•Irrevocable life insurance trust To cover estate taxes on his and his spouse's death, an irrevocable life insurance trust is also recommended. The business owner's company could potentially be worth millions, creating a significant tax burden for the family. Irrevocable life insurance trusts are usually funded with second-to-die life insurance policies (for a husband and wife). The amount of the life insurance policy should be enough to cover the potential estate tax burden projected by the estate planning attorney, accountant, or financial planner.
•Place children on payroll The business owner also should consider putting his children on payroll to transfer income from a high tax bracket to a low tax bracket. Based on the current reported income, Mr. Barajas notes that the business owner may no longer be able to claim his children on his individual tax return. By shifting income to children, the children would file their own tax returns and could also qualify for some of the tuition tax credits or deductions.
•Succession plan Since it appears that most of the couple's wealth is in the business, Mr. Barajas notes that a key consideration will be a succession plan in case of a premature death or disability to ensure capable continuance of the business and continued income for the family in the event of the business owner's death.
Allocation Proposal
5% Cash and Equivalents
25% Short-Term Fixed Income
14% U.S. Large Company
14% U.S. Large Value
14% U.S. Small Company
18% International Large Value
6% International Small Company
4% Emerging Markets
Mr. Barajas suggests the business owner review his $90,000 investment portfolio
to ensure asset-class diversification.
SAVING FOR COLLEGE
Mr. Ramirez: Assuming four years of college at an estimated cost of $40,000 per year, a total of $160,000 would be required for each child. Savings and investments can continue throughout their college years.
With a 4-year-old:
Factoring in that the child has 13 years until college, and assuming a 6 percent return, approximately $683 per month would have to be invested.
With a 10-year-old:
Factoring in that the child has seven years until college, and assuming a 6 percent return, approximately $1,200 per month would have to be invested.
529 college savings plan:
Different states offer different plans; in some cases the plan offered by an individual's residency state may not be suitable for an individual's goals. Generally, $11,000 per individual may be deposited into this account per year, without gift tax. For this investor profile, a combined total of $22,000 can be deposited into a 529 account, tax deferred. Earnings and withdrawals for qualified higher-education expenses are free from federal tax.
Mr. Barajas: The couple's children are 14 and 8 years away from entering college. The probability of both children entering college while both parents are professionals is very high. Mr. Barajas recommends establishing education savings accounts. Contributions to all education savings accounts are made with after-tax dollars, but the treatment of withdrawals varies substantially. Withdrawals from certain accounts are federal income-tax free when used for certain qualified expenses, while other accounts tax a portion of the withdrawals but place no restrictions on their use. In addition, control of the assets in certain accounts changes as the beneficiary or student reaches legal age, and the types of assets that can be held in education accounts also vary.
For the couple in this scenario, Mr. Barajas notes that two 529 college savings plans would be a solid investment choice for the children. Among investment options:
529 college savings plans
Authorized and created under section 529 of the Internal Revenue Code, the plans help families save for their children's higher education. These plans are sponsored by states and managed by investment managers, and proceeds can be withdrawn, federal income tax-free, for use at any accredited post-secondary school in the country. Generally, contributions are invested in specific portfolios and mutual fund-based investment options. The plan accommodates as little as $15 a month, as well as larger contributions (up to $11,000 per year without exceeding the federal gift tax exclusion). The plan allows contributions on behalf of beneficiaries over age 18, as well as the individual, and remains under the control of the account owner indefinitely.
Coverdell education savings accounts
Formerly Education IRAs, these can be used to pay for college, secondary school, or primary school. Earnings accumulate tax- and penalty-free if used for qualified education expenses such as tuition and books. Accounts can be established by any adult, with contributions up to $2,000 per year allowed on behalf of a child through age 18. Accounts can have assets invested in a range of securities, including mutual funds and individual stocks and bonds. Accounts transfer to the beneficiary once he or she reaches age 30.
UGMA and UTMA accounts
Traditionally, parents and other family members have used UGMA (Uniform Gift to Minors Act) or UTMA (Uniform Transfer to Minors Act) accounts as a tax-advantaged way to provide funds for college. But control over withdrawals remains an issue, Mr. Barajas notes. For UGMA and UTMA accounts, contributions are considered irrevocable gifts that generally transfer to the minor when he or she reaches age 18 or 21, depending on the state. UGMAs and UTMAs can accept virtually any form of contribution, and in certain cases, even works of art or precious metals. The assets in UGMA/UTMA accounts automatically transfer to the child when the child reaches legal age (21 in most states). If a child decides not to attend college, for example, assets can be withdrawn, beneficiaries can be changed to another family member, or the account can be left for future use.
