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by Donna Byers
After more than 40 years of providing tax and financial planning services, I am convinced that “sudden wealth” is a responsibility for which few people are adequately prepared. In fact, I would estimate that fewer than 10 percent of those who suddenly come into great amounts of money will keep it even for their own lifetime.
Sad scenarios play out again and again as individuals pay unnecessarily large tax bills and squander large sums of money, leaving little or nothing for themselves or others. Lottery winners, recipients of legal or insurance settlements, star athletes, wildly successful entrepreneurs, and heirs to vast estates have all allowed windfalls to slip through their fingers either through action or inaction.
You can blame all sorts of social and cultural ills for this phenomenon, but over the years I have found that a lack of education and planning are the main culprits. The two go hand in hand, whether you are a parent trying to prepare a child for an inheritance, or someone of modest means who is faced with questions of what to do with an unexpected pile of cash.
In my experience, a major issue with recipients of sudden wealth is that many of them have an inadequate understanding of financial planning. Surprisingly often, those who inherit a fortune are not prepared to properly manage it. In fact, a person of modest means may be just as well equipped to handle financial decisions as a person with much greater assets and resources.
A Wall Street Journal article titled "Lost Inheritance" quotes research showing young Baby Boomers spending, donating, or otherwise not saving half of every dollar they inherit. All too often, children with inheritances are not prepared because their parents are not honest and forthcoming with them about the scope of their wealth and what it takes to grow and maintain it.
Starting early gives a young person plenty of time to develop an understanding of the technical aspects of saving, investing, taxes, and charitable responsibilities. And yet a 2012 study by U.S. Trust found that more than half of high net worth parents had disclosed very little about their wealth to their kids.
I’ll admit, it’s not likely that a 10-year-old is going to understand the tax advantages of trusts or municipal bonds. But parents can pass along their vision and discipline, as well as their goal-setting and prioritizing skills. These will serve the children well when the time comes to weigh the difference between short-term wants (a new car, a dream vacation, or some other material goods), and long-term financial needs (retirement, education for children, a financial legacy).
Like an inheritance, the settlement of a lawsuit, sale of a business, insurance payout, or divorce agreement can give rise to sudden wealth. Without a combination of planning and self discipline, the apparent winner can quickly become the loser, ending up worse off financially than if he or she had never received the payout.
Carefully constructed trust documents are a common method of passing on wealth. Depending on the type of trust, there may be tax advantages today and for the eventual beneficiary. But even these legal arrangements must take into account the human tendency to spend unearned riches without a plan.
Choosing the right trustee is critical. If a professional trustee is nominated in the trust document, it is important to also name a family member or some other responsible person to serve as an advisor or “protector” of the beneficiary’s best interests. The document’s author can also provide language to give clear instructions on how beneficiaries should be treated with regard to requests for unusual or excessive withdrawals.
There are well-known examples of lottery winners accepting their prize in a lump sum, and others who opt for annual payments over a period of years. Choosing the multi-year payout often reduces the total tax liability, and actually puts more money in the winner’s pocket. It also gives the newly wealthy person more time to set priorities based on family needs, create a budget, and consider future tax issues. It’s like a kid getting a very large allowance and having to plan how to make it last.
Counseling on opportunities to create substantial tax savings is a first step toward helping the suddenly wealthy keep more of their windfall. It is generally possible, for example, to use a charitable remainder trust or favorable gifting and titling options to make a significant difference in the future tax consequences of the giver and his or her family members and heirs.
Whether a lottery winner takes a single payment or installments, changing that choice is extremely difficult and costly — if even possible. It can also cost significantly more in taxes. For example, if a lottery winner dies with a large uncollected balance subject to state and local tax, his or her heirs may want to close on all tax liabilities and collect all of the remaining installments. After all taxes are paid, only a small percentage of the original face amount is likely to remain. This outcome could easily be avoided with proactive tax planning.
Transferring prize money from an individual’s name to a revocable trust as an afterthought is also a costly process that may require court orders and other complications. In both of these scenarios, a tax advisor, financial planner, and estate planner can take an individual down several life paths to see how today’s decisions might play out over time.
It’s easy to judge those who have it all but can’t manage to keep it. But instead of shaking our heads and wondering what happened, it is the responsibility of those who have wealth or expect to receive it to seek guidance, advice, and counseling as a buffer against financial disaster. It is not an accident when the outcome is positive. Those who educate themselves and then their children on important financial matters and responsibilities can develop skills to cope with the pressures of sudden wealth.
Donna Byers, CPA, PFS, Senior Manager, Private Client Taxdonna.byers@CLAconnect.com or 520-352-1235
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