Estate Planners: 9 Months Left for Tax-Free Transfer of $10 Million

White paper shows how investors can use trusts, life insurance and annuities to pass millions through exemptions expiring at year end

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Financial advisors catering to high-net-worth investors have just nine months to help their clients transfer more than $10 million to their heirs free of estate taxes before generous exemptions expire at the end of this year.

Andrew Friedman, a principal in The Washington Update, which focuses on the impact of public policy on the financial services industry, has written a 10-page white paper detailing the wealth transfer opportunity. The paper points out that while it is well known that compromise legislation at the end of 2010 extending Bush-era temporary tax reductions increased the estate tax exemption to $5 million, it is less well known that the lifetime gift tax exemption was also raised to $5 million.

That means that wealthy investors need not die in the balance of this year to take advantage of this opportunity but may—through a combination of irrevocable trusts, life insurance and annuities—pass on a larger amount of wealth today free of tax than is likely to be available in years to come.

Since the $5 million current exemption amount is available to each spouse individually, and since the combined $10 million can appreciate throughout the donor’s lifetime, the estate tax reduction now available represents a significant advantage over the $1 million exemption set to take effect in nine months. And since the law allows the same generous exemption for generation-skipping transfers, investors can use the current laws to endow their grandchildren as well as their children.

Friedman’s paper, available to Washington Update members, places a lot of emphasis on how investors fund their wealth transfer trusts. Irrevocable trusts are effective at minimizing estate taxes but can be problematic from an income tax perspective, he writes. To get around this conundrum, Friedman recommends investing in assets that generate assets taxed at low rates. If those assets are stocks, bonds and mutual funds, then tax-efficient investing techniques or tax-free securities such as municipal bonds are critical to lowering the tax bill.

But the paper makes clear that life insurance may be the optimum investment because neither the investment earnings nor the death benefit are subject to income tax, meaning that heirs can receive their inheritance entirely income and estate tax free.

Irrevocable life insurance trusts, known as ILITs, also have the advantage of providing a tax-free source of funds in the event that heirs running an illiquid family business face a tax bill they otherwise could not pay without selling the business. An investor may also combine the ILIT with an annuity that guarantees a stream of income will be available to pay the policy premiums.

While the ILIT may be optimal, there are scenarios where an investor may benefit by investing the trust assets in an annuity. Like the ILIT, a trust invested in an annuity pays no tax on earnings as long as they remain in the annuity, but when the trust makes withdrawals from the annuity, the income is taxed at ordinary rates. If the trust recipient needs current income throughout her lifetime, an annuity can provide that and ensure that the income benefit is not impaired even if the underlying investments decline.

If the spouse has no need of income, an annuity may still be the best option in circumstances where the spouse is uninsurable. And in cases where the spouse may only on occasion desire recourse to the trust’s income – for extended travel or medical expenses – an annuity can act as a “spigot,” making earnings available on an as needed basis.

Friedman looks at fancier ways to transfer wealth such as an IDGT or a GRAT. The mechanics of these two instruments vary, but what they have in common is they enable the donor, rather than the trust itself, to pay any income taxes the trust earnings generate. This further widens the amount of wealth a donor can pass on to heirs tax-free. Friedman says the current combination of low values for some asset classes (such as real estate) and low interest rates the donor is mandated to pay on taxes due make now an ideal time to use these trusts.

Regardless of which trust and which assets advisors recommend for their clients, what is clear is the window on this wealth-transfer opportunity closes at the end of 2012 unless Congress reauthorizes these generous exemptions.

See AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012, throughout the month of March.

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