A Trust Fund? Oh, the Possibilities--and Pitfalls

While many of her contemporaries dread the onset of middle age, Michelle Ingram DeLong can hardly wait.

“I’m the only person I know looking forward to turning 40,” she says with a hearty laugh. That’s when DeLong, 38, will be allowed to take control of a trust fund created for her by her paternal grandmother.

When her grandmother died in 1971, the account was valued at something less than $60,000. Michelle can’t quite remember; she was only 10 years old at the time.

As an adult, DeLong has often cursed her lack of access to the trust, which has grown to about $180,000 under a bank’s management. For example, some of the money would have come in handy for helping DeLong buy, remodel and furnish her first home five years ago.

On the other hand, DeLong appreciates her late grandmother’s wisdom in requiring her to wait.

The self-employed graphic designer has a flair for fashion, likes to travel and, she admits, tends to outspend her income. When DeLong was 21, she went on a shopping spree with the $18,000 proceeds of another trust fund left her by a great-aunt. Not a penny remained after she bought a used BMW and clothes, took a trip to the Caribbean and visited a friend in Utah.

Looking at Cash Flow, Debts a First Step

Twenty years later, DeLong has a different perspective. She views her grandmother’s gift as a retirement nest egg for her and her husband, Roger DeLong, 38, a laser engineer for Schlumberger Technologies Inc. in Simi Valley.

It could also be tapped to finance the college education of their daughter, Bailey, 3. Still, DeLong is tempted to use some of the trust to satisfy immediate needs; she would like to replace her aging car and buy a bigger home.

Conflicting desires--to preserve the trust fund yet spend some of the proceeds--prompted DeLong to seek a Money Make-Over. DeLong also was interested in learning how to reduce taxes and debt.

Mark S. Pash, a certified financial planner in Encino who evaluated the DeLongs’ finances at The Times’ request, noted that, to the extent she’s in debt, Michelle already has spent some of her trust fund.

Charges on the DeLongs’ credit cards have crept up to $17,000. Accounting for $5,000 of that, Michelle said, are recent emergency repairs on her 1988 Jeep Cherokee and Roger’s 1987 Cadillac and expenses for a vacation to New York and Washington, D.C.

The DeLongs also owe $7,000 to the Small Business Administration for a disaster loan that repaired earthquake damage on their two-bedroom, two-bath Valley Village home. Pash was not overly concerned about the SBA loan; with its 3.9% annual interest rate, he regards it as cheap money.

However, reducing rates on their credit card debt would be wise, he said, either by taking out a consolidation loan through a credit union or by switching balances to cards charging lower interest rates.

“The DeLongs need to analyze their cash flow and write down everything they spend” to identify expenditures that are unnecessary, Pash said. Although the trust fund could pay off debt, that option is two years away. In the meantime, the DeLongs should live on their current income--they grossed about $90,000 last year but netted about half that--and not increase debt further.

Besides reviewing spending habits, Pash advised the couple to save some money by reducing their tax bill. One strategy would be to take advantage of potential tax deductions in Michelle’s profitable graphic design business. A second strategy would be to increase their tax-deferred retirement savings to reduce their taxable income. Finally, how Michelle takes control of the trust will affect their tax bills.

Pash’s primary suggestion for Michelle’s business, Ingram Design Studio, is to pay Roger for his services in handling computers and intellectual property matters. Because Roger already pays close to the Social Security, or FICA, maximum tax amount on his $65,000 engineering salary, he wouldn’t have to pay additional Social Security taxes on income from Michelle’s business. This would reduce her income and her Social Security tax burden, which is twice the amount for an employee. The self-employed pay both the employer and employee portions of Social Security.

This strategy is appropriate because Roger does substantial work for the business, but has a theoretical drawback: It could reduce the retirement benefit Michelle would receive on her own account from Social Security. Yet the risk is small, because if she outlives Roger, she most probably would collect more as a widow from his Social Security account than on her own account.

Savvy Tax Strategy Could Reduce Burden

Other strategies may reduce taxes on her business. Pash and Robert C. Eddy, a certified financial planner in San Diego who also reviewed the DeLongs’ finances, said that leasing a car provides significantly larger tax deductions than car ownership for the self-employed. And if the den in which Michelle operates Ingram Design Studio is used exclusively for that business, Eddy said, she could get additional deductions by depreciating her home and/or deducting some of the home’s maintenance costs.

Since Michelle started her graphic design business in 1990, her annual net income has ranged from $25,000 to $65,000. Eddy and Pash said that in a good year, she should buy new equipment, stock up on supplies and increase retirement contributions.

