A common concern among our clients is their income in retirement. When you’ve received a paycheck for much of your life the prospect of retiring and no longer having that recurring income can be really tough emotionally. This is how we help you recreate that paycheck in retirement.
A significant portion of the average retiree’s income comes from their portfolio these days. Invested assets will generate income from three sources:
- Interest on bonds and other types of bond like investments
- Dividends on equity and grow investments
- Distributions and capital gains; this is a difficult area to estimate since it can vary widely each year.
- You will also have Social Security payments at some point perhaps at your full retirement age of the latest when you are 70.Social Security is in effect an inflation adjusted bond, if you are receiving $2,500 per month ($30,000 per year) with bond yields as low as they are and assuming a 2% yield you would need to have $1.5M in bonds to generate that much income.
The remainder of your income will come from the capital gains distributions and possible liquidation of your portfolio each year. It is a common concern that people have that they are selling part of their portfolio each year to augment their income needs. As long as the net average total amount you withdraw from your portfolio does not exceed 4% annually, this should not be a concern. Multiple studies have shown that at a 4% safe withdrawal rate the odds are very high that you will not deplete your savings over 30 years. (We recommend you have detailed projections created since this is a general guideline).
Psychologically it may be useful to have money automatically transferred from your portfolio to your checking account each month automatically, we set that up for a lot of our retired clients. That is effectively part of your retirement paycheck with your Social Security and any other recurring income you may have.
The “Bucket” Approach
We use the “bucket” approach. To make sure you have reserves to meet that “paycheck” need and to also act as a buttress against market declines, you should have three buckets from which to draw funds:
- A cash reserve held in very liquid investments that are very low risk. This could be a money market account, savings account, and possibly very short term treasuries and CD’s. We typically recommend a reserve bucket that is the equivalent of 8-12 months of your cash flow need. This cash reserve should be automatically replenished from dividends and interest generated from your portfolio. It is also replenished when it becomes too low by rebalancing and also bonds maturing (if you have individual bonds as part of your portfolio).
- A bond reserve with the safest bonds in a bond portfolio created to meet your particular cash needs and circumstance. The amount held in bonds varies also depending on the portfolio allocation you have chosen. In any case it’s recommended you hold anywhere from 3-7 years’ worth of your spending need in the safest bonds. We suggest either municipal bonds, CD’s or government bonds, all of which have either very low risk or no risk associated with them. We do not recommend using corporate bonds since the additional yield does not justify the additional risk. Corporate bonds also have a nasty tendency to become “correlated” with the stock market during bear markets like the one we experienced in 2008.
- The third bucket are the growth assets you have in your portfolio, including large stocks, small stocks, REIT’s, etc. When times are good and your portfolio grows rebalancing these investment will periodically replenish both your bond bucket and also your cash bucket.
An advantage of this approach is it enables you to make it through a lengthy bear market without having to liquidate growth assets that might have declined in value. With the cash reserve and the bonds, you may have 4-8 years of protection against that happening. This is an important strategy to reduce the effect of “sequence” risk on your portfolio. For a detailed explanation of sequence risk read one of our past blogs.
We’ve all seen this on the front pages of magazine’s like Money and Kiplinger’s: “Five funds you need to buy now!”, or “The 50 Best Mutual Funds and ETF’s for 2018.” You may also be familiar with Morningstar’s star rating system where they rate a fund on a scale of 5 stars with 5 the highest. Advisors and consumers have relied on that star system for years to help them choose mutual fund managers. Does it really help? In 2017 the Wall Street Journal investigated the system and analyzed its predictive value; their result: Morningstar’s system is not particularly useful in predicting future performance. When they examined many 5-star funds they also discovered that many of the funds were small when they received a 5-star rating, with their high rating attracting many investors causing the fund to grow dramatically with ratings in future years falling. That might be evidence that many managers cannot invest the same way they did when they were small or that their performance might have been based originally on a few lucky picks.
A case in point is the Fairholme fund, Fairholme invests in US stock independent of size, and they seem to be all over the map over the years, investing in large, midcap and small cap at various times. (Full disclosure we use to use this fund). For years it outperformed its peers by a wide margin (13% per year), then suddenly it experienced a terrible year in 2011. That year the fund lost over 32% while the S&P index gained 2%. (Around the same time Morningstar named Fairholme fund of the year). Now if you compare Fairholme to the S&P 500 index, the Russell Midcap Index and Russell 2000 it has severely underperformed all of them:
Since their focus on company size has been variable we think it is fair to compare them to these three indices.
