Adjusting For Tax Changes Is The Key To A Winning Estate Planning Strategy

Estate owners need offensive, defensive and often preemptive strategies

By John S. Budihas

NBA coach Pat Riley says success depends on how well a team can adapt to and challenge the offensive and defensive strategies of an opponent. The New England Patriots won this years Super Bowl by quickly identifying and then reacting to their opponents running and passing attacks.

How well one prepares for and adjusts to change is critical on the playing field. Its just as important in the world of financial planning, especially when you consider the ever-evolving tax environment.

For instance, estate owners need to adjust to changes in tax law, health and family circumstances, plus business and financial circumstances that could make difficult the transfer of property both at death and during life. They need offensive, defensive and often preemptive strategies.

High-net-worth clients are concerned about the volatility of transfer tax law. They should be. The passage of the Economic Growth Tax Relief and Reconciliation Act in 2001 introduced 300 changes to transfer tax laws that can deplete wealth and make the transfer of assets more difficult.

For example, high marginal estate tax rates take a hiatus in 2010 and then return in 2011. Also, EGTRRA repeals 100% of the state death tax credit in 2005. Only 25% of the available credit can be used as a subsidy in 2004.

Since 1982, many states made their inheritance tax equal to the available federal credit. These were called the “sponge tax” states. The federal credit subsidized estates that filed a 706 federal estate tax return with state inheritance tax obligations. State death taxes offset the federal estate tax the estate was obligated to pay.

Because EGTRRA replaces the federal estate tax credit with a tax deduction, many states face the loss of millions of dollars in revenues from death taxes. Many of these states now hope to preclude those losses by either creating their own marginal death tax schedules or aligning those schedules to whatever the pre-EGTRRA credit had been.

Another expected source of wealth depletion is EGTRRAs lifetime gift cap, which restricts lifetime wealth transfers to $1 million. Lifetime gifts exceeding $1 million now are subject to a tax rate of at least 41%.

Fortunately, your clients can employ life insurance planning techniques to neutralize the potentially devastating effects of EGTRRAs transfer tax changes and other estate shrinkage due to litigation, creditor proceedings or divorce settlements. Life insurance can replace assets lost from these circumstances or it can be used to pay taxes incurred at discounts of 70% or more.

For example, a 45-year-old male could purchase a $500,000 death benefit for asset replacement or estate tax settlement for approximately $3,500 annually. Thats a 99.3% discount purchase price in the first year.

Even after that 45-year-old exceeds his life expectancy in 40 years, the death benefit would have been purchased at a 72% discount. Life insurance death benefits can be realized for pennies on the dollar. The size of the discount depends on the age and health of the insured, the amount of insurance protection issued, and the insureds longevity.

Life insurance positioned within a trust allows death proceeds to be insulated from the aforementioned estate and transfer taxes. The trust should be irrevocable but flexible so that it can adapt to changing laws and relevant circumstances. A trust gives the trustee full discretionary powers to sell, distribute or move the trust assets should tax law changes and circumstances so dictate.

Other trust provisions, such as a spendthrift clause, combat creditor attachments. A trust protector provision allows a third party to change the beneficial arrangements of the original trust by adding or subtracting beneficiaries. A trust can provide a beneficiary with special powers of appointment that allow trust assets to be distributed in accordance with the beneficiarys last will and testament, instead of the trust provisions.

Such powers can neutralize potential generation tax consequences and allow for adjustments in family circumstances. These 3 elements create a dynamic trio for option planning to neutralize the harmful effects of unforeseen change.

One also needs to implement options to address not only what happens to a clients assets at death but also what happens to those assets should the client become legally incapacitated or impaired during life. How will the estates owners preserve, manage and distribute their assets once the law says they are judged to be incompetent?

Revocable living trusts (RLTs) and durable powers of attorney can avoid the state-mandated court review process and the appointment of guardians and custodians over the property and person of the incapacitated individual. Should the grantor of an RLT become incapacitated, the designated successor trustee assumes all trustee powers the grantor had and can continue asset accumulation, protection and distribution for the incapacitated person.

Broad durable powers of attorney over property (DPOA) that are acceptable by third-party financial institutions also allow the designated attorney-in-fact the right to act as the “agent” of the incapacitated estate owner in specified financial undertakings. The DPOA should explicitly permit the agent to make “complete” gifts of the owners property for estate tax purposes.

A DPOA may even allow the “agent” to re-title an incapacitated owners property to a pre-existing RLT to consolidate assets and centralize the management of those assets in the most cost- and tax-efficient way. Be aware that not all institutions treat DPOAs the same.

Failing to plan for change can result in a failed asset accumulation, protection and disposition plan and untold depletion of estate assets. Tax law changes let financial professionals provide the needed solutions to real problems. With proper planning, you can help your clients adjust to whatever financial obstacles they face in transferring wealth.

John S. Budihas, CLU, ChFC, CFP, is a business, estate and trust planning consultant for the individual life division of Hartford Life Insurance Co., a subsidiary of The Hartford Financial Services Group, Inc. He can be reached at john.budihas@hartfordlife.com.


Reproduced from National Underwriter Edition, October 7, 2004. Copyright 2004 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.