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Tell Your Clients: Many Heirs Still Have To Pay Income Taxes

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After death, far more is paid in income taxes than in estate taxes. This is a fact that producers need to address with clients.

Only the richest people pay estate taxes. But anyone with an IRA, employer retirement plan, or annuity will pay income taxes upon distribution of the benefits. For example, the heirs of your building janitor, who has a 401(k), will pay income taxes after death.

Naturally, early distribution penalties do not apply at death. But the income taxes still must be paid.

And, absent retirement planning, the entire account balance might have to be distributed within five years of death–with income taxes due accordingly.

Insurance and planning professionals often put too much emphasis on estate taxes, without proper consideration of income taxes at death. To be sure, death taxes in this sense include not only estate taxes, but also income taxes.

A better way to approach life insurance prospects who have a retirement plan might be this: Instead of speaking about life insurance needs at the start, discuss income taxes due after death.

Then, after identifying the income taxes as a problem, discuss life insurance as the solution.

The problem of income taxes is not a new development. If you were to search the National Underwriter Web site archives for articles on Income in Respect of a Decedent (IRD), you would find articles on this issue.

Using life insurance to protect the IRD assets from shrinkage is also not a new idea.

But, discussing the income tax issue first–that may be a different approach for many producers. It is a retirement planning approach and not a life insurance planning approach.

Another reason favoring this approach is the new estate tax law. While that law purports to make estate planning easier, the reverse is true–the new law has made estate planning infinitely harder.

Now, to develop an estate plan for all situations, one must plan for three possibilities: the increase of the exemption equivalent to $3.5 million by 2009, the repeal of the estate tax for 2010, and then, in 2011, the return to estate tax as it would have been without the new estate tax law.

To say the least, that presents an impossible situation.

Even if the estate tax law is eventually repealed permanently, the repeal would probably include carry-over basis, which will apply now only in 2010. Carry-over basis means that if heirs sell inherited property, that property may be subject to the same income taxes that would have been paid by the deceased during life. The step-up in basis to fair market value at death, which currently applies to non-IRD assets, would not apply.

If carry-over basis applies, this would be further reason to protect assets from income tax shrinkage at death.

The type of policy to buy may vary according to the sophistication and needs of the buyer.

A cash value policy may provide important additional retirement security for a prospect of modest means. A variable life policy may provide protection from inflation and enable the owner to profit from prosperity. Any equity life product should provide similar advantages. And, a popular feature of these contracts is a return of premium benefit, so that the heirs will at least receive an amount equal to total premiums paid.

Many clients do not understand that while their estates may not be subject to estate taxes, they still may need life insurance for income tax reasons. The life insurance will ensure that their heirs receive the full value of a lifetime of hard work.

So, IRD assets should be protected from tax shrinkage just like estate assets.

Douglas I. Friedman, a partner in the Friedman & Pennington, P.C. law firm of Birmingham, Ala., is national counsel on estate and business planning for insurers. E-mail him at [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, August 20, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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