If you suddenly inherited $500,000, what would you do with it? A lot of people very quickly reply, “Pay off the house!” However, in many cases, that instinct to shed yourself of mortgage debt is the same instinct that will dismantle the potential generational wealth that provided the inheritance in the first place.
If you bought your house more than a few years ago and your credit score paints you as a responsible borrower, it’s likely your interest rate is somewhere in the neighborhood of 2.5% to 3.5%. Using that half-million-dollar inheritance to get rid of your mortgage would save you from paying that interest, but at what cost?
The average long-term stock market return is 10%. If, instead of discharging your mortgage, you were to supercharge your investment accounts, the gains could far exceed what you’d save in mortgage interest. Those gains would further the generational wealth passed down from your relative. You have a better chance of growing that $500,000 to $1 million through prudent investing than you have of your house increasing its value by 100%.
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Then, you need to consider the next generation. If you have more than one child, that paid-off house is likely to be sold, dividing the money. Each child will then get a fraction of the home’s value, which can be viewed as a dilution of the estate’s value. If each generation makes similar decisions regarding their inheritances, it’s easy to see how the original estate’s value will be significantly watered down by the time your grandchildren inherit from their parents.
Scenarios like this are why 90% of inheritances are completely gone by the third generation: People inherit money, then spend it without having a carefully considered plan for doing so. Frequently, that plan needs to start with you, lest your heirs make imprudent decisions that reduce the impact of the estate you worked your entire life to build.
Estate planning: Not just for the mega-rich
A common misconception of generational wealth is that it’s purely the domain of the fantastically rich. There’s plenty of anecdotal evidence to suggest this is true: After all, we still regularly see the impacts of the immense generational wealth enjoyed by descendants of Rockefeller, Carnegie and Vanderbilt.
While it’s true that being a multibillionaire makes it easier for your wealth to enhance many generations of your heirs, it isn’t true that such an immense fortune is a requirement for true generational wealth. With proper estate planning, even a modest single-digit millionaire can provide for their family for many generations to come.
Foundations are key
Successful generational wealth is built on a foundation of careful planning. If you’re placing the first brick in that foundation, that means it’s up to you to set the rules and parameters for your inheritance.
Simply willing all of your assets to your children will put that inheritance on a shaky foundation. Your heirs can now do anything they choose with the assets, leaving you to hope they make wise decisions that build upon the inheritance you’ve left them. However, as we’ve seen, that simply doesn’t happen in the majority of cases.
Instead, making sure your assets are available to your heirs in a more structured manner, designed to erect barriers to unwise financial decisions and prevent wasteful family fighting and excess taxation, will give your generational wealth foundation a much better chance of helping your heirs thrive.
Put your trust in a trust
Much like generational wealth itself, trusts are often seen as having been designed only for the extremely wealthy. In reality, they’re an excellent option for almost anyone with an estate to pass on. Trusts provide several tools to help you accomplish your generational goals.
Wills are frequently subject to challenges from family members who feel they should get a larger share of the estate. These challenges involve hiring attorneys, potentially draining thousands of dollars out of the estate. Trusts, on the other hand, are much less vulnerable to challenge.
Even if your will isn’t challenged, it will likely go through the probate process, which also involves hiring lawyers. Because trusts assign their assets to a beneficiary while you’re still alive, in most cases they don’t have to go through probate, meaning more of the money in the estate will benefit your heirs.
Yet another benefit of using a trust is that you can set the rules by which money is distributed from it. Once distributed, a willed inheritance is entirely under the control of the heir. With a trust, you can restrict unfettered access to the assets, helping ensure they aren’t squandered.
One particularly effective trust technique is to tie withdrawals to salaries — withdrawals from the trust are permitted only up to the heir’s income. This helps keep the trust healthy by not distributing assets too quickly, while also giving your heirs the freedom to pursue careers they enjoy.
For example, teaching is a vital but not very lucrative profession. A teacher making $50,000 per year may find it difficult to get by. However, a trust supplementing those wages with an additional $50,000 per year will have a significant impact on the teacher’s standard of living.
Don’t neglect tax planning
It's important to plan for how taxes may impact your estate when leaving a legacy for the next generation. If done properly, your heirs can inherit tax-free or at least pay less in taxes than they otherwise would.
When the Tax Cuts and Jobs Act expires at the end of 2025, federal estate tax limits will revert to around $7 million (adjusted for inflation) per individual, with anything above that dollar amount subject to a 40% tax. This led to a sobering conversation with a client, who set a goal to double their money before they die in order to provide a healthier inheritance for their heirs. I explained that without tax planning, they’d have to triple their assets in order to double them for their heirs because much of the estate would be slashed by 40%.
To add to the pain, tax-deferred accounts are subject to taxes upon withdrawal, meaning you’re adding to your heirs’ tax bill simply by leaving them retirement accounts in your estate.
Instead, we’ve begun a process of converting that client’s tax-deferred retirement accounts to Roth equivalents. This won’t save them any money, but it will allow that money to pass on to their heirs without being subject to taxation upon withdrawal.
As a generational wealth-building tool, significantly reducing taxation is hard to beat. Most people who inherit considerable estates are resigned to the idea they’ll have to write a check to the IRS. An estate planner’s job is to help them put that checkbook away.
This is why financial advisers do what we do: Someone who works their entire lives to build an estate for their heirs should be confident their estate will benefit the people they care about for generations to come. With proper planning, that’s an eminently achievable goal.
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