So how can you tell a manager’s performance is really based on skill? (Something you would have wanted to know about the manager of Fairholme in 2010 when they seemed to be crushing most equity indices). There are ways to analyze their performance using statistics. Comparing a manager’s performance against various indices provides useful information regarding their investment approach (this is called style analysis). You can then compare their performance against a “synthetic” fund that is composed of those indices. Using the composition of the fund and comparing it to a combination of index funds that would match that composition some have concluded that it would take at least 18-20 years to determine if Fairholme’s out performance (before 2011) was manager skill or luck. For some funds with a more volatile track record it might take as long as 100 years before it can be shown with a high degree of certainty that a fund’s performance is based on skill.
Active managers also have some headwinds when compared to an index fund: the low expense ratio and greater tax efficiency of most index funds. Most actively managed funds have expense rations in the .8-1.2% range annually while most index funds are in the .1-.35% range. Just to match an index the fund manager has to automatically outperform it by .7% or more, a high hurdle. That combined with the fact that Index funds tend to be more tax efficient means that at the beginning of every year a fund manager has to beat an index by over 1% on average just to justify their existence.
Over the years we have gradually concluded that it is easy to try to find a fund that seems to have beaten the market but it is hard to find one whose performance can be proven to be skill and not luck. Because of this we mainly use funds and ETF’s that are index based or based on a strategy that is not an attempt by a manager to “beat” the market but is instead based on a mechanistic strategy. A strategy meant to capture a certain risk vs. return component of the market or a particular exposure that fits into our client’s overall asset allocation.
Many people aspire to having a second home down the shore or in some other vacation spot. Buying one is a huge financial commitment that may place a serious drain on your resources, and costs can be high for something you may only use 4-8 weeks a year. Costs include:
- Opportunity Cost: The opportunity cost on the funds you have tied up in your down payment and the equity you have in the home. If you can earn 6-7% on your invested assets and you have $100,000 in equity in the home you need to consider that as a sunk cost. Granted it should be offset by appreciation in the home but there have been many instances where certain vacation areas lose popularity and homes do not appreciate or they actually decline in value.
- You may spend anywhere from $25,000 to $100,000 to furnish a second home.
- Maintenance: A good rule of thumb is to estimate that maintenance on the home can cost from 1-3% of the value of the home annually. You also need to be prepared for large expenses like replacing a roof or other costly systems in the home. Maintenance might be costlier than your main home since you are not there and some items you might handle yourself will required that you hire someone. Sometimes small issues can morph into big ones if you are not there when they begin.
- Ongoing expenses: Include property taxes, utilities, insurance, etc. Insurance costs can be 20% higher than your principle residence since insurance companies view it a higher risk since someone is not their all the time.
- Flood insurance: many homes are in flood zones and flood insurance can be costly.
- Mortgage: you will probably have one unless you are willing and able to pay all cash. Even if you can it may not make sense if mortgage rates are 6% or less and you can earn 6% or more on your invested assets. We do suggest you get a fixed rate mortgage and not an interest adjusted one if you plan on keeping the property for 5 years or more.
Consider that a vacation home costing $500,000 (in NJ) might cost:
Property Taxes: $6,000
Maintenance: $7,500 (1.5%)
Flood Insurance: $1,000 +
Mortgage Interest: $19,000 (400,000 mortgage, 5%, 30 years, first year interest)
Opportunity Cost on Down Payment: $6,000 ($100,000 down payment; 6% assume rate of return on invested assets).
Utilities: $2,000 – $5,000 (can vary widely depending on air conditioning use, off season use, etc.)
On the low end that second home may cost you $43,000 per year!
Renting the Home
You could defray some of the costs by renting the home part of the season, a home at the NJ shore might rent from $1000 – $3500 per week depending on location and size of the home. A problem with this is that you will need to rent it during peak season so it will not be available to you for much of the summer unless you limit the rental to say 8-10 weeks. If you do you might realize $16,000 – $25,000 and possibly cut your carrying costs in half. Unfortunately, that rental income will come with a price: dealing with tenants who will not treat the property as carefully as you do and you may need a place to store personal items to protect them from abuse and theft from tenants. Renting the home dramatically defeats the purpose of having the second home. We also did not mention that you will probably owe a realtor commission for the rental and you may want to consider hiring a property manager with a local presence to take care of issues that might arise.
Purchasing a second home means you will feel obligated to vacation there every year. You may end up going there instead of traveling to other places because of this “obligation.” On the other hand, it may be a place where you can spend time with your family and become the social center for family and friends.
