It is with a sense of foreboding that most Americans circle April 15 in red ink on their calendars. But for advisors with senior clients for whom estate planning and overall tax minimization are top priorities, tax day is just another spring day.
That’s because the process of devising, implementing and (if need be) updating tax-minimizing strategies for clients is a year-round responsibility. It demands diligence, creativity and a firm grasp of the products and strategies that work best in reducing client tax exposure, both while they’re alive and after they die. It also demands flexibility, because tax policy and client circumstances change frequently.
That’s where life insurance enters the picture. Two features – the ability to transfer a policy’s death benefit tax-free to beneficiaries and the tax-deferred growth of cash inside a policy – make life insurance products (mainly permanent policies) one of the most powerful instruments for addressing estate tax and income tax liabilities among seniors. So whether tax day is looming or not, there’s usually a good reason for advisors to sit down with clients to discuss how life insurance can improve their tax situation.
“It’s a very leveraged tool,” says Jack C. Harmon Sr., CFP, CIMA, founder and president of Harmon Financial Advisors in Atlanta. “If you have a permanent problem [with tax exposure] that you can’t find your way around otherwise, life insurance is a great way to resolve tax issues for pennies on the dollar.”
With its wealth-transfer and estate-protection features, life insurance offers protection and peace of mind to people who see their assets as increasingly vulnerable in light of the mounting federal deficit, long term care costs and the uncertain future of the Social Security and Medicare programs, says Ted Kurlowicz, JD, LLM, CLU, ChFC, professor of estate planning at the American College in Bryn Mawr, Pa. “People are saying their inheritances have not turned out to be what they thought they would be. And I think it’s only going to get more difficult for people in that respect. The guarantee of inheritance [offered by life insurance] is a really undersold concept today, but one that’s going to grow in importance very quickly.”
Fully exploiting the leverage life insurance provides as a tax tool isn’t always a straightforward exercise, however. Some maneuvers can be complex and may require the involvement of an accountant, attorney or other specialist. For the lowdown on the most effective tax strategies incorporating life insurance, from the simple to the complicated, the obvious to the obscure, the time-tested to the newly minted, we turned to a panel of advisors and tax experts. Here are some of their suggestions, each a readymade reason to reach out to your senior clients:
Act fast because this one will soon disappear: Buried in the fine print of last year’s omnibus tax bill, the Pension Protection Act is a provision that for the next two tax years (2006 and 2007) creates an annual exclusion of up to $100,000 from gross ordinary income for otherwise taxable distributions from a traditional IRA or Roth IRA directly to a charity or other qualifying not-for-profit institution (such as a university).
The contribution must be made directly by the IRA trustee to the qualified charity on or after the date the IRA owner reaches age 701/2. Such a distribution is not considered part of the IRA owner’s deduction for contributions to charity; it is counted as part of the IRA owner’s required minimum distribution for that year.
Not only is the so-called “bypass” provision a “big gimme for charities,” says Grace C. Wellwerts, CFP, CLU, principal at the Rocky Mountain Planning Group in Avon, Colo., it also creates a scenario that is well suited to the purchase of a permanent life insurance product such as survivorship universal life.
In one situation, a Wellwerts client used a $100,000 distribution from his IRA as a cash gift to his college alma mater. As required by the new law, the university then used the money to purchase a second-to-die UL policy on the client, of which the school is both the owner and the beneficiary. The client nets a tax deduction and avoids paying ordinary income tax on the gift while satisfying his charitable inclinations.
For situations where a client has contributed the maximum amount to tax-favored retirement plans: Clients who have maxed out their 401(k) and IRA contributions in a given year can purchase a life insurance policy to at least gain the advantage of tax-deferred growth, using a leveraged tool to build the value of an estate. As a tax-minimization move, it is not as desirable as an IRA contribution but it is preferable to standing pat, says Jim Ivers, JD, LLM ChFC, professor of taxation at the American College.
A couple of factors must be weighed in determining the efficacy of this maneuver, he notes. If the policyholder later opts to take cash out of the policy, that cash will be subject to the ordinary income tax rate, not the lower capital gains rate that would apply had the money instead been used to invest directly in an equity. Further, it is important to consider whether any such withdrawals receive FIFO (first-in, first-out) or LIFO (last-in, first-out) treatment.
In trusts we trust: From an estate planning perspective, says Kurlowicz, couples whose assets total in the $4 million to $10 million range would be wise to consider establishing an irrevocable trust incorporating life insurance, aka an ILIT.
From a legal standpoint, an ILIT is among the most solid estate planning options for the wealthy, Kurlowicz explains. “I spend a lot of time talking people out of aggressive stuff that seems too good to be true and might not pass the smell test. Done correctly, this one usually passes that test. It solves a lot of problems.”
With the typical ILIT, a couple makes a cash gift to a trust to fund purchase of a permanent survivorship policy. The trust is the owner and beneficiary of the policy. The money lies outside the couple’s estate, thus avoiding inheritance taxes when the death benefit passes to the beneficiary. Structure is crucial with an ILIT, so be sure to consult an insurance agent and tax attorney who are each well-versed in the process, he suggests.
For taxpayers of more modest means: A client in the middle-income bracket whose income puts him on the brink of having his Social Security benefits taxed at a higher rate may benefit by placing funds inside a cash-value insurance policy rather than in a currently taxable investment or even a tax-exempt municipal bond, according to Ivers.
Taxation of Social Security benefits increases as a taxpayer’s provisional income increases, until the maximum allowable percentage of benefits (85 percent) is exposed to taxation, he explains. But the internal buildup in an insurance policy isn’t counted as provisional income for the purposes of determining the level at which Social Security benefits are taxed. So in the case of a married couple filing jointly, where they face the prospect of having the maximum 85 percent apply to their benefits if their income exceeds $75,000 for the year, if putting funds into an insurance product instead of another investment reduces their provisional income below that $75,000 figure, this can be a worthwhile maneuver.
When wealth transfer can’t wait: In some cases wealthy clients want to see their money begin working for heirs while they’re still alive.
If so, Wellwerts suggests the client (and spouse or partner) can make a gift of up to $100,000 to an heir (such as a child), who then in turn uses a portion of the gift to purchase a survivorship life policy on the gift provider, keeping the remainder for their own use. The heir (child) is the policy’s owner and beneficiary.
“You’re reducing your estate by the maximum allowable amount,” she explains. “Your estate is gaining a policy that grows tax-deferred and the kids are getting money right away.”
For the sake of estate flexibility: If a client still faces substantial estate tax liability, says Harmon, even after exhausting all available tax-reduction options, and his or her estate lies predominately in illiquid types of investments such as timber, a small business, a ranch, etc., – “things you just can’t or don’t want to liquidate on short notice and get true value on them” – it could be time to purchase a permanent life insurance product to cover the value of that portion of the estate.
Harmon says he tends to favor variable universal life policies in these types of cases. “Properly managed, [a VUL] can go a long way toward caring for itself after a few good years of performance by the investments inside it.”
An oft-overlooked allocation advantage: When it comes time to rebalance the portfolio of a client whose holdings include a VUL policy, it is important for advisors to remember that reallocations within the VUL typically won’t be subject to capital gains tax as would reallocation of assets in other equity-based accounts, Ivers says. “You can move assets from one fund to another within the policy without incurring current tax on any gain. That’s something people don’t always think about.”
But for advisors and clients who do think about those kinds of things, April 15 likely won’t be such a scary day.