One of the Biggest Challenges Facing Financial Planners

February 01, 2012

One of the biggest challenges I face in my line of work is deciding when to explain things in more detailed technical terms and when to explain them in more understandable  “practical” terms.  For example, when discussing the income limits for traditional and Roth IRA contributions, most financial professionals will tell you the limits are based on your adjusted gross income (AGI) when technically they are based on your modified adjusted gross income (MAGI).  In many cases, such as this one, the difference between the practical and the technical may be so small that it’s just easier to speak in practical terms. The problem is that if you don’t know the technical stuff, it’s easy to make a financial mistake.

Take for instance estate taxes.  Most financial professionals want you to know that if your assets are worth less than $5,120,000 then you don’t have much to worry about, and in a practical sense that is very true. But technically speaking, there is a lot more to it than that.  Here is a brief overview of some of the technical side of estate taxes:

When you hear someone refer to the “estate” tax what they are referring to is a tax that is assessed when assets are transferred at death.  In other words, the estate tax is technically a form of “transfer” tax.  Assets can be transferred during your lifetime (subject to a “gift” tax), or they can be transferred when you pass away (subject to an estate tax).  This is a very important thing to understand because the government offers a lifetime transfer tax credit that taxpayers may use to offset any gift or estate taxes owed.  It is because of this transfer tax credit that someone can leave a $5,120,000 estate to beneficiaries this year without incurring an estate tax, but ONLY if none of the transfer tax credit has been used during the deceased’s lifetime.

Without going any further, you can already see that this topic is highly complex and can be easily misunderstood. People often think that they have to pay a tax on a gift or an inheritance that they receive rather than on what they give away because they see it as a form of income. There’s also the misconception that gifts that exceed the annual exclusion are immediately taxable rather than a reduction in the lifetime transfer tax credit.

To make matters worse, tax laws change constantly. This year, the lifetime transfer tax credit would cover the tax liability on transfers up to $5,120,000, but that credit may not stay around forever.  If it changes (as it is scheduled to do next year) taxpayers with sizeable estates (greater than $1,000,000) could miss out on the opportunity to transfer some of their wealth and thereby take advantage of the relatively high lifetime transfer tax credit that applies this year.

Actions taken in one financial area can also impact others. When someone applies for Medicaid benefits, Medicaid will look to see if any assets were transferred within the last five years and include those transferred assets in the calculation of Medicaid eligibility.  If a parent or grandparent suspects that they may need Medicaid benefits in the future, they should plan on transferring assets sooner rather than later.  These assets would fall under the gift tax rules, which are directly related to estate taxes.

Practically speaking, most people don’t want to know much about gift and estate taxes.  Instead, they just simply want to know how much their estate can be worth before they owe an estate tax.  But as you can see, what you don’t know can hurt.  Don’t settle for just a superficial understanding of things.  Challenge yourself to learn the details and use that knowledge to educate others.  Not only will you impress your friends, but you might just save them from making the financial mistake of a lifetime.