You may want to consider instead, renting a home someplace for a few weeks. There are several advantages to that:
- You can vacation in many different places. We have personally rented homes in Italy, London and Iceland, the costs ranged from $1,500 to $2,500 for a couple of weeks. If you rent someplace for a month expect the average cost per night to drop further.
- The total cost will be much less long term since you will only be paying the cost when you are actually using the home.
- With the advent of rental services like AirBnB it has become easy to check out homes, view their ratings from prior renters and rent homes, apartments, etc. in many exotic places.
- You do not have the fixed costs of owning a second home and it frees up the capital to be invested.
Know the Costs
We have created a spreadsheet that can estimate the costs of purchasing and owning a second home. Contact us if you would like us to analyze the costs for you.
Choosing a financial planner or advisor can be a daunting task, especially if you are faced with trying to determine how they are paid, how competent they are, and what credentials are actually important. Let’s discuss each of those “three C’s.”
Advisors may be paid through commissions, fees or a combination of both. When an advisor “sells” you a financial product like a mutual fund or an insurance policy they are paid by the insurance company or brokerage firm that “creates” the product. Some advisors are only paid by you; they may charge you for a detailed analysis of their finances and/or they may charge you a percent of any investments they manage for you. There are also advisors that both receive commissions and also are paid by you (“fee-based”) for a plan or for asset management. Whomever you hire, it is important to understand how they are paid since it might (but not always) affect the types of advice you receive. An advisor that charges for a plan or an asset management fee and cannot receive commissions is generally considered a “fiduciary.” A fiduciary is someone that works for you and must legally act in your best interests not their own. Generally, advisors that are compensated this way and act as “fiduciaries” have the fewest conflicts. They should be diligent in disclosing to you any conflicts that might still exist and how they will either avoid the situation that leads to the conflict or how they will “manage” it.
(CFP® certificants will be required to act in your best interests for financial advice regardless of their method of compensation beginning in October 2019.)
With fee-only advisors you always know the cost of the relationship since you pay them directly, with commission based advisors you may not have a clue since sadly there is no requirement that they disclose how much they earn from products they might sell you.
How can you tell your advisor is competent? It sure is difficult but there are some things to consider. First do they have a certification? There are plenty of advisors out there who do not, yet they have official sounding titles like “wealth advisor.” We’ll describe the education and certification that real advisors should have below. Besides having a designation or certification you may want to drill in on the advisor’s core competency by asking some pointed questions, including “how many years experience do you have,” and “what are your specialties?” Make sure the advisor has formal training in areas they claim as specialties. You may want to ask to view a sample analysis they did for a client (any advisor should have a sample with names changed or blacked out). When you look at the sample plan make sure it has at least the following sections:
- Planning Assumptions
- Clients goals
- Detailed analysis with backup and discussion
- Detailed recommendations with a discussion of the potential impact of the recommendations and tradeoffs among various recommendations
- Action item list with due dates
That is just a partial list. Not all advisors will have competency in every area so it is important to discover how they deal with that. For example, Fee-Only advisors cannot sell products but they may recommend you purchase more life or disability insurance. Do they have a list of trusted outside experts that they work with? Does that list include attorneys, insurance agents, and possibly accountants?
There is one membership organization that has pretty specific requirements for their members, that is the National Association of Personal Financial Advisors (NAPFA). Their members are required to:
- Submit a financial plan for peer review
- Be CERTIFIED FINANCIAL PLANNER™s (CFP®)
- Take 60 hours of continuing education every 2 years (the highest requirement in the industry).
- Adhere to a strict requirement that they be fee-only and act as fiduciaries in every circumstance. In fact they sign an oath compelling them to act as fiduciaries in every circumstance.
While even those strict requirements are not a guarantee that the advisor is competent it does certainly increase the chances that they are prepared to properly assist you.
The financial planning field is saddled with a plethora of titles and supposed certifications. It seems as if this is meant to make things more confusing for the consumer who is trying to get good advice. We suggest you ignore all titles like “wealth manager” or “financial consultant” and instead ask what actual education and certifications the person has. While many certifications exist the most important are the ones that require a broad background in many aspects of financial planning. There are two that fit that bill, CERTIFIED FINANCIAL PLANNER™ (CFP®) and Chartered Financial Consultant (ChFC). The CFP® designation is more widely known and it requires that certificants take a comprehensive exam, and a course that requires them to actually write a financial plan. The CFP® designation is owned and awarded by the CFP® board a non-profit organization that protects the mark and also sets high standards for the behavior of its certificants. The ChFC requires more course work but it’s certificants do not have to take a comprehensive exam, they do have to write a financial plan though.
