In part one in this series, we discussed building wealth with the goal of creating financial security. Now for those already on the path to financial security, we turn our focus to the next generation, or generations, and ways you can help set them up for ongoing financial success and fewer financial obstacles, thus opening the door to building what we call generational wealth.
Generational wealth can create myriad opportunities for your descendants, enhancing their educational prospects, improving their earning potential, and increasing their chances for financial stability. The value of generational wealth can extend beyond monetary aspects, including imparting enduring family values and wisdom.
Building generational wealth involves setting a strong example for your descendants and enabling them to enjoy a financially secure lifestyle. Imperative to achieving financial success—we continue to stress—are planning, remaining focused, and making intentional decisions.
Education Funding
One way to help a next generation is to lessen or eliminate the financial burden of college costs. I recently posted an article detailing not only the high cost of college education, but the lack of options for students to get their hands on those dollars (https://hbkswealth.com/insights/saving-for-future-college-costs/). Many students are graduating with mortgage-size payments for their education, which becomes an obstacle to getting started saving for their financial future as well as accommodating their current financial needs. Some vehicles for mitigating huge post-college debt include:
529 Plans
- While contributions to a 529 plan are in after-tax dollars, taxes on the growth of the funds are deferred and are accessed tax-free if used for qualified education expenses. An investment of $500 per month for 18 years ($108K in total contributions) grows to $215,370 assuming a 7 percent annualized rate of return; that’s approximately $107,000 in growth that is not taxed if used for qualified education expenses.
- As well, 529 plans are flexible. For example, you can change beneficiaries to a fairly expansive list of family members of the original beneficiary, including leaving the assets for future generations, such as your grandchildren. Plus, a provision of SECURE Act 2.0 allows for the transfer of unused 529 funds to a Roth IRA for the beneficiary with no tax consequences. The transfer is subject to the annual contribution limits for Roth IRAs, assuming the beneficiary has earned income of at least the amount of the transfer, and a lifetime maximum, currently $35,000. These flexibilities lessen the concern of modestly overfunding your 529 plan.
- The drawbacks include the possibility that a child or grandchild does not go to a qualifying educational institution, and they want to withdraw the money for non-qualifying expenses. The earnings in that account may be subject to federal income taxes as well as a 10 percent penalty.
- However, there is a built-in protection for the parent or other individual who opens the account for the child. That person remains the account owner and retains control of the account unless and until they decide to change the account ownership.
Custodial Accounts
- If you are concerned about whether a school choice qualifies or overfunding an account due to a scholarship or choosing to attend a lower-cost school, there are alternative ways to save for education, including custodial accounts.
- One benefit of a custodial account is that the assets can be accessed for other expenses, such as car purchases, weddings, a down payment on a home, retirement savings, and so on.
- Custodial accounts do not come with the tax benefits of a 529 plan. The investment income and realized gains are taxed in the year they are realized. Additionally, you might have to file a tax return for the minor, and investment income over a certain limit could be taxable at the parent’s tax rate.
- At a point in time, the minor will be required to take over as account owner and take control of the assets. In most states that age is 21, but depending on the type of custodial account can be as young as 18. Depending on the state you live in, you might be able to stipulate that the transfer of ownership would occur as late as age 25. One consideration of opening a custodial account could be how financially responsible you believe the benefactor will be at the age they take control.
Cash Value Life Insurance
- With cash value life insurance, the premiums you pay go to build cash value and are invested for growth. As it is on the child’s life, the policy is comparatively low cost. The intent would be to fund the college education using the returns on the invested premiums first, then use a loan against the policy to address remaining cash needs.
- Not only can the growth of the cash value of the policy provide an asset for the child in the future, the child will also have long-term permanent life insurance to protect their future heirs. Additionally, if they choose not to go to college, they can use the dollars for other purchases without incurring penalties. Another benefit is that these dollars would be accessible tax-free as long as enough cash value is left in the policy to keep the policy in force.
- One consideration relative to this investment vehicle is policy ownership. The minor cannot own the policy, and if a parent is the owner it would be part of their estate if they died. Also, changing ownership will change the registration, and potentially be a taxable event. Consider using a trust as owner to avoid potential pitfalls.
- Before using the cash value of one of these policies, it is imperative to work with an insurance expert to ensure that you don’t overfund the policy causing a Modified Endowment Contract (MEC), or withdraw an amount that causes the policy to lapse. Either scenario could result in a taxable event.
