short, the idea is: prioritize Roth for humans, prioritize tax-deferred for charity. And to the extent possible, especially prioritize Roth assets for humans with the highest tax rates.

What Is Estate Planning, and Do I Need to Worry About It?

When I recently asked for suggestions of specific estate-planning-related topics to write about, one thing that immediately became clear is that many people aren’t entirely sure what estate planning is — and whether it’s something they should be thinking about.

To put it bluntly, estate planning is planning for your incapacitation or death — choosing, for example, what will happen to your financial assets, your minor children, and your health care in such situations. As you can imagine, that’s a pretty broad field, and almost everybody has at least some degree of estate planning that they should be doing.

At the simplest level, estate planning would include making sure that the beneficiary designations on your retirement accounts and insurance policies are up-to-date. (Remember, it’s the beneficiary designation that controls where the money goes, regardless of what you say in your will.)

A very basic level of estate planning would also include making sure that you have a will that accurately reflects your wishes for any other assets (i.e., assets that do not pass directly to a named beneficiary outside of the will).

At a more advanced level of estate planning, some people will benefit from creating a trust to serve any of several different purposes. In short, a trust is a legal entity to which you would give some of your assets. Those assets are then managed by a person or entity whom you name (the “trustee”), for the benefit of some other person(s) or entity.

A trust can be helpful, for example, if there is somebody to whom you wish to leave assets, yet who you do not think should be put in charge of managing those assets (e.g., because of a disability or because of a well-established history of poor financial decisions).

Alternatively, trusts can be helpful for people on their second marriage. For example, imagine that you want to leave your assets to your new spouse, but you want to be sure that any assets remaining after that spouse dies go to your children from your first marriage (rather than to that spouse’s children from his/her first marriage). In such a case, you could put the assets in a trust, naming your spouse as a beneficiary to receive income from those assets for the duration of his/her life, and naming your children as beneficiaries who will receive those assets after your spouse’s death.

For some people, estate planning involves engaging in various activities to minimize the effect of estate taxes. This is, however, not a concern for most people these days, given the size of the federal estate tax exemption: $5.43 million in 2015, twice that for married couples.

Estate planning also includes several topics that are not strictly of a financial nature, such as choosing a guardian who will care for your children in the event of your death, or granting a medical power of attorney to a trusted family member or friend, so that he/she can make health care decisions on your behalf if you become incapacitated.

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