Baby Boomers Need to Adopt “Open-Book Estate Planning”
High net worth elderly households need to proactively disclose their estate plans to their heirs.
An unprecedented number of Baby Boomer elderly folks have a lot of wealth that will positively impact their heirs’ financial lives - but they hate talking to their heirs about it.
This is a big problem and needs to change.
Important: The following is for educational purposes only and does not constitute legal, tax or investment advice. Quiet Wealth does not provide legal advice or tax advice. Do not implement any estate plans without first consulting an estate attorney. Please consult a tax advisor before implementing any strategy to reduce taxes as part of your estate.
I work primarily with mid-career and pre-retirement professional households. When working with these clients, one of the questions I always ask is:
"Do you expect to receive a meaningful inheritance from your parents?"
About 50% of the time, I get the following answer: "No, my parents probably won't have much of an estate besides the house."
And about 50% of the time, I get the following answer: "I'm pretty sure that my parents have a lot of money and that I'm going to get a good inheritance, but I have no idea how much money they have or what my inheritance will be."
And about 0% of the time, I get the following answer: "Yes, I have a good idea what my parents' financial situation is, what their estate plans are, and around how much I should expect to receive."
This is bad - elderly parents and children should be talking to each other about this topicfor a number of reasons. This blog post talks about why this failure to communicate is bad and why wealthy Baby Boomers need to…ahem…evolve their thinking when it comes to how open they are with their heirs about their estate plans.
But first, some background…
The Most Impactful Inter-Generational Transfer of Wealth Ever Is About to Happen
We are about to enter an era of wealth transfer that has been decades in the making. While inheritance has happened for millennia, what is about to happen in the United States will be more impactful for this generation than any other in the history of humanity (a bold claim, but I think it’s correct) for a few reasons:
1) The introduction of birth control and more women in the workforce in the 1960s meant fewer children for Baby Boomer families than for families in previous generations.
In 1960, the average fertility rate was 3.7 births per woman. By 1973, the fertility rate had declined to 1.8 births per women. This is important because with fewer children the inheritance gets split fewer ways, and therefore the inheritance is more financially meaningful to each child than it would have been to previous generations.
2) The Baby Boomer professional class was the last generation to graduate from college largely without significant student loan debt.
Without a ton of debt weighing them down after graduating school, Baby Boomers could focus on saving and buying a home soon after graduating. And as long as they kept their job early in their career, the financial market downturn in 1970s didn’t really hurt their wealth because they didn’t have much wealth at that point.
3) The introduction of 401(k) plans and other deferred compensation retirement plans in the 1980s led to much greater retirement savings for those that did save.
Prior to the 1980s, people generally funded their retirement lifestyle through Social Security and pensions, and this system worked in large part because life expectancy was much lower (especially due to higher tobacco use). In the 1980s, Congress recognized that actuarial trends were changing and created new retirement savings programs to encourage employees to save and invest their own money rather than relying exclusively on safe but low-return traditional retirement programs. This created a pool of investable savings for a much larger number of workers that hadn’t previously existed for the most part. And a large portion of this new savings was invested in stocks.
4) Baby Boomers also benefited from a significant increase in profit margins among US companies.
Whether you look at operating margins or margins as percentage of gross value add (as in the chart below), there is pretty clear evidence that corporate profit margins are much stronger than they were 30-40 years ago.
5) Middle-to-upper class Baby Boomers benefited from a number of valuable new tax breaks and significant government deficit spending during their working years.
Tax breaks such as lower capital gains tax rates and the capital gains exclusion on home sales provided meaningful value. In addition, net deficits of approximately of 85% of GDP provided additional economic benefits / reduced taxes that previous generations did not benefit from.
6) Baby Boomers benefited from a 40-year bull market in bonds and a significant decline in interest rates over their working years.
Not only did falling interest rates significantly reduce mortgage and other debt-finance household expenses for Baby Boomers, but they also enabled excellent returns in fixed-income securities and likely also helped inflate the valuation of their stockholdings and real estate holdings.
A significant increase in margins has enabled healthy returns for stock investors over the last 40 years.
7) Finally, many Baby Boomer retirees have been extraordinarily lucky with retirement-stage "sequence of returns,” especially if they held a risky stock-heavy portfolio. Consequently, many are far wealthier than they expected to be.
In terms of creating intergenerational wealth, the most important life stage in which to get lucky with stock market returns in the first 10 years after retirement.
