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Financial Security by Design

Tax Efficiency and Your Trust Documents

Peter James Lingane. Revised 7/18/99.

There are income and estate tax benefits if your taxable, pension and trust assets are managed in a coordinated fashion, with each investment held in the way that is most tax efficient for the portfolio as a whole. The principle of coordinated management should be codified in an investment policy statement and incorporated into living trust and power of attorney documents.

Introduction. It is often said that one should not let the tax tail wag the investment dog, meaning that one should make financial decisions for bone fide investment reasons rather than solely for tax purposes.

But, once that you have made the decisions about what you want to hold in your investment portfolio, thinking about taxes can improve your investment return. Broadly speaking, you should hold title to your investments in the way that generates the least tax and that delays the tax payment as long as possible.

Lower the Tax. Interest, dividends and business income are taxed at ordinary tax rates whereas gains on the sale of investments and some gains on sale of business assets are taxed at lower rates when held for more than a year (Endnotes, ref. 1.) Growth within IRAs and similar tax deferred pensions is approximately tax free.

The investor can therefore lower his tax bill by owning capital assets rather than assets which produce interest or dividends and by holding those assets which generate the most tax in IRA or similar accounts.

Delay the Tax. Capital assets also provide an opportunity to delay the payment of tax. If you hold stock, for example, tax is deferred until the stock is sold. IRAs, pensions and annuities are other examples where the tax is deferred until the money is withdrawn (ref. 2.)

Tax on gains from business assets and rental properties are delayed until the property is sold. Tax can be further delayed by "exchanging" rather than selling the property. Tax deferral opportunities can make direct investment in real estate more tax efficient than investing in companies which invest in real estate.

The ultimate tax deferral occurs when one dies owning a capital or business asset because of stepped up valuation at death. Any income tax liability on the appreciation of a home or rental property or stock portfolio is, in effect, forgiven at death. Capital and business assets owned within a pension or annuity account are not eligible for a stepped up valuation at death.

Allocation Strategy. In order to generate the least amount of income tax and to delay the tax as long as possible,

Example. You own $50,000 in stocks which return 10% annually and pay no dividends inside an IRA account and $50,000 in bonds yielding 6% in a taxable account. What is your asset allocation? How might you establish a 50:50 stock to bond allocation?

Asset allocation calculations must use nominal valuation less the estimated income tax liability. If the IRA would be subject to tax at a 35% marginal rate upon liquidation and if there is little tax liability associated with the bond account, the current allocation is approximately 40% bonds and 60% stocks.

If the target allocation is to be 50% stocks, about $8,750 worth of stocks must be purchased for he taxable account.  The final portfolios would be an IRA with a nominal value of $50,000 containing all stocks and a taxable portfolio with $8,750 in stocks and $41,250 in bonds.

The real world is more complex than this simple example. You will have to reach for your calculator and talk to your adviser if you are to draw conclusions appropriate to your personal situation. You will also need to consider custodial and other fees that might increase the cost of owning assets in pension or annuity accounts and the impact of taxes and transaction costs if you were to change to a more tax efficient portfolio.

The point is that there can be income tax benefits from coordinated management of pension and taxable portfolios, with each investment held in the way that is most tax efficient for the portfolio as a whole.

Suppose That There is a Trust. Assume that, in addition to a taxable and tax deferred account, there is also a trust. Perhaps the client is a widow with assets of her own and an IRA and a by-pass or credit shelter trust from her husband's estate.

The new consideration is that the income tax rates for trusts are generally higher than the rates for individuals. Therefore, it is income tax efficient if the trust distributes all dividends and interest to the surviving spouse so that the income appears on her tax return and not the return filed by the trust. But, since capital gains rates are the same for individuals and for trusts, there is no income tax incentive for the trust to distribute its capital gains.

Two examples will illustrate how the situation of the surviving spouse should affect investment decisions within the trust.

Again, there are income tax advantages from coordinated management.

What About Estate Tax. Another consideration is that the surviving spouse does not have unfettered rights to the money in the by-pass trust. As usually written, the trust assets are available to her if she he needs the money but any money she does not need passes to someone else upon her death.

The interests of the surviving spouse and of the remainder beneficiaries are opposed in a by-pass trust. These opposed interests require the surviving spouse to draw upon other assets before drawing upon the trust.

The rights of the remainder beneficiaries require the trustee to grow the trust if this can be done without jeopardizing the income needs of the surviving spouse. The trust investment strategy depends, therefore, on whether the surviving spouse in likely to need the trust assets.

If the trustee were to invest without considering how the other assets of the surviving spouse are invested, he would probably choose a mixture of stocks and bonds and the surviving spouse would probably receive interest and dividends from the trust. This is not attractive if the surviving spouse does not need the trust income because the assets in the trust are not subject to estate tax at the death of the surviving spouse. Why should she gets a check every month that she does not need and on which she must pay income tax? Why, when she dies, should her heirs have to pay estate tax on the unneeded income transferred from the by-pass trust?

So, What is the Problem? Obstacles to managing assets in a coordinated fashion include

In addition, your trust and other legal documents may not support – and might even impede – coordinating the investment strategies of your personal and trust assets. Many trust documents require that the "income" be paid to the surviving spouse and that the "principal" be retained within the trust. The Revised Uniform Principal and Income Act, or something similar in each state, codifies dividends as "income" and capital gains as "principal." Consequently, a trustee may be reluctant to overweight the trust assets in growth stocks because this would require him to dip into "principal" to meet the needs of the surviving spouse.

I suspect that many trusts are invested with yield being a substantial portion of the total return in the mistaken belief that this is the trustee's fiduciary duty towards the surviving spouse.

You need to remind your trustee, when defining his responsibilities in the trust documents, and your attorney in fact that managing the trust in coordination with those who manage your other assets has the potential to enhance the remaindermen's position without increased risk to the surviving spouse.

An Investment Policy Statement should be part of your living trust and power of attorney documents. This statement allows your trustee and attorney in fact to understand that you want them to coordinate their investment strategies for your benefit and for the benefit of your surviving spouse and heirs.

Your investment policy statement might also include



  1. The Internal Revenue Code distinguishes between capital assets (for example, tangible property, like personal residences, held for personal use and investment property like stocks) and 1231 property (real estate and depreciable property used in a business.) Gains on capital assets are reported on Schedule D and are taxed at a maximum of 20% if held for more than one year.

    Gains on the sale of 1231 property are reported on Form 4797 and are taxed at capital gains rates under some circumstances.

    Losses are treated differently from gains. For example, there is no deduction if you sell your personal residence at a loss. However, a loss on 1231 property can be offset against ordinary or capital gains income. Investment losses can be fully offset against capital gains but offset to only a limited extent against other income. Losses on small company stock is treated differently still.

    Both capital assets and 1231 property receive a stepped up valuation at death under most circumstances.
  2. Pensions, and especially annuities, may impose significant additional charges that would have to be figured into a quantitative analysis. These accounts may also impose restrictions on your access to your money.
  3. For example, a stock index fund or a security based on a stock index.

This is not a complete discussion of the issues nor is it a full recitation of state and federal tax laws and regulations. Always review your personal circumstances with a competent adviser before making any investment decision and seek the advice of your attorney before changing your legal documents.

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