She now has a simplified employee pension-individual retirement account, or SEP-IRA. If she switched to a SIMPLE-IRA, or savings incentive matched plan for employees-individual retirement account, she would be allowed to put more money into tax-deferred accounts. As the employer, Michelle could save $6,000 in a SIMPLE-IRA, compared with $2,200 in her SEP-IRA. (Generally, the SEP-IRA allows more retirement savings at higher income levels.)

Roger should also increase his retirement savings to the highest level allowed.

“It’s always advisable to maximize retirement savings, but it may not be practical,” Eddy said. “The $17,000 in credit card debt tells me the DeLongs probably can’t afford to put more in retirement. For every $1,000 they put into a retirement plan, they save $360 in taxes, but they’re out $640 for living expenses.” Thus, all the extra retirement savings may have to come from Michelle’s trust fund in 2001.

After making these tax moves, Pash thinks the couple has a good chance of dropping from the 28% to the 15% federal tax bracket. That could happen if their taxable income--what’s left after most deductions, but before most credits and not including capital gains--were $43,051 or less.

By being in a lower bracket when assets from Michelle’s trust are liquidated, they could save money on capital gains taxes, which are 20% for people in the 28% federal tax bracket and only 10% for those in the 15% bracket. (Although estate taxes were paid at the time of her grandmother’s death and the trust pays income taxes every year, any untaxed increase in value is subject to capital gains tax.)

Careful Planning Will Pay Off Later

Partly for that reason, Pash and Eddy said the most important tax move would be to control the timing of such capital gains taxes by arranging for Michelle to receive the assets without the bank trustee selling them first, called receiving “assets in kind.”

Michelle needs to start talking to the bank about this issue soon, the planners said. If the trust doesn’t require the assets be sold when the trust is liquidated, the bank should be willing to cooperate.

Pash recommended how the trust fund should be spent in two years: $17,000 would pay off credit card debt, $25,000 would be set aside in an emergency cash reserve, $50,000 would be applied to buying a bigger home and $30,000 or more would be used indirectly to enable the couple to increase tax-deferred retirement savings over the next few years. The rest--possibly $80,000 by 2001--would remain for long-term investing other than tax-deferred plans.

Eddy emphasized that all these strategies depend on not using up the trust on living expenses. “Before they touch the trust money, they should keep their credit card debt either level or decreasing,” Eddy said.

Eddy said Michelle has the advantage of being able to prepare for the trust and reinforce the lessons from her earlier experience with an inheritance. “If you get a windfall like a trust fund too soon, it influences your lifestyle. If you get it later, you have already established your lifestyle.”

*

Suzy Hagstrom is a regular contributor to The Times. To be considered for a published Money Make-Over, send your name, age, phone number, income, assets and financial goals to Money Make-Over, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053 or to money@latimes.com. You can save a step and print or download the questionnaire at https://www.latimes.com/HOME/BUSINESS/FINPLAN/make-over.htm.

Information on choosing a financial planner is available at The Times’ Web site at https://www.latimes.com/finplan. The site offers stories, phone numbers, addresses and links to related sites.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

The situation

Investor: Michelle Ingram DeLong

Challenge: How to use trust fund wisely to eliminate debt, buy a larger home and get a head start on retirement savings.

Solution: Reduce spending, defer taxes with new strategies for home businesses and maximize benefits of retirement accounts.

This Week’s Make-Over

* Investors: Michelle Ingram DeLong, 38, graphic designer; and Roger DeLong, 38, a laser engineer

* Gross annual income: About $90,000

* Goals: Manage Michelle’s trust fund wisely when she gains access to it in 2001. Reduce debt, save for retirement, buy a bigger house in 2001 and plan for daughter Bailey’s college education.

Current portfolio

* Cash and savings: About $2,000

* Real estate: About $37,000 in home equity

* Trust fund: Currently controlled by a bank, valued at about $180,000

* Retirement accounts: Michelle has a “simplified employee pension-individual retirement account” or SEP-IRA, totaling about $14,000. Roger has a 401(k) retirement savings plan with $6,000. Both are invested in stock and bond funds.

* Debts: Mortgage of $193,000, disaster repair loan of $7,000, credit card debts of $17,000.

Recommendations

* Reduce debt.

* Review tax-reduction and tax-deferral strategies for Michelle’s business and retirement accounts.

* When trust funds are released, eliminate debt, make down payment on a bigger house, maximize all retirement saving, create a cash reserve and invest the rest.

* Increase life insurance coverage to $250,000 for Michelle and $750,000 for Roger. Get rid of accidental death policies and buy umbrella liability coverage instead. Boost disability coverage.

* Draft a will.

Meet the Experts

Mark S. Pash is a certified financial planner in Encino and co-owner of Pash & Benson International. He handles clients on both a fee-only and commission basis.

Robert C. Eddy is a certified financial planner and enrolled tax agent in San Diego. He serves clients on a fee-only basis. His practice is called Creative Capital Management.