We don’t like to think of our own death, but given its inevitability, sooner of later, we need to be ready to pass along our worldly goods to others. Having a good estate plan is key. One of the smartest advisors in this area is Elizabeth P. Anderson, CFA, the founder of Beekman Wealth Advisory, a boutique financial consultancy in New York. Here is the first of three parts of her advice on this crucial subject:
The decisions you make now about where your assets go after your death can affect people’s lives profoundly. This three-part article walks you through some of the basic issues involved with estate planning. This initial part is figuring out how much your estate is worth.
Most people avoid thinking about, let alone planning for, their death. And yet making arrangements can be a liberating experience. Relieving your families of the burden of having to do it for you is also a demonstration of consideration, kindness and love.
Estate-planning advice often revolves around the choice and creation of legal structures and documents, such as wills and trusts. Indeed, these are critical tasks and you should consult a knowledgeable trusts and estates attorney to get them done right. However, before determining which structures to use for your estate-planning goals, you first need to figure out exactly what those goals are.
The most basic estate-planning issues to address are 1) how much you can give, 2) who gets your assets and 3) when, either during your lifetime or after your death. These three issues are interactive. A change in one can affect the others and the outcome of the estate-planning process.
A few words of caution (and encouragement) before beginning: Estate planning is a complicated and highly personal endeavor, with many moving parts. It’s usually best to proceed methodically, breaking down the project into manageable steps and then completing one at a time.
First, how much can you give away? Figuring this number out requires a few steps and a little math.
1. Net worth = assets – liabilities
How much you have is your net worth — the total value of what you own, minus the total amount you owe to creditors. To determine your net worth, the first thing to do is to gather the most recent records of what you own and what you owe.
On the asset side (what you own), these records include bank statements, investment statements (such as from mutual fund accounts and retirement plans), trust assets and business interests. Appraisals of personal property if appropriate and estimates of the value of other tangible property, such as real estate, should also be included. On the liability side (what you owe), the relevant documents include credit card statement, mortgage statements, tax bills, student loan statements, business loan documentation, and any other evidence of indebtedness.
Once you have the documents collected, you create an organized listing of assets and liabilities. Your net worth is the amount by which your assets exceed your liabilities.
There are many net worth calculation tools available online for free. For example, Rutgers University provides a relatively complete and well-designed worksheet. Some calculators do the math for you.
One nuance to be aware of in calculating your net worth is contingent assets and liabilities. They are assets and liabilities that don’t yet exist, but likely will, given the passage of time or a specified event occurring. For example, life insurance is the most important contingent asset for most people planning their estates. The death benefit does not yet exist, obviously, when you calculate your own net worth, but you should include it when thinking about how much to leave.
2. Portfolio spending = total spending – earned income
Once you have your net worth calculated, and you know how much of a portfolio you have, the next step is to figure out how much of a portfolio you need to support your life. The first step in this calculation is to determine how much you spend.
This is another place an online tool works well. Many spending calculators are available with a simple Internet search. You enter your monthly or annual spending by category (housing, food, clothing, insurance, entertainment), and the calculator totals it up for you. Be sure to include an estimate for foreseeable, but lumpy, amounts, such as for home maintenance needs (new furnaces, new roofs).
Now that you have your total spending, the next step is to figure out how much of that spending needs to be funded by your portfolio. First, you add up all income, including wages, salaries, pension, Social Security benefits and alimony. Then, subtract your income from spending. This is the amount that you need to pull from your portfolio, or portfolio spending.
3. Required base = portfolio spending / sustainable spending rate
Next, calculate the size of the portfolio you need to support your spending. We call this your required base. You divide the portfolio spending amount by the sustainable spending rate.
The sustainable spending rate is the percentage of a portfolio that you can withdraw each year without diminishing the portfolio value. It is total investment return minus inflation and taxes. Most practitioners use a rate of 4% as a general guide, but this can vary from person to person.
Thus, if 4% is the sustainable target spending rate, and your spending needs from your portfolio are $100,000 per year, you need a portfolio of at least $2.5 million. If you spend more than 4%, or your starting portfolio is less $2.5 million, you diminish the value of your portfolio over time.
Armed with all of these numbers, you can now approximate the amount of your portfolio that you can give away during your lifetime without impairing the quality of your own life.
4. Asset surplus = net worth – required base
If your net worth exceeds your required base, this amount is your asset surplus. If your net worth is $4 million and your required base is $2.5 million, you can gift up to $1.5 million during your life. On the other hand, if you don’t have an asset surplus, you may not want to give away your assets while you are alive.
5. Income surplus = earned income – spending
Even if you don’t have an asset surplus, you may still have an income surplus. If your annual spending needs total $100,000, and your annual after-tax income is $125,000, you can give away up to $25,000 per year without disrupting your lifestyle.
If so, note that the government sets an amount one can give as a gift each year without incurring gift taxes. The Internal Revenue Service calls it the annual exclusion amount. This now is $14,000 per recipient in 2014. Consult your tax advisor or trusts and estates attorney about annual gifts exceeding this amount.