Many Baby Boomers who retired in the early 2010s did in fact receive this luck. During the 2010s, the S&P 500 had a compounded annualized return of 13.5% per year. Even if a retiree had invested in the a 60% stocks / 40% fixed-income portfolio during this period, they still likely would have received a return of somewhere around 7-8% per year. Given those returns, many older Americans who retired in the early 2010s, especially those who maintained their a modest lifestyle, experienced an INCREASE in their retirement savings during the 2010s despite the fact that they were no longer receiving earnings from work!
As a consequence of all of these factors, one of the common themes that I have seen from people who are in their 70s, living modestly and who retired with a decent, but not extravagant, amount of retirement savings is that they are now far wealthier than they ever expected to be.
To be clear, these trends did not help all members of the Baby Boomer generation. Lower-to-middle income Baby Boomers probably received some benefits from these trends, but most of these lower-income households probably didn't save enough during their lifetimes to fully benefit from these positive dynamics.
But these trends undoubtedly helped a huge number of upper-middle class and business-owner Baby Boomers. Most of these people likely never imagined themselves as ending up multi-millionaires. But quite often, they now have a net worth of $2 million or more, especially once home equity is included. And with the heavy early retirement spending years behind them, it is likely that many of these families will have $1,000,000+ estates, if not much more.
It's Hard to Understate the Eventual Positive Impact of These Bequests to Gen X Heirs
When you take into account both the unprecedented size of estates that many upper-middle income Baby Boomers have and the much lower number of natural heirs relative to previous generations, this will result in incredibly impactful bequests happening for millions of Gen X households in the coming years.
Here is an illustrative example: let's assume the following base case retirement planning scenario for a couple in their 50s, first assuming that they don’t get any retirement:
Jim and Joan are both age 50, and together earn $200,000 of gross household income, which grows annually with inflation. They have two children finishing up college.
They currently have $500,000 in retirement savings and are saving 10% of salary per year in retirement accounts with a 3% of salary employer match; they have no other savings currently
Their retirement savings is invested in a 70% stocks / 30% bonds portfolio and generates am assumed blended annual return on investment of 6.35%.
They own a house. They still owe $200,000 on their mortgage, which has an interest rate of 4% and 15 years left to pay down.
Their total household expenses besides the mortgage are $120,000 per year before retirement and $100,000 per year after retirement; their expenses grow annually with inflation.
When I run this basic scenario in eMoney Advisor, a financial planning analytics application, the simulation shows that without any inheritance, it is likely that the couple could retire at age 65 with about $1.5 million of savings, almost all of it in retirement funds. At their passing at age 90, they leave their kids an estate of around $1.3 million, almost all in pre-tax retirement funds..
Now let's assume that Jim's parents pass away when the Barretts are age 55. The parents have an estate of $1.2 million, of which 50% is in cash and real estate and 50% is in pre-tax retirement funds. The estate is split evenly between Jim and his sister. Therefore, the Barretts receive $300,000 of cash and a $300,000 Inherited IRA.
These additional financial resources provide the Barretts two alternative retirement choices:
Instead of retiring at age 65, the Barretts can now retire at age 61 or 62 with pretty much the same long-term financial retirement outcome as before, OR
They can still work until age 65 but end up with an estate of close to $5,000,000, which they can give to their kids.
Obviously, the Barretts could also choose other alternative uses of the money, such as spending more in retirement or paying off their grandkids' student loans. The point is that the inheritance opens up a range of new possibilities that are tremendously impactful both for the Barretts and their children.
What Happens When Family Members Don't Talk About Estate Planning
Here's the problem in practice: the Baby Boomers aren’t talking to their kids, and so couples like the Barretts can’t really plan for an inheritance.
In most situations I’m seeing, the adult children have absolutely no idea how wealthy their parents are. It is a scenario I'm seeing over and over again with my late-career clients.
Just as an example, I recently asked a 50-something client how large she thought her 85-year old parents' eventual estate would be, and she said, "Probably somewhere between $1 million and $4 million. Within that range, I have no idea." This client had one sibling, and so each of them would probably get between $500,000 and $2 million.
That’s a big difference between the low end and the high end of the range! A financial plan for a late-career household is completely different if the family expects a $2 million inheritance vs. $500,000 inheritance.
But right now, clients such as this one can't make life plans because they have no idea how much money they should expect to receive.
Cross-Generational Tax Planning Isn’t Just for the Uber-Wealthy Anymore
One of the reasons why elderly parents with estate values is they don’t see any value in doing so. In particular, it’s common for elderly folks in the $1 million-$5 million net worth range to think that their situation doesn’t require any kind of complicated tax planning because they’re well below the estate tax threshold. (And many estate attorneys also adopt this philosophy.)
