Wealth Management Tips from Tax Mama

Eva Rosenberg, the Internet's Tax Mama, hosted an hour-long web conference yesterday on protecting assets and preserving wealth. She invited wealth management expert Roccy DeFrancesco from The Wealth Preservation Institute to present four completely legal strategies for protecting your home, business, and investments, and minimizing taxes.

You can hear the presentation for free from the Tax Mama web site, but you have to sign up for a free member to access the archives. Here's what you do.

1. Go to the Tax Mama sign-up page and register as a member. Don't worry, membership is free. Leave the payment area blank.
2. Once you are signed-in, go to the Wealth Management Workshop of the Tax Mama site to read the transcript of the seminar. Or click play in the Audio Acrobrat toolbar to hear the seminar.

For those who are interested in my executive summary of the presentation, here it is, along with links for your own personal research.

Summary of Roccy Roccy DeFrancesco wealth management web seminar:

You can protect your personal and business assets using the following four strategies:

1. Protect your business income and assets by forming Limited Liability Companies (LLC) or Family Limited Partnerships (LP) in asset-friendly states. How it works: if your company is sued and the judge rules against you, the judge will issue "charging orders" against the LLC or LP to force the company to pay the legal judgment. Charging orders put creditors at a disadvantage because the creditors will receive no cash, but will get a share of the company's profits along with a tax liability.

For more information, see

• Charging Orders for Limited Liability Companies (from legal and tax publisher CCH) and
• Charging Orders and the New Uniform Limited Partnership Act (from the American Bar Association).

My take on the discussion: Protecting your business by forming an LLC or LP is a smart move, but the charging order provision may or may not help, depending on the states where you conduct business. The big disadvantage: LLCs and LPs are governed by state law, and not all states have conformed to the model language presented in the Revised Uniform Limited Partnership Act. LLCs and LPs should be formed in the state where you conduct your business, so this strategy may have limited impact in other states. Roccy stated that Arizona, Delaware, New Mexico, and Nevada have the best state laws for protecting business assets. As with all legal strategies, you should consult an attorney.

2. Protect your investment income and assets by using equity-indexed annuities (EIA). Like index mutual funds, the annuity tracks a broad market indicator (such as the S&P 500), but with a twist. In years when the market generates gains, the annuity throws off income, but less than market rates. For example, if the S&P 500 goes up 15% for the year, the annuity might pay out 12%. But in years when the market declines, the annuity will pay out zero percent. Thus your investments perform modestly over time, without losing your principal.

For more information, see

• Equity-Indexed Annuities (from the Securities and Exchange Commission),
• Equity-Indexed Annuities: A Complex Choice (from the National Association of Securities Dealers),
• Equity Indexed Annuity (from Wikipedia), and Questions To Ask Before Buying an Equity-Indexed Annuity (from MostChoice, an insurance referral network),
• An Overview of Annuities (from the Banking Guide at About.com),
• What are Index Funds? (from the Mutual Funds Guide at About.com), and
• What’s the Buzz About Equity-Indexed Annuities? (from the Personal Insurance Guide at About.com).

My take on the discussion: Equity-Indexed Annuities (EIAs) are a hybrid between a variable annuity and an index mutual fund. According to the SEC web site, "the typical equity-indexed annuity is not registered with the SEC." That means, if you have a dispute with your insurance company, you'll have to resolve your complaint with your state insurance commissioner. Also, EIAs have high administrative fees, which can drag down the performance of the fund. All investors should take prudent steps to diversify their investments using asset allocation techniques. It could be that a savvy investor can moderate the ups and downs of the financial markets through smart planning. Investors can also seek the advice of an experienced Certified Financial Planner.

3. Protect assets with substantial appreciation using a private annuity trust. How it works: investors transfer ownership of an investment with substantial capital gains to a private annuity trust. No gain is recognized on the transfer of assets to the trust; instead the taxes are deferred until the income is paid out to the investor. The trust sells the assets without tax consequences and issues an annuity to the investor. The private annuity trust combines three important tax elements: investors recover their cost basis tax-free, capital gains on sale of the assets are spread out over the life of the annuity, and remainder of the income stream is taxed as ordinary income.

