For those who care about their estate planning and own life insurance to protect their families, 2007 is shaping up to be a pivotal year.
The reason: Based on the interplay between Sections 2035 and 2042 of the Internal Revenue Code, gifts of life insurance on the life of the donor are included in the estate of the donor for 3 years, starting from the date of the gift. If a person makes a gift of life insurance in 2007, the policy won’t be out of the estate until 2011.
The year 2011 is also important in estate planning because that’s when the estate tax “sunset provisions” of the Economic Growth and Tax Relief Reconciliation Act of 2001 take effect. Barring an intervention by Congress, in 2011 top estate tax rates will go back up to 55% (60% for estates over $10 million) and exempt amounts at death will revert back to $1 million, as if EGTRRA never happened.
If the “sun sets” on estate tax reform, then for many individuals with estates valued over $1 million and couples with estates valued over $2 million, 2011 becomes the year in which they would want their insurance out of their estates. And if that’s the case, then the time to make the gift is now.
Each net worth figure across the top of the accompanying chart includes $1 million of life insurance, owned personally. A $5 million gross estate, for example, is actually a $4 million net worth plus $1 million of life insurance. The various estate tax scenarios that exist under current law are listed down the left side of the chart.
In any given year, one of these scenarios could be the law in effect when you die, even if that occurs many years from now. After all, it’s the estate tax law in effect when you die that counts. And no one knows (1) when death will occur or (2) which tax rate scenario will apply, so it’s good to look at multiple possibilities.
The chart also includes larger estate values because estates grow in value over a long period of time. And it’s important to know what the tax outcome for those estates would be under each of the tax scenarios. This allows you to plan the client’s estate as if the tax picture at their death looked like 2007, 2009, 2010 or 2011 (2008 is the same as 2007).
The decision to give away life insurance is important because an insured can derive tremendous personal benefits from owning life insurance. The cash values of the insurance, for example, grow tax-deferred and are generally protected from the claims of personal creditors.
With personally owned life insurance, cash values can be withdrawn up to premiums paid and/or borrowed without tax (unless the policy is a modified endowment contract) to supplement the insured’s retirement income. Generally, the death proceeds of life insurance are paid income tax free and are protected from the claims of personal creditors.
Also, the insured doesn’t have to make large gifts to pay premiums. And he or she can change the beneficiary as many times as desired. Even a trust can be named as a beneficiary.
However, when insured individuals keep these benefits (such as the ability to change beneficiaries, withdraw funds or take policy loans) the death proceeds will be taxed in their estate because the benefits are incidents of ownership.
According to the attached chart, in a year in which estate tax rates and exempt amounts are the same as they are in 2007, the estate of a couple with a $4 million net worth and $1 million of personally owned life insurance (a total estate of $5 million) will attract federal and state inheritance taxes of $553,004 ($365,724 federal tax and $187,280 state tax). The state inheritance tax used in this example (and in the chart) is derived from using the maximum state death tax credit in use prior to its phase-out under EGTRRA and a $1 million exemption amount at each spouse’s death.
Of course, some states like Florida have no state inheritance tax; other states like New York have higher state inheritance taxes. So the use of the maximum state death tax credit table and a $1 million exemption amount for each spouse is just a convenient approximate.
According to the attached chart, in a year in which estate tax rates and exempt amounts are the same as they are in 2007, the estate of a couple with only a $3 million net worth and $1 million of personally owned life insurance (given a total estate of $4 million) would attract federal and state inheritance taxes of only $103,920 because only state inheritance taxes apply (just as if it were 2010). As compared with the $553,004 tax bill on a $5 million estate, the difference of $449,144 would be the cost associated with the last $1 million of estate value–which would be the life insurance!
That’s a tax rate of 44.9% on the life insurance. With almost half of the insurance going to the government in taxes instead of heirs, clients might think they are overpaying for coverage. For tax years like 2011 (when the maximum state death tax credit is reinstated), the additional tax would be federal estate taxes only of $550,000 ($1,495,000 less $945,000) and the rate of tax on the last $1 million would be 55%.
For those who realize why making a gift of insurance to heirs (or to a trust for their benefit) might save taxes, the good news is that attorneys can help make those trusts a bit less “irrevocable.” Valuable trust provisions can be created to give beneficiaries and trustees powers over trust assets during the life of the insured. For example, a 5-by-5 withdrawal power or SLAT (spousal lifetime access trust) can provide access to trust assets by the spouse of the insured during life.
Also, appointing a non-family member or professional as trustee to exercise powers over trust capital for the benefit of family members might be an option. Making a gift of a policy to a trust doesn’t necessarily mean the benefits of the policy are completely lost until the insurance death proceeds are paid. The trust beneficiaries can benefit from the trust during the life of the insured while keeping the death proceeds out of the estate.