The CFP® board has adopted a very strong set of ethical requirements for their certificants including a new requirement that they act as Fiduciaries whenever they are providing financial advice (beginning October 2019). That strong requirement does not exist for ChFC certificants.
You may encounter many advisors with both designations. You may also encounter advisors who have continued their education and received an advanced degree in the field including a Masters or PhD. Advisors who have done that should be considered the educational “elite” in the field.
One other designation worth mentioning is the Chartered Financial Analyst (CFA) which is owned and awarded by the CFA Institute. While the designation is only focused on investment analysis and management, advisors who hold the designation have acquired very deep knowledge in that specialty. The designation requires that applicants pass 3 exams that are roughly 6 hours in length and the course material includes statistics, economics, investment analysis, portfolio management, etc. Roughly 8-15% of candidates actually finish and receive the designation. Like the CFP® designation certificants are required to adhere to a very strict set of ethical standards. If you are hiring an advisor to help manage your portfolio this designation is important.
We suggest you consider advisors who are fee-only, act as fiduciaries and hold the CFP® or ChFC designation as a minimum.
Assessing your risk tolerance is an essential component of planning. It drives how you should be invested based on your personality and how you might respond emotionally to market declines. There is a critical second component to the planning process as it relates to investing, an assessment of your risk “capacity.”
Determining your ability emotionally to accept risk drives how you should be invested. In 2008 if you were fully invested in the S&P 500 index your portfolio would have declined in value by 38%. We like to put that in dollar terms: a $1M portfolio would be worth $620,000 at the end of that year. Some people can accept that type of decline because they are confident of two things: markets do recover (albeit how long it might take is guesswork) and they have plenty of time before they need to touch their assets. In that sentence we have demonstrated both the person’s risk “tolerance” and their risk “capacity.” Unfortunately, many people in retirement cannot accept that large a decline and they may not have enough time for things to recover.
Assessing risk Tolerance:
Risk tolerance questionnaires are usually the method used to assess your risk tolerance. Until recently we used a type of questionnaire that asked questions of a more qualitative nature, for example: “How much could your investments drop before you felt uncomfortable?” The questionnaire we used was one that was created after years of academic research that relied on the responses from thousands of completed questionnaires to create a formula for translating responses into a risk “number.” We used that system for many years, recently though we adopted a different approach that assesses your risk tolerance using questions that explore how you might respond to the trade offs between gaining an uncertain percent on your portfolio with the possibility of a relatively significant loss vs a certain but small loss. Questions that show the types of trade offs that exist in investing real dollars might be better ways to capture your feelings about risk than qualitative questions that do not. Responses to the questions lead to a “risk number” that is on a scale of 0-100. For perspective the S&P 500 is assigned a risk number of 78. Risk numbers can be used to match your tolerance with a portfolio that has a similar risk profile, which is quite useful.
Assessing Risk Capacity:
Risk tolerance is half the equation, assessing your capacity for risk is just as important. Risk capacity is simply defined as how much money you can afford to lose without having to change your plans. Creating a financial roadmap helps you understand your risk capacity, knowing how much income you need from your portfolio each year to support your lifestyle will drive your risk capacity. For example, if you need to withdraw 5% from your investments annually that combined with a 20% decline in the market can turn a portfolio worth $1M into one worth $750,000 after just one year. If you have trouble adjusting to a cut in your spending and you still need to withdraw $50,000 from your investments suddenly your 5% withdrawal has become a 6.7% withdrawal, something that is not sustainable for a very long time. Your risk capacity can be increased by having some liquid assets available to act a “shock absorber” during market declines. A combination of 6-12 months reserves in a very liquid account like a safe money market account and having the equivalent of 3-5 years’ worth of your spending needs in fixed income can help improve your capacity to take risk on the remainder of your portfolio. We spend a lot of time here working to determine your risk capacity and helping with strategies to improve it.
The NAPFA Board of Directors has elected Stephen C. Craffen to the position of 2018-19 NAPFA National Chair. Steve will serve as Chair-elect until his term begins on September 1, 2018. He was first elected to the Northeast/Mid-Atlantic Region Board (NEMA) in 2008, and was elected 2013-14 NEMA Board Chair. In 2015, Steve was elected to the NAPFA Board of Directors. His election to the 2018-19 Chair position will allow him the opportunity to guide NAPFA into the future, and influence the financial planning profession as a whole.