Life Events or Future Wealth Building:
Once you have decided what to do relative to education funding, you might consider helping with future expenses, including reducing or eliminating the financial burden of first-time events such as a car purchase, wedding, a first-time home purchase, or to build long-term financial wealth. You likely started out having to balance your living expenses with debt payments, and saving for a car, home, retirement, and your children’s education. To help your next generation reduce those financial burdens and get a head start on building their wealth, you could use a variety of vehicles, including:
Custodial Accounts
- A custodial account, also known as a Uniform Transfer to Minors Act (UTMA) account, does not require independently drafted legal documents outside of standard account paperwork and custodial agreements. You can invest the account funds in stocks, ETFs, mutual funds, and fixed investments. If you systematically invest $100 per month for 25 years, at a 7 percent annualized return, the account would grow to approximately $81,000. If the assets continue to earn a 7 percent annualized rate of return for 40 years, that $81,000 could turn into approximately $1,212,000.
Cash Value Life Insurance
- As mentioned above, if the cash value of a cash value life insurance policy is not accessed for education costs, it can continue to grow and be available for later-in-life events. Additionally, if it continues to grow throughout the beneficiary’s working years, they could use it as a stream of retirement income, which would reduce how much they need to save for retirement. Again, the dollars grow tax-free; as long as the policy stays in force, they can access the original cost basis and the growth as a loan, both tax-free.
Roth IRA
- The greatest benefit of a Roth IRA is tax-free growth. As long as distributions start after age 59½, that growth is also tax-free when distributed. As the dollars contributed are after-tax dollars, there is no immediate tax benefit, making a Roth IRA a long-term investment vehicle. Roth IRAs are especially beneficial for individuals with a long horizon to retirement and those in a lower tax bracket. They are also a tax-efficient way to pass assets to your heirs.
- Assuming your children or grandchildren have reported earned income, they can make a contribution to a Roth IRA up to either their earnings or a maximum of $7,000 (for 2024; indexed for inflation). Parents and grandparents can give them a head start to building for their retirement by making contributions, which also must comply with those limits. Making a contribution of $7,000 per year for six years, a total of $42,000, with a 7 percent annualized return would amount to approximately $630,000 in 40 years with no additional contributions. That is approximately $588,000 they will never pay taxes on.
- Although the long-term tax benefits of a Roth IRA are attractive, you need to be aware of potential tax consequences if you access the dollars early. Distributions before age 59½ could be treated as ordinary income for tax purposes on the gains, plus incur a 10 percent penalty. There are some qualifying events that may avoid the penalty but not the income taxes.
Future Generations and Beyond
You could use these funding vehicles to pass along generational wealth not only to your children but to your grandchildren. Another vehicle would be to use a permanent life insurance policy on you or your spouse or a second-to-die policy on both of you to provide potentially larger inflows for future generations. The cash value policies mentioned above are on the life of the child and intended to fund their needs by building cash value. The death benefit of the policy on yourself could provide a financial windfall for your heirs.
When you are younger and need a large death benefit to take care of your heirs in the event of a premature passing, we typically use term insurance. However, when the purpose is to provide a permanent death benefit, we look at permanent life insurance policies with the intent of keeping them in force throughout your lifetime. There are several different types of permanent life insurance, so be sure to work with your advisor on what type of insurance best matches your intent.
There is a great deal to consider when planning for not only your future but for that of future generations. Being intentional and goal-oriented is critical for success, as are making sure you regularly review your plan and make tweaks where necessary.
We are here to help you build your legacy. For more information on the strategies outlined in this series of articles and help starting your journey to building generational wealth, contact an HBKS wealth advisor at 814-459-1116 or email me at btaylor@hbkswealth.com.
IMPORTANT DISCLOSURES
The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. If you would like investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.
Any investment involves some degree of risk, and different types of investments involve varying degrees of risk, including loss of principal. It should not be assumed that future performance of any specific investment, strategy or allocation (including those recommended by HBKS® Wealth Advisors) will be profitable or equal the corresponding indicated or intended results or performance level(s). Past performance of any security, indices, strategy or allocation may not be indicative of future results.
The historical and current information as to rules, laws, guidelines or benefits contained in this document is a summary of information obtained from or prepared by other sources. It has not been independently verified, but was obtained from sources believed to be reliable. HBKS® Wealth Advisors does not guarantee the accuracy of this information and does not assume liability for any errors in information obtained from or prepared by these other sources.
HBKS® Wealth Advisors is not a legal or accounting firm, and does not render legal, accounting or tax advice. You should contact an attorney or CPA if you wish to receive legal, accounting or tax advice.
