Passing Wealth to Another Generation


By John Vineyard

October 3, 2017


Although we spend a lot of time discussing strategies to insure that our long-range spending doesn't exceed our means, most people who confront this also wonder about how best to pass some of their wealth to another generation. They want to do it in a way that works for their families, for themselves, and takes account of the tax laws[1]. Parents, grandparents, and aunts and uncles all think about helping another generation deal with the quandary of college costs. In many cases, a multi-prong approach can produce a balanced result that works for a variety of possible futures.


No other major cost of living item has risen as fast as the sticker price for college. The inflation rate for college has been about three times the consumer price index for the last four decades. While we know this situation is unsustainable in the long term, and we know that the current model of college must change over the next 20 years, it's hard to imagine any future where the cost will not remain a big hurdle for most families. Here, we consider four basic ways that college expenses can be partly covered through a long-range plan to transfer wealth.


I. Grandparents gifting to parents. Gifts are subject to the $14,000/year/person limitation on the tax-free transfer of assets to another. Over the years it is possible to donate a very considerable sum to a child's parents. But there are behavioral issues that cause many people to shy away from this. The parents may have other more urgent expenses, and such a gift does not compel them to spend your gift towards a grandchild's college education. The earnings on such funds are subject to taxation at the parents' tax rate, which eats into investment returns. Would grandparents give the parents the resources needed to pay the share of taxes on such a gift? Management of the funds can be a considerable responsibility. Like all the options we discuss, this requires the services of a qualified investment advisor.


II. Gifting to the child. This is done by setting up a Uniform Transfers to Minors Act[2] (UTMA) account in the child's name. Two parents, each giving three children 14,000/year for 18 years would transfer a whopping total of $1,512,000. Under the current law, earnings above $2,000 from such an account are taxed at the parent's rate, not the child's, so this approach may also be subject to considerable tax. Under the gift to minors act the child generally has full possession of the funds at age 18, whether they are mature enough for it or not. We have known some parents who established such accounts and simply didn't tell the child that small detail, spending from the account as college expenses were incurred. Another issue is that balances in a child's UTMA account have the effect of reducing college financial eligibility by 20-25% of the UTMA balance. If the family has good communication about this type of gift, things may go well, and the 18-year-old won't squander it. However, it's difficult to look a grinning baby in the eye and foresee what sort of adolescence it will have. An 18-year-old may decide that having the account means she doesn't have to go to college and can buy a motorcycle instead. On the other hand, many kids just aren't college material, but are nevertheless responsible enough to benefit from this direct transfer.


III. Using a 529 college plan. These plans are long-term tax-advantaged vehicles specifically intended to facilitate college savings. As they've been around for a good while most people have at least a glancing familiarity with how they work. They pay college expenses, very generously defined, including tuition fees, supplies, room and board, and computers (if required by course work). A wide range of institutions and programs can count as colleges. On behalf of a beneficiary, a donor invests in one of a state's designated plans. The funds grow tax deferred until they are used for college expenses. If the withdrawals are used for qualified college expenses, they are free of federal tax. Plans vary greatly from state to state and occur in two forms: prepaid plans and savings plans. The prepaid plans are generally usable only within one state system, and so may be inappropriate given that it's hard to foresee the ideal college for a two-year old. Many states provide state income tax deductions for all or part of the contributions of the donor for contributions to that state's 529 plans. The principal grows tax-deferred, and distributions for college costs are tax exempt. There generally are no income or age restrictions as to who may be a beneficiary.


529 plan assets can be held by a parent, a grandparent, or by the prospective student. If they are held by a parent, the distributions are not counted as parental or student income. If they are owned by a grandparent, they will not be considered (as the rules stand now) as an asset when calculating financial aid. The least attractive option would be for the assets to be held by the student.

Anyone can buy assets in any state's plan, not just the state in which they live, but there may be tax implications to owning an out-of-state plan. Investment choices are limited to those offered by each state's plan. It's necessary to examine various competing plans to compare fees and investment options. Management fees can vary greatly from state to state; the accumulated difference between paying a 0.3% fee and a 1.2% fee over many years is very considerable. At intervals, established 529 plans can be rolled into other state plans. It's easy to set up automatic direct funding of 529 plans. The web site is a good resource about 529 plans.