It is important to manage a portfolio in a tax-wise fashion to help maximize your return in the long run. There are several strategies that can be used to do that, here we discuss them.
- Asset Placement: different asset classes produce different amounts of recurring taxable income with different classifications under the tax code. Common stock dividends are usually treated as “qualifying dividends” if you hold the stock for a certain time (typically 60 days for common stock). They are taxed at the same rate as the capital gains rate that is applicable to your marginal tax bracket (0%, 15% or 20%). Income from REIT’s and bonds is taxed as ordinary income so it may be taxed at a rate as high as 37% (the top bracket in 2018). You can increase tax efficiency by holding those types of asset classes in your tax-deferred or tax-free accounts. Some assets also generate a lot of recurring income in particular natural resources, and alternative investments. Typically, we recommend the following holding order for different asset classes:
|Preferred Account Type||Note|
|Natural Resources||Tax Deferred||High recurring ordinary income|
|Alternatives||Tax Deferred||Frequent tax events|
|International Bonds||Tax-Deferred||High Income tax free not available|
|Real Estate||Tax-Deferred||High income does not qualify for special dividend rate|
|Bonds||Either||Can purchase tax-free municipals in a taxable account|
|International Stock||Taxable||Dividends not qualified but not as high as other asset-classes|
|Domestic Large||Taxable||Dividends taxed as qualified|
|Domestic Small||Taxable||Dividend rate low, taxed as qualified.|
- Choosing more efficient vehicles: Mutual funds are not generally tax efficient, they must distribute all, or substantially all (90% or more) of net investment income and at least 98% of capital gain net income to the shareholders annually. Sometimes because of this it might make sense to hold off from investing in a mutual fund during the last 2-3 months of the year. Buying a fund late in the may lead to receiving part of your investment back as a capital gain distribution creating a taxable event. That can happen even if you really have no gain in the fund. Another disadvantage for the mutual fund type investment vehicle is that amounts a mutual fund distributes can be dramatically increased if it suffers a round of shareholder redemptions. When that happens fund, managers may have to sell highly appreciated stock to fund the redemptions with the resulting capital gains that are realized distributed to the existing shareholders that are left behind. Exchange Traded Funds (ETF’s) do not have to distribute their gains to shareholders, they can be retained, reinvested with the gains reflected in increased share price for the ETF. ETF shares are also do not have the disadvantage that mutual funds have with redemptions; ETF shares are not redeemed instead they are sold on markets like a stock instead of the shares being wiped out by a mutual fund company they are purchased by someone else. If you are in a higher marginal tax bracket, ETF’s may be the preferred investment vehicle.
- Proper bond selection: Bonds can be held in either taxable or tax deferred accounts. If they are held in a taxable account and you are in a high marginal bracket you can purchase municipal bonds therefore we are relatively indifferent to which account should hold them. It is important to know what your marginal bracket is to determine if the tax equivalent yield for a municipal bond is at least as high as the yield on taxable bonds.
- Capturing losses: Capturing losses may not always provide the benefit one imagines. When you sell an investment that has declined from it’s purchase price to a lower value, if you sell at the lower value and use the proceeds to purchase another investment that investment will have a cost basis that equals the value at which you sold the losing stock or fund. If the new investment appreciates back to the original value of the first investment and you sell you have now paid tax on a gain that equaled the prior loss. Therefore, capturing losses is really only a deferral of taxation. In effect your real gain from the transaction is only on the earnings you received on the money you did not pay in taxes. Capturing losses does make sense in some circumstance thought for example if you want to offset gains in the same year and there is a good chance you might be in a lower tax bracket in the future possibly due to retirement or a reduction in tax rates (as we just experienced).
Knowing what tax bracket, you are in and in particular what marginal bracket you are in is important in determining which strategies are most useful to improve the net after tax return for your portfolio. Proper tax management of a portfolio can improve your net return (after expenses and taxes). Some estimate that your realized return can be as much as .25% higher annually.
Stephen C. Craffen
Steve was interviewed by a couple of his NAPFA friends at “Zebra Smash”, the discussion was focused on Modern Portfolio Theory and the advancements that have been made over the years. You can listen to the interview here:
Estate planning for families that include children from parents who have been married a couple of times can be complex. Sometimes ensuring that all the children are treated fairly means you may need to take measures to protect their inheritance if you die prematurely. Your current spouse may not have any emotional tie to them so they could disinherit them either innocently or with malice.