But this isn’t usually true.
There are lots of important tax considerations for elderly families in this net worth range for whom cross-generation tax planning could be valuable.
As an example, assume the following relatively straightforward situation:
Angela and Frank are in their 80s. They have $1 million in their retirement accounts, $500,000 million in their taxable brokerage accounts and a $500,000 house, for a total estate of $2 million.
They have two daughters, Betsy and Mary.
Betsy is a partner in a law firm and her husband is a business executive. Angela and Frank know that Betsy and her husband earn a lot of money.
Mary is a public-school teacher and is unmarried.
Angela and Frank's estate plans are to split all the assets 50/50 between the two children.
This is almost certainly a tax-inefficient estate plan. Because Betsy and her husband are likely in a high tax bracket, the retirement account assets are less valuable to Betsy and her husband than they are to Mary, who is likely in a lower tax bracket. Consequently, Mary should be the beneficiary of all of the retirement accounts. If, for instance, Mary's marginal tax rate is 24% and Betsy's marginal tax rate is 35%, the shift from a 50/50 split of the retirement accounts to 100% to Mary would save Angela and Frank's daughters, in aggregate, tens of thousands of dollars in taxes.
But the complexities don't stop there. If Angela and Frank give need to create a mechanism in their estate plans such that Mary gets compensated for taking on all of the pre-tax retirement assets - keep in mind that $1,000,000 in pre-tax retirement accounts is not the same as $1,000,000 of assets from the estate, which are typically stepped up in basis and therefore don’t have any attached future tax liability for the heir. Therefore, to keep the after-tax amounts equal, Mary also needs to receive a small amount of the remaining assets that are stepped up in basis.
Another great cross-generation tax planning opportunity is pro-active gifting.
This is especially true if gifting would enable the gift recipients to max out their retirement contributions, thereby reducing their current income tax liabilities, or stuff money into Roth 401(k)s or Roth IRAs.
These illustrate a couple of many scenarios where it is super valuable for Baby Boomers to disclose their financial situation and understand their children's financial situation.
There’s just one problem: most Baby Boomers aren’t talking about their financial situation and estate plans with their heirs.
Baby Boomers Need to Adopt "Open Book Estate Planning"
Here’s the crux of the issue: a lot of Baby Boomers hate the idea of talking about their financial situation and their estate plans with their children. I've heard many of the usual excuses:
"I don't have the time or energy to do this."
"I have designated one child to take care of my affairs, and he/she will figure it out."
"I don't want my kids expecting this inheritance. Something bad might happen, and I might need the money." (Many people say this even when it’s clear they have plenty of money.)
"I just don't like talking about this stuff with my children."
And the worst excuse: "I haven't reviewed my estate plans in 20 years."
If I'm being frank, these are all terrible excuses.
There are a couple of other excuses where the dynamics get tricker, like:
"I don't trust one or more child to manage their inheritance well."
"My kids don't all get along unfortunately."
"I'm not giving equal shares to my children."
These are definitely challenging situations to manage. But, again, they are all bad excuses not to have a frank discussion with your children. In fact, not having this discussion with your children prior to your death can lead to decades of animosity among your heirs, and I don't know any parent who wishes that outcome for their offspring.
So as painful as it can feel to many elderly folks, the only solution is open the kimono and tell their kids what their financial situation is really like and what their estate plans are.
Just Get Estate Planning Conversations Done
How does an elderly household have this conversation? Have a family meeting that includes your estate attorney and maybe your financial advisor in attendance.
And these days, with Zoom or Google Meet, you don't have to have this meeting in person (but it's nice if you can). Video can work very well, at least as a starting point for laying out the situation. In addition, you may want to have some pre-meeting one-on-one conversations with each of your heirs to understand their sensitivities coming into this process.
An estate attorney and financial advisor can take the lead in preparing materials that you can use as a basis for the discussion. That’s why you hire advisors: to help you strategize and prepare for important life moments just like this! And your advisors can do a lot of heavy lifting of helping you feel prepared and confident.
Finally, if you are one of those wealthy retired folks who dreads having this discussion, keep in mind that it’s likely going to be the type of situation where you’ll feel a lot better after having done it, and you will feel a significant weight off your shoulders.
And if you are a child of wealthy elderly parents who have kept their estate plans a secret, maybe send this blog post to them with a note: “Hint, hint…”?