For more information, see

• WSJ: Private Annuity Trusts May Not Work (Tax Professor Paul Caron's summary of Wall Street Journal article),
• Private annuities and self-canceling installment notes (from The CPA Journal),
• Creative Strategies Help Keep Tax Burden Down,
• Private Annuity Trusts: Questions and Answers (both from the Wall Street Journal's Real Estate Journal),
• Saving Money With A Private Annuity Trust (from Investopedia), and
• Private Annuity Trust (from Wikipedia).

My take on the discussion: The private annuity trust does not minimize taxes. Instead, it is a way for investors to spread out their capital gains over a number of years. By spreading out the tax consequences, your investments continue to grow, and so it is conceivable that your investment earnings (interest, dividends, capital gains) will help pay the tax bill. There seems to be on-going concern among tax professionals whether the IRS will subject private annuity trusts to further scrutiny. On the financial side, deferring taxes might end up costing you more than paying taxes now, if capital gains tax rates go up or if your marginal income tax rate goes up. Annuities are contracts between you and an insurance company, so you should read all the fine print before investing. Anyone considering a trust should seek counsel from an attorney and a tax professional.

4. Protect your main home by using a low-interest mortgage to cash out the equity on the house, and invest the proceeds in investments that are protected from creditors (such as life insurance, annuities, LLCs, or FLPs). How it works: a homeowner takes out a low-interest mortgage against the equity in his or her main home, and invests the proceeds. This strategy is designed to do two things: keeps creditors from viewing the house as an easy target for legal judgments (because the house now has little equity due to the mortgage), and presumably the homeowner would be able to invest the cash in stocks, bonds, and mutual funds and earn some money. So, if the homeowner took out a mortgage at 6%, and invested wisely with an 8% return, the homeowner would be using his house to make money, pay off the loan, and still have more money than he started with.

For more information, see Roccy DeFrancesco's information on what he calls the "1% CFA Mortgage Program" (from the Wealth Preservation Institute). You'll also want to read this discussion from Bankrate.com: FAQ About Trading Equity for Cash.

My take on the discussion: This is the first time I've heard of this strategy, and there's little information I can dig up about it. If your primary goal is protecting your home from possible legal judgments, you should dig into the homestead and bankruptcy laws of your state - those laws are designed to protect your most valuable assets from creditors.

If your primary goal is freeing up cash to invest, you could consider refinancing your mortgage to a low, fixed-rate loan and invest the difference between your old mortgage and your new mortgage into the financial markets. (This is similar to the old saying in life insurance: buy term and invest the difference. The idea is to reduce your costs to the minimum, and use your savings to boost your investments.) The basic idea here is actually an old idea: it's called leveraged investing. Investors use leverage through a margin trading account. By using leverage, your profits will be bigger, and your losses will be bigger too. You can actually lose more money than you initially invested by using leverage.

The biggest risk in cashing out all the equity in your home: what if you lose a lot of money on your investments? What if your investment returns don't cover the interest rate you are paying on your mortgage? And what if creditors take your investments rather than your house? While Roccy's cash-out mortgage sounds like a good deal, you should consult an attorney (to talk about state laws protecting your house) and a certified financial planner (to talk about ways to boost your investments).

The Bottom Line

I thoroughly enjoyed Roccy's presentation, and I wholeheartedly thank Eva Rosenberg for making it possible. His four wealth-building, asset-protection ideas are smart, legal, and might be appropriate for high-net-worth individuals with unique financial planning needs. The devil, as always, is in the details. That means individuals should seek advice from objective, unbiased tax and legal professionals. The simplest asset-protection plan would involve good business practices, adequate insurance, smart tax planning, and prudent investment strategies that have stood the test of time. The strategies that Roccy recommends go above and beyond the basics, and are worth a look if you have unique needs.

If you have any wealth management techniques you would like to share, share your comments with About.com.