by Archie M. Richards, Jr., CFP^®
March 21, 2005

Katherine was 55 years old in 1979 when her husband died, leaving her with a trust of $1 million. Knowing nothing about financial management, she turned to the only advisor she knew: Julian, the attorney who had drafted her husband's trust document. Julian didn't tell Katherine that he knew little about investing.

Katherine told Julian, "My family and I need 8 percent cash income each year."

Having grown up during the Great Depression, Julian was inclined to avoid stocks. He invested the entire portfolio in municipal bonds, which at the time earned 12 percent, tax free. He has retained nothing but municipal bonds ever since.

But as interest rates have fallen, the return to Katherine has dropped by more than half, while the cost of living has gone up.

Katherine's trust remains at $1 million. But stocks, to which Julian failed to diversify, have appreciated by more than 12 times. The loss to Katherine and her family from not doing something that would have worked out well - the opportunity cost - is enormous.

Turning to a trust lawyer for investment management was a mistake. Being a lawyer does not in itself qualify one to invest other peoples' money.

The failure to diversify was disasterous. Everyone should diversify. A mixture of stocks, bonds, and real estate investment trusts is vital, and the stock portion should be divided among various types of stocks, including foreign ones.

Finally, an attorney who drafts a trust should not be made trustee. It's too easy for him to disguise errors made in the drafting. No lawyer should accept such a conflict of interest.

***

Estelle writes, "A member of my family needs money, in an amount greater than the $22,000 tax exclusion. Is the tax on such a gift figured on the giver's income, the receiver's income, or on some other basis?"

The tax isn't figured on anyone's income, Estelle. Here's the story:

The federal government taxes individuals in two ways: It taxes a person's income all the way along, as you know. Later, it taxes the person's wealth, one time, when the property is transferred to someone else. This is called the transfer tax.

Eventually, everybody transfers their property, either gifting during life or transferring after death.

There are several important exemptions from the tax:

• Transfers to spouses and qualified charities are exempt altogether.

• Gifts of up to $11,000 each year to each of any number of people are excluded. If the gifts are undertaken jointly with the spouse, the exclusion, as you're aware, is $22,000.

• A third exemption is actually a credit, although it's usually described as the equivalent of an exemption. (Exemptions reduce the amount being taxed. Credits reduce the tax itself.) In 2005, the exemption equivalent is $1.5 million.

In 2006, the exemption equivalent increases to $2 million. In 2009, it goes to $3 million. The exemption equivalent for gifts remains at $1 million throughout.

In 2010, the transfer tax is repealed altogether. But in 2011, the darn thing is scheduled to be reinstated with an exemption equivalent of $1 million.

Without the participation of your spouse, let's say you give away $111,000 this year to a family member. Of this, $11,000 is this year's exclusion; $100,000 counts against your estate's exemption equivalent.

You die many years later, with an estate worth $1 million. We'll assume that the exemption equivalent is then $1 million.

In the transfer tax return, your $100,000 gift is added back to the $1 million value of your estate, making $1.1 million. Since the exemption equivalent is only $1 million, the extra $100,000 is subject to the transfer tax.

If your estate were worth $900,000, you'd be home free - in your heavenly home, that is - with no tax charged. The $900,000 plus the $100,000 prior gift would be no greater than the $1 million exemption equivalent.

As to income taxes, a gift to an individual is not an income-tax deduction to the donor, and it is not income-taxable to the donee. But if you give income-producing property, the income then becomes taxable to the donee and not to you.

Don't you just love tax complexity?