Consider the following example of a husband and wife who both have children from prior marriages and have a child together:
Consider the following:
- If John predeceases Mary: Assume Mary has no affection for or relationship with John’s children from his prior marriage. At her death, she leaves them out of her will, and they are left with nothing from John, (who had a simple “I love you” will that left everything to Mary). They are effectively disinherited through a bad sequence of events and poor planning unless their mother Sue (who may or may not have much of an estate) leaves them something. Or if Sue is married and leaves everything to her new husband he could leave everything to someone else effectively leaving no inheritance for John and Sue’s children. This means that things John (and possibly Sue) might have worked hard for never benefit their own children from their marriage.
- If Mary predeceases John: John remarries, he marries a much younger woman who outlives him; since Mary left everything to John, her child from her first marriage could be disinherited if John leaves everything to his new wife who will most likely out live him. Or his younger wife could still care enough about Mary’s son that she does leave him something but John’s young wife may live for many more years meaning any inheritance Mary’s son would have received may be delayed for 20-30 years.
Those are just two of many possible sequences of events. While every scenario cannot be anticipated some estate planning techniques can reduce the risk that someone’s children are not left out in the cold. Here are two.
QTIP Trust (Qualified Terminal Interest Property) – Is a testamentary (created through a will at someone’s death) trust used by married couples to control the disposition of assets in their estate after the death of their spouse. John’s will would create the trust and specify which assets that he owns individually will be in the trust. Assets he leaves to the trust will qualify for the unlimited marital deduction if his executor makes a QTIP election on his estate tax return. A requirement for those assets to qualify for the unlimited marital deduction is that his wife Mary must receive all the income generated by the assets for the remainder of her life. The assets in the trust will also be counted as part of her gross estate at her death. John though has designated who will receive the assets at his wife Mary’s death and that choice is irrevocable. Using this estate planning technique, he can make sure that his children are never disinherited.
Mary can also include this type of trust in her will to protect her the legacy of her son from her first marriage.
Unfortunately, a QTIP trust is not the most appropriate technique if a person has the bulk of their assets in IRA’s, 401K’s, or other qualified types of accounts that will become subject to the Required Minimum Distribution rule. The reason is complex and related to the requirements that all income from the assets in a QTIP trust be distributed to the remaining spouse every year. The definition of income for an IRA may clash with the definition of income under some state’s rules regarding trusts.
Irrevocable Life Insurance Trust (ILIT) – Another and perhaps more appropriate method of protecting children in a mixed family circumstance is life insurance combined with an Irrevocable Life Insurance Trust (ILIT). Here a trust is created while the spouse is living (unlike a QTIP which is typically created at death through a will). The trustee of the ILIT applies for life insurance on the life of the spouse and the trust owns the policy, the spouse pays the policy premium each year by gifting funds to the trust. The trust is created for the benefit of whomever the spouse selects, in this case possibly a child. At the death of the spouse the life insurance is paid to the trust which may then invest the proceeds and pay the income to the child, provide them with rights to the principle under certain conditions (maintenance, education, support, or health) and perhaps gradually pay the corpus out to them at specific ages (25, 30, 35, for example). This type of trust has other benefits including protection of the assets from the child’s creditors. This is a short and simple summary of this type of trust which could accomplish many of a parent’s goals for the protection or creation of a legacy for their children, one not affected by remarriages. It does come at a cost though, the cost of life insurance and the requirement that the spouse be insurable. It is also recommended that the spouse consider setting this trust up when they are younger and the cost of life insurance is less.
Here is a summary of the 2 approaches:
|QTIP Trust||ILIT Trust|
|When Created||At First Spouse’s Death||During Lifetime|
|How Funded||Assets that qualify for marital deduction||Life insurance purchased by trustee|
|Duration||Does not benefit child until second death||Benefits children at the death of their parent (first death)|
|Income Beneficiary||Must be spouse to qualify||Child(ren) or anyone chosen|
|Restrictions||IRA’s are not appropriate to fund the trust||Can be life insurance but may also gift other assets (not IRA’s)|
|Cost||Typical costs for trust management||Life insurance premium and typical trust management costs.|
|Advantage||Spouse controls disposition of assets after their death||Benefits children at their parent’s death (no wait for the second death of a step-parent).|
|Disadvantage||Child may not receive inheritance for years. Asset may be depleted by remaining spouse||Cost of life insurance.|
This is a brief non-technical summary of a couple of approaches to consider if you do have children from prior marriages.
Stephen Craffen MS, CFA, ChFC