18 Jan How to Grow and Maintain Generational Wealth
by Kevin Woods
As its name implies, generational wealth is the passing down of assets from one generation to the next. Assets can include a business, real estate, securities, even intellectual property. Anything that has a financial value associated with it and that can have its ownership transferred to another individual can constitute generational wealth.
While this generational wealth transfer can provide a tremendous advantage to heirs, it is not an easy task to carry out, and once transfer occurs, wealth preservation is not guaranteed. In fact, research shows approximately 70% of families lose their capital in the second generation and 90% lose it in the third, according to Money.com.
This often comes as a surprise to wealthy families. However, several factors usually come into play:
- Not working in the family business. The family business may have served as the primary engine of wealth creation for the current or previous generation. Heirs who are not involved in the business cede control to outsiders who may not have the family’s best interests in mind.
- Increases in spending. Heirs are often unaware of the costs of real estate and other large purchases, and spending can easily spiral out of control. Indeed, the spending (and saving) habits of the previous generation may have been a substantial factor in the accumulation of wealth, and subsequent generations most likely possess different views.
- Changes to tax laws. While there are certain laws in place that allow for the legal transfer of ownership of assets to another individual, fluctuations in tax laws, especially over a long period of time, can wreak havoc on a portfolio or any profit from the sale of an asset.
While you cannot control certain actions in the future, especially with respect to business competitors or the price of real estate, there are certain fundamentals that you can control. Let’s have a look at a few ways to build generational wealth, in addition to a few ways you can protect it legally.
How to Build Generational Wealth
It goes without saying that Individuals who wish to transfer their wealth to heirs need to build or acquire assets and invest wisely in their lifetimes. This is generally over the long term, as money often grows slowly. However, with the right plans in place, heirs can enjoy the fruits of your labor and wise decision-making.
Investing in stocks for the long term is one of the most generally accepted strategies for building wealth.
Over shorter time frames, stock market returns can be volatile, but the Standard & Poor’s 500 Index has experienced losses in only 10 of the 45 years spanning 1975 to 2019, according to Investopedia, demonstrating that over the long term, stocks can deliver attractive returns to a portfolio. Individuals make money from stocks generally in two ways: capital appreciation (selling high after buying low) or income from dividends. Obviously, the latter is much more passive, as dividends are sent to your brokerage account and you can decide to take the dividends or simply re-invest them.
However, in general, most investors opt for capital appreciation and hope that their investment portfolio grows in value during earlier phases of a wealth building strategy. Stocks have outperformed almost all other asset classes over most 20-year periods. From 1928 to 2016, the S&P 500 returned an average of 9.5% per year. As a comparison, three-month Treasury bills return 3.5% and 10-year Treasury notes return 5%.
How to Maintain and Pass Down Generational Wealth
Building wealth is one thing; maintaining it and passing it on to heirs is an entirely separate challenge.
Generational wealth planning includes the preparation for a successful and profitable transfer of assets to beneficiaries. The following need to be considered, the sooner the better, to avoid having to make last-minute decisions based on unexpected emergencies (i.e., illness or death).
Create an Estate Plan
An estate plan is a group of documents that essentially protect your assets and your loved ones in your absence. The estate plan includes an inventory of your assets and personal property and includes instructions as to how you wish to pass them down. Some of the documents in an estate plan include a will, living will, power of attorney, medical power of attorney, and a trust.
Name the Beneficiaries For All Financial Accounts
An estate plan serves as a shield that protects your assets from legal challenges, streamlines the disbursement process, and ensures that your legacy will be carried out. The will identifies and specifies your beneficiaries, or exactly who will receive certain assets, in addition to an executor who will properly distribute your assets.
Decide Whether to Use a Will or a Trust (or Both)
A will is a legally enforceable document explaining in full detail how you wish for your assets to be distributed after you die. There may be other matters, too, such as who will take care of any dependents, such as children or other family members.
Another legal entity that should be considered is a trust, or a fiduciary relationship in which you authorize a third party, known as a trustee, to handle asset distribution for your beneficiaries. For large, complex estates, it is generally advised that a trust be created as part of the estate plan.
