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The Capital Transfer Strategy: Math or Magic?

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Wealthy clients between the ages of 65 and 85 have accomplished many financial objectives and accumulated a nice nest egg for their families. Now they are faced with a new challenge: protecting those assets from the devastation of taxation when assets are passed from one generation to the next.

How to address this challenge? One solution is the capital transfer, which offers a simple way to increase the inheritance left to beneficiaries.

Demographics of The Market

Retirees today are very different from previous generations. They are healthier, more active, wealthier, better educated and living longer. They are traveling and working. Many work not out of necessity but because they want to stay active.

Excluding their residence, one-third of retirees have assets in excess of $200,000; 19% have assets in excess of $400,000; and 7% are millionaires. Where is their money invested? According to 2003 statistics from the Administration of Aging:

o 25% own IRAs;

o 29% own stocks and mutual funds; and

o 71% own certificates of deposits (CDs) or interest bearing accounts.

A critical issue for retirees is deciding how to manage their money. They know they should purchase long term care insurance and are concerned about outliving their resources. But the insurance is expensive.

They know they should do estate planning, but it also is expensive. In addition to the cost, estate planning is also confusing. Besides, estate taxes are going to be repealed, right?

Seniors today are better educated and more informed about financial issues than were prior generations. They read magazine articles, listen to radio shows and watch television. Much of the information they receive advocates “spending down your estate” for estate tax purposes and to qualify for Medicaid in the event of a catastrophic illness. However, their No. 1 concern is outliving their resources.

The dilemma they face is whether to transfer assets out of their estate now and risk needing them later or waiting until later to transfer the assets and run the risk of losing them to the government. Preserving their IRA nest egg now may, in fact, result in losing the majority of it to taxes at death.

IRA Tax Trap

Individuals over the age of 70 own 14% of the $2.6 trillion dollars invested in IRAs. The average IRA for individuals ages 65 to 69 is $112,588. The balance is slightly lower for the over-70 group, most likely because they have started withdrawing required minimum distributions.

Most retirees hold IRAs as their “nest egg.” With this mindset, clients are angry when they are forced to begin taking required minimum distributions. They want this money to be protected. Many intend to save it as an inheritance for their children and/or grandchildren.

IRAs were great vehicles for accumulating wealth, but clients must begin taking distributions at age 70 1/2. Many clients are unhappy about taking this income and paying the income tax on those distributions. When the IRA is passed to beneficiaries, the entire amount is subject to income tax upon distribution.

Using Capital Transfer

Capital transfer means trading an asset such as a non-tax qualified annuity, a CD, or an IRA for a single premium life insurance plan. It provides a tax-efficient way to pass wealth to heirs or to a charity. Capital transfer allows for minimum tax erosion of your assets. Why?

Properly designed and funded, life insurance can produce a better after-tax financial result. Capital transfer is a method to maximize the realized value of any asset earmarked for distribution to the next generation or to charity.

Is capital transfer for everyone? Absolutely not! The technique works best for individuals who have reached retirement age, are living comfortably on retirement income and are insurable. It is also for individuals who don’t need the income stream from the asset and who have designated certain assets for beneficiaries.

To illustrate, consider Alice, a 72-year-old widow with $450,000 in an IRA that she wants to leave to her only daughter, Samantha. Alice is living comfortably on her husband’s pension and does not need or want the income the IRA generates with her annual required minimum distribution. Each distribution will reduce the value of the IRA and will be subject to income taxation.

Alice’s net worth is $1.3 million, so she is not concerned about federal estate taxes. However, the IRA total, when distributed, will be subject to income taxation. Samantha could take distributions over her life expectancy, but Alice knows that Samantha will want the money right away and is likely to take an immediate lump sum distribution.

This will result in maximum income taxation of the lump sum and will erode the value of the IRA by as much as 45% after federal and state income taxes. Proper planning can maximize Samantha’s inheritance.

If Alice surrenders the IRA today and pays the income taxes based on the 36% tax bracket, she will have $288,000 to invest in a single premium life insurance contract. That amount can purchase a policy with $762,039 of death benefit guaranteed for her lifetime. Samantha will receive the $762,039 in life insurance death benefit income tax free, vs. the $288,000 left in the IRA after taxation. (See chart.)

Tax efficiency of capital transfer

Capital transfer is nothing more than moving dollars from a tax inefficient investment to a tax efficient investment. What is a tax inefficient asset? A general definition would include assets that result in current income taxation, yield a low rate of interest, or are subject to taxes at one’s death.

What is a tax efficient investment? Life insurance. Life insurance provides both tax deferral during life and a tax-free death benefit.

When weighing a client’s options, remember that the capital transfer strategy is not suitable for every client. Capital transfer planning works best for individuals who:

o Have reached retirement and are between the ages of 65 and 85;

o Have assets producing income that are not being used for living expenses; and

o Have assets, not needed for income, that are earmarked for beneficiaries.

A hard decision

If the client cashes in the IRA now, pays the taxes and reinvests the remaining balance in life insurance, the beneficiaries will receive a larger inheritance, income tax free. Many of today’s life insurance products will guarantee payment of those proceeds.

Liquidating the IRA and paying the taxes now is a significant emotional hurdle you will have to overcome with the client. A client over age 70 1/2 may be more willing to use a required minimum distribution as a premium payment stream into the life insurance contract.

Ownership of the life insurance

If the assets are not being used as an income source, they probably are being held for the combined purpose of being:

o a source of emergency funds; and

o a future inheritance for children and/or grandchildren.

If estate taxes are not an issue, the client can retain ownership of the life insurance policy by making funds available in the event of an emergency through withdrawals and loans. If estate taxes are an issue, the client should consider an irrevocable life insurance trust or having the children own the life insurance. Regardless of ownership, the beneficiaries will receive the death proceeds free of income taxation.

Other assets

Other assets that should be considered for capital transfer are certificates of deposit, mutual funds, stocks and bonds, matured government bond and municipal bonds.
These assets generate current income that is taxable. If that income is not needed, paying income taxes each year is tax inefficient and ultimately erodes the money intended for the beneficiaries. Regardless of the client’s current asset type, life insurance will usually result in a superior outcome for beneficiaries.

Offer your high-net-worth clients and their advisors a capital transfer strategy that maximizes the tax effectiveness of their planned family or charitable legacy. The capital transfer strategy allows you to prospect in the lucrative wealth transfer market.

Donna K. Nearhood, J.D., CLU, ChFC, is an agent for Columbus Life Insurance Company, a unit of Western & Southern Life Financial Group, Cincinnati, Ohio. You may reach her at [email protected].