If the student doesn't need to use all the 529 assets, the plan beneficiary can generally be changed. Most plans allow the donor to reclaim the funds any time, but with such a 'non-qualified' withdrawal, the earnings portion of the balance is subject to income tax plus a 10% penalty. There is also the possible recapture of state tax deductions or credits if the plan assets are not used for college expenses.


Although the donor retains significant control of a plan's assets, they are not included as part of the donor's estate for tax purposes, so the plans can also serve as an estate planning tool.


IV. Paying college bills directly. This underutilized approach has various attractions. Grandparents' resources generally are not considered in financial aid applications, so a mere intent to provide support does not reduce the child's eligibility for financial aid. The big attraction is that grandparents can pay college bills directly in any amount without incurring gift tax or reducing their basic estate tax exclusion. One advantage of this approach is that the grandparent has some time to watch and  see if the beneficiary will make good use of the funds. Not only does the plan to pay some college bills directly not impact financial aid eligibility, but it doesn't trigger the $14,000 gift tax limitation.


Contributing to a grandchild's college expenses is a very attractive option for the intergenerational transfer of wealth. As a targeted act, it avoids some of the risks involved in substantial direct gifts to young persons. 529 plans are deliberately structured by the taxing authorities to encourage college savings. They can also have the added attraction of limiting the taxes on wealth transfers, and helping to reduce a taxable estate.


My advice is to study all options listed above, and perhaps also a few others that may be unique to your own situation. We like the idea of a mixed strategy combining several of these options. There is also a behavioral advantage in a child's growing up knowing that he/she will be responsible for coming up with a good share of the cost of their own higher education.


It's good for a child to see that some funds have been set aside targeted directly towards their higher education. Giving for college may also be a good way to accomplish an intergenerational transfer of wealth.  It's good for you to be able to see the benefits of giving up close. There is also an attraction to the child's growing up with his own savings plan. Direct gifts to start such a plan can have a valuable teaching role. The combination of these things can help build a foundation for financial literacy throughout life. Lastly, bear in mind that the most valuable things in life are experiences, not things. College is an experience, not a thing.


Passing wealth to future generations is a huge topic. The funding of college expenses is only a tiny piece of it. We will address other aspects of the process in further letters.


[1] Most families don't have a Federal estate tax problem. The basic estate tax exclusion is $5.43 million per person, and various planning tools make it possible to lower the likelihood of owing federal estate tax even further. Spouses may give each other unlimited gifts without incurring gift taxes. Individuals may also give up to $14,000 per year to an unlimited number of recipients without incurring gift taxes. If you give over $14,000 to one person in one year it means that you are using up some of the $5.43 million exclusion. (State estate tax rules vary widely and require separate study depending on where you live. New York's estate tax 'cliff' is a special, tricky case.) Wealthy families have special behavioral factors to weigh as well as financial ones. See, for example, "Navigating the Dark Side of Wealth:  A Life Guide for Inheritors and Beyond," by Thayer Willis. All tax questions need to be referred to a professional tax expert; all legal arrangements such as Trusts and Wills need to be handled by a professional who is well qualified in providing those services.

[2] Sometimes referred to as Uniform Gift to Minors Act. In most states the age of majority is 18, though in some it is 21.






On Not Being an Expert


John H. Vineyard 

June 15, 2017


Most of the time, it's easy to find punditry warning us that we are on the brink of a major stock market break. It's also easy to find punditry saying that our opportunities look very good just now.[1] After all, the level of market prices at any time represents the current battle line in the struggle between these two views. As at most times, we can find evidence to support whatever view we want to take.


It's good to remember that the record of punditry in foreseeing the major market moves has never been impressive. There were few who predicted the severity of the 1929 market crash. In that year, the famous economist Irving Fisher declared that stocks had reached a new, permanently higher plateau. In 1954, the famous market guru Benjamin Graham was asked in Congressional hearings whether stock prices were too high, now that they had at last decisively exceeded the levels before the Great Depression. Graham, said no, the market wasn't too high, but if it went higher it would be. These words were spoken by one of the most revered of all investment experts just at the beginning of the tremendous 1954-1969 bull market. Much as we might think, in hindsight, that it was there, we can't find much evidence that the 2001 market break was accurately foreseen, nor was the magnitude of the 2007-9 drop. Most analysts have been surprised by the length and magnitude of the bull market recovery since 2009. What's a careful investor who doesn't have ready access to the financial chatter to do?


