The following illustrates a common tax planning scenario for high net worth clients and an insurance-based solution for satisfying their goals.

Will and Sarah Wald have focused on careers and family for most of their lives and now find themselves in a comfortable stratum of the marketplace. They acknowledge that paying estate tax is a given and they want to alleviate tax issues on current and future income.

Paula Producer was conducting a non-qualified deferred compensation plan review at Horizons Architectural when she met Will Wald, a senior architect at the firm. Will deferred his bonuses for 16 years, matched at 50% by the firm, and had looked forward to enjoying the significant retirement income he would eventually receive.

He retired last year and he and Sarah are now contemplating the income tax burden they will face, on income they neither need nor want, when his distributions begin. Will talked with Paula about their dilemma. She suggested they meet with his lawyer and CPA to discuss an exit strategy.

With Will’s deferrals and the employer match, his account is valued at more than $7,500,000, which will fund annual payments of $500,000 for 15 years. If Will dies during the term, his family will receive the balance of his deferral account, but the employer match will cease.

First things first

Paula focused on the terms of the employer match ceasing if Will dies during the distribution period. At a 50% match, significant wealth for his heirs could be lost. She noted that Will deferred his bonuses for years in anticipation of the employer match, accumulating greater wealth for himself and his family.

The fact that he and Sarah no longer need the income generated by his NQDC plan should not keep him from taking steps to preserve as much of the wealth as possible for his heirs. Paula suggested that Will use a portion of each distribution to fund, in their irrevocable trust, a life insurance policy on his life to replace the lost benefits if he dies prematurely. Will and Sarah agreed that he will set aside $70,000 a year to fund a $3 million policy, and pay income tax on it each year.

Counter-intuitive planning

Next, Paula proposed that Will gift his remaining distribution of $430,000 each year to charity, to provide him with an annual charitable income tax deduction to offset the receipt of the distribution. Neither Will nor Sarah was interested.

They have long believed that charity begins and ends at home. Paula asked them to be openminded, as she explained how other clients created and preserved generational wealth for their families, often with little or no taxation, by including charities in their estate plans.

Although initially reluctant to give the money to charity, Will and Sarah agreed when they learned there were few options to avoid immediate taxation of the plan distribution and still benefit their family. At Paula’s urging, they agreed to add a nocost charitable giving rider to their policy. They set a date to meet with their lawyer to finalize the plan.

The tradeoff

Will made it clear that his purpose is to legally avoid income tax on his annual distributions. To address this, it was agreed he would set up a 15-year charitable lead annuity trust (CLAT) to gift the remaining $430,000 of the initial NQDC payment. As a grantor trust, the income earned in the CLAT is attributed to Will.

Although he will not pay income tax on the $430,000 because of the charitable income tax deduction, he will pay income tax annually on the earnings of the CLAT. If properly structured, Will should also receive a charitable gift tax deduction, and the value of the CLAT should not be taxable in his estate at his death.

Will intends to set up rolling CLATs each year to receive his charitable gift. “Rolling” CLATs give Will the ability yearly to determine if the 7520 rate, which is the key interest rate that must be used for gift tax purposes, is conducive to using a CLAT, giving him flexibility each year for other charitable options.

Something for everybody

The Wald CLAT is designed to “zero out” at the end of the 15th year, meaning payments to charity are calculated to consume all principal and interest by the end of the trust term. The 7520 rate is 5.6% and is used for the trust term.

Charities under the first CLAT will receive over $600,000 at the end of 15 years, and more than $9 million over the course of the rolling CLATs. More than $4.5 million could go to the heirs gift tax-free and estate tax-free if the Wald’s actual earnings continue to average a net 9%.

Although the Walds were enticed by “getting something for nothing” in the zeroed out CLATs, their views of charitable giving are changing. For now, they are feeling good about the amounts charities will be receiving from their first CLAT and are excited by the possible tax-free benefit for their heirs.

Deborah Moon, Esq., CLU, is director, advanced markets for the U.S. Division of Sun Life Financial in Wellesley Hills, Mass. She can be reached at deborah.moon@sunlife.com.