Planning Techniques For The Other Tax

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Due to uncertainty arising from the one-year federal estate tax phase-out in 2010, some clients are reluctant to implement an estate plan. They may assume that, without the estate tax, everything will simply pass to the next generation free from any taxes. This is not the case.

During the next 20 to 30 years, $9 trillion will pass from one generation to the next; Uncle Sam and the states will want a piece of that transfer. By recommending a simple wealth transfer plan such as a smart trust, a gifting program or a way to leverage deferred annuities, you can make sure your clients money goes to the right peopletheir heirs.

The Other Tax: State Inheritance Tax

No sooner than the ink was dry on the Economic Growth Tax Relief and Reconciliation Act of 2001 did states begin to decouple from the federal system and implement their own estate tax structure. Pre-EGTRRA, the federal tax code gave taxpayers a credit for federal estate taxes paid to the state governments on the federal tax return.

This allowed the states to pick up any taxes that were left. This is known as the sponge tax or pick-up tax. In the past, most states were satisfied with the sponge tax.

However, under EGTRRA the state death tax credit and the sponge tax are disappearing from 2005-2010. As a result, many state legislatures have passed measures to capture the tax revenue they are losing or have maintained a separate tax system. So far, 24 states have decoupled and more are expected. (See Chart 1.)

What Will the Tax Be?

The type and amount of the state death tax varies from state to state, thus making planning difficult. For example, if a person owns property in one state and lives in another state, then both states will be allowed to impose a tax on the value of the property and the size of the estate. So, without proper planning, a client may be faced with both a federal estate tax and two state taxes.

Lets look at an example.

Charlotte and William Eagan, ages 70 and 72, respectively, have an estate worth $5 million, growing at 5% after-tax. As Pennsylvania residents, they have been following the tax legislation and are reluctant to implement an estate plan. The estate, which the Eagans want to leave entirely to their children, consists of real estate, a deferred annuity and cash.

As Chart 2 illustrates, without planning, the Eagans only can pass 55% of the estate to their children. And even if the federal estate tax is repealed, the Eagans will still pay over $1 million in state taxes.

Wealth Transfer Planning Strategies

The Eagans can transfer more to their children by implementing simple planning techniques. These include setting up a simple gifting program, a smart trust, or using their deferred annuity to fund the program.

The Power of Gifting

Each individual is permitted annual exclusion gifts of $11,000 per person, free of gift taxes. William and Charlotte can therefore gift $22,000 to each of their children for a combined total of $44,000. This has several tax advantages, including:

? Reducing the size of the taxable estate. By entering into a gifting program, the Eagans give away part of their taxable estate, thus leaving less to be taxed upon death.

? Providing an opportunity to gift assets outside the taxable estate. Assets may be gifted to an irrevocable life insurance trust (ILIT). When properly drafted, the trust will not be subject to gift taxes and it will reduce the amount available for taxes.

? Helping to pay taxes. A gifting program, combined with an ILIT, may provide a pool of money for the Eagans heirs that may be used to pay taxes or related expenses.

Using Deferred Annuities

The Eagans may set up a gifting program to reduce the size of their taxable estate without tapping into liquid assets using their deferred annuity. If they dont need the annuity for income tax purposes, they can convert it to a single premium immediate annuity and gift the annual distributions to an ILIT using their annual exclusions.

The trust can purchase a life insurance policy on their lives. While potentially engendering certain costs and risks, the transaction can reduce the Eagans taxable estate. They also can avoid the double tax of income and estate tax that is applied to the annuity at death.

Smart Trust

If the Eagans are hesitant to establish a trust because they dont want to give up access to potential cash values, then they might consider a Smart Trust (or spousal ILIT), which provides such access. Lets look at the Eagans estate with a wealth transfer plan.

William and Charlotte use their deferred annuity to fund a life insurance policy inside a trust. The annuity, worth $500,000, is converted to a single premium immediate annuity.

The Eagans can gift the distributions to a Smart Trust using annual exclusion gifts and purchase a Survivorship UL policy with a level death benefit of $1,672,281. Chart 3 shows the numbers in year 10.

Tabulating the Benefits

By using wealth transfer planning strategies, the Eagans can increase significantly the amount left to their heirs, regardless of what they will pay in state and federal taxes. The combination of these planning techniques allows them to leverage their deferred annuity to purchase insurance inside a Smart Trust. By setting up a Smart Trust, one of them can retain access to potential cash values.

is director of marketing, advanced markets, at John Hancock USA, Boston, Mass. You can e-mail her at jroper@jhancock.com.


Reproduced from National Underwriter Edition, December 30, 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.