If Using a Trust, Decide Whether it Will Be Revocable or Irrevocable
A revocable trust, or living trust, are trusts in which the terms can be changed at any time while the trustor (you) is alive. Such modifications might include a change in the beneficiaries or the process of how assets will be sold and the proceeds distributed among beneficiaries.
An irrevocable trust refers to a trust that cannot be modified after it is created without the consent of the beneficiaries. For both types of trusts, a trustee must manage the trust in accordance with the guidelines created when the trust was established. While the irrevocable trust seems rigid, there are tax benefits associated with its use.
Understand The Different Federal Estate, Gift and Generation-Skipping Transfer Taxes
Taxes can certainly take a bite out of the proceeds beneficiaries receive upon the transfer of your assets. One tax to be aware of is the generation-skipping transfer tax (GSTT). To ensure that taxes are paid when assets are placed in a trust, the federal government levies the GSTT when there is a transfer of property by gift or inheritance to a beneficiary (other than a spouse) who is at least 37½ years younger than the donor.
Of course, it is always wise to consult with estate and tax attorneys on the proper creation of these legal entities and associated documentation.
How to Grow Generational Wealth
As mentioned earlier, investing in stocks has generally been accepted as the way to build wealth over the long term and the strategies discussed above are all ways to ensure as much of that wealth is passed down from one generation to the next. But generational wealth can also be compounded through additional strategies, namely investing in real estate and growing a business.
Invest in Real Estate
Unlike stocks, real estate is an illiquid investment strategy: It cannot be bought and sold as quickly as a stock or a share in an index fund. Further, real estate requires more time for the asset to appreciate and money to put down for the purchase (a 20% down payment is often an obstacle for most people).
However, over the long term, owning real estate can pay off. If a rental property is paid off, payments from tenants provide predictable cash flows. If the ownership of that rental property is passed on to heirs, they can reap the benefit of these cash flows.
There are also several important tax advantages to owning real estate. First, in many instances, the capital gains on the sale are exempt from the capital gains tax. Thanks to the Taxpayer Relief Act of 1997, individuals pay no capital gains tax on the first $250,000 they make when they sell their home; for married couples, it is a $500,000 exemption, says Investopedia. Restrictions apply, but this is one of the biggest tax advantages to buying and selling real estate.
Establish and Grow a Business
Family-owned businesses are a significant portion of our economy. According to the U.S. Census Bureau, about 90 percent of American businesses are family-owned or controlled, accounting for 62% of the nation’s employment. In fact, the business may serve as the primary driver of a family’s income at the current time, funding all other investments and asset purchases. As the business generates income, wealth accumulates along with it.
However, succession is another story, and most family-owned businesses do not continue on to an owner’s heirs. According to the Family Business Alliance, about 30% of all family-owned businesses survive into the second generation. Only 12% make it to the third generation, and a tiny 3% of family businesses are operating at the fourth-generation level and beyond.
If the business does not survive to the next generation, then the next generation cannot reap the rewards generated while the business is operational. Families need to decide whether succession makes sense, or if not, evaluate other options, including hiring outsiders to run the business, shutting it down and liquidating its assets, or selling to a competitor or investor.
Planning Your Legacy
Over the next decade, millennials are expected to inherit over $68 trillion from their baby boomer parents, according to a study from Coldwell Banker. While the itch to spend might be great, heirs need to consider strategies to preserve as much as they can and understand any and all tax consequences.
While no two generational wealth strategies are identical and they can become quite complex, it’s never too early to begin estate planning and setting up legal entities to protect the assets you’ve worked so hard to accumulate. For individuals with sizable assets, the earlier the estate planning begins, the smoother the transition will be later on. Lean on experienced wealth advisors, tax accountants and estate lawyers to understand the various options that exist. Incorporate financial literacy into your estate plan and educate your heirs. This can help you sleep better at night knowing that they will be managing their gifts responsibly, providing them with benefits for years to come.
Reach out to a registered wealth advisor at Gratus Capital today to learn how to get started building and protecting your legacy.