As you ponder how to position your own portfolio, it's helpful to review the experience of recent decades. Since the 1990s there have been three major bull markets, the first ending with the market break in 2001, the second lasting from 2003 until the next peak in October 2007. After plunging a for third time in 2007-2009, markets recovered and are now in the 8th year of the current bull market.


What kind of a break might you expect if we encountered another decline like the last two?


From the peak in January 2001 to the next trough in February 2003, stocks fell 36% over 25 months. The second big decline lasted from October 2007 until February 2009, with the Standard & Poors 500 Index losing 51% over 16 months.


How long has it taken prices to recover from these major breaks and get back where they were before? Recovery from the first break took from the bottom in February 2003 until November 2005, or 33 months. Recovery from the 2007 break took from the February 2009 bottom until March 2012, or 37 months.[2] In both cases, the recovery took longer than the decline. The 2003-2005 recovery was 30% longer than the 2001-2003 decline; the 2009-2012 recovery took about 130% longer that the 2007-2009 decline.


How does this help us position ourselves if we still see ourselves as long-term investors? First, we need to consider the long term to be at least 5 years. You needed that much time to recover from the break and gain enough on your investment to justify all the drama and stress. For some with limited resources, a minimum of a 10-year horizon might be more suitable.


To soften this stark reality, it's good to remember that most people are diversified investors, so that with reasonable allocations to cash and fixed income, their actual investing experience would have been less extreme than the swings in the S&P 500 alone. The 51% decline in stocks from October 2007 through February 2009 would have been more like 27% for accounts that had 40% in fixed income. On the other hand, the 40% bond allocation would have resulted in roughly a 190% gain since the low in 2009, compared to a 290% gain for a pure stock portfolio.


But you could have done worse than hold the pure stock portfolio. If you had hung in there while the market began falling, then finally given up and sold out near the bottom, only to get back into the market some years later, you might have 'earned' most of the decline but missed a good chunk of the recovery.

How do we deal with the natural human reaction to the pain of sudden loss? For most people, this means positioning themselves so that the extreme swings don't knock them out, causing them to make the worst decision at the worst time. They have to recognize that recent history shows they might encounter a 36% loss for their stocks over 2 years, or even a 50% loss over 16 months. Time really drags when the value of your portfolio just keeps sagging. Such declines are sobering experiences even for the most seasoned investors.


It seems appropriate to proceed on the assumption that you can't guess the timing or the magnitude or the direction of the next big market move. But you can be positioned so that when it comes you can take it in stride. Short term investors are a special case. But most people need their accounts to last longer than five or even ten years.


For younger investors, the horizon is usually measured in decades. For investors in the accumulation phase of their lives, market breaks are great opportunities.

My suggestion would be to be positioned so that you could endure a 39% drop, or even a 50% decline in stocks, and then be able to wait at least three years from the bottom to see values get back where they were. Any spending rule you have for your accounts needs to take this reality into account.


This advice is only based on actual market behavior during our lifetimes, not crystal ball gazing. Still, the wide range of events that have buffeted the markets over 30 years covers a lot of experience. It's a pretty good sample.


The rewards of being able to ride out the scary times and focus on the long term can be gratifying indeed.

[1] Just a recent sampling: "One in Five Investors See Internet Stocks as Bubble-Like," John Dietrich, The Wall Street Journal, June 14, 2017; "Bill Gross Warns all Financial Markets 'Increasingly at Risk,' John Gittelsohn June 13, 2017; "Don't Fear Today's Stock Market:  It's no Late 90s 'Bubble.' Gary Smith,, June 14, 2017; "This Rally has Legs, and Broad Reach, Too," Ben Eisen, The Wall Street Journal, June 6, 2017; "Preparing Clients for the Coming Market Correction, Investment News, June 12, 2017. To be fair, there are some sage accounts recognizing the sharp diversity of opinions. See "A Tale of Two Markets:  Politics and Investing!" by Aswath Damodaran, Seeking Alpha, June 7, 2017. The author makes the point that although stock prices appear high they don't appear high relative to the alternatives. Nor does he extend himself to the point of actually declaring whether we are approaching a bear market or a big economic boom.
[2] This leaves out the effect of dividends. If you take dividends into account then the length of the recovery period is somewhat shorter.