The change in control of Congress from Republican to Democratic, coupled with a new president occupying the White House in 2009, may mean a change in the tax code. Certainly, the federal estate tax code will need to be addressed before its temporary loss in 2010 and, by all accounts, federal estate taxation is not going away. With tax laws possibly changing and estate taxes remaining, how does one handle these tax-uncertain times?
Now is the time for a strategy that mitigates multiple tax areas, including estate taxation, and a strategy that permits enough flexibility to react to changes in the tax code in the future. But what is it?
Survivor life insurance and a Single Owned Survivor (SOS) standby trust
Let’s take one fictional example that might fit well with this strategy. Pat and Jan are married, both are corporate executives and both earn significant income. They have minor children to protect financially.
Under their current plan, if something happens to one of them, the group life insurance and personal insurance combined with the surviving spouses’ income would be more than enough to take care of the surviving spouse and the children. In this example we will assume Jan is the most likely to die.
Jan and Pat have three concerns:
? Minor children protection: What happens to the children if Jan and Pat die in a common accident and there is a loss of both incomes?
? Tax-insulated retirement income: The couple wants to ensure they have plenty of money for their retirement on an after-tax basis, even if income tax rates go up.
? Federal estate taxation: The couple’s estate is considerable now but does not create a federal estate tax liability. However, any asset growth may lead to a federal estate tax liability, perhaps in the near future. They want a strategy that allows for estate taxation benefits.
Let’s see how a variable survivor life policy with the SOS trust may help answer the couple’s three concerns. Before you head down this path, you need to ensure these strategies and products are suitable for your clients’ long-term life insurance needs. You should weigh their objectives, time horizon, risk tolerance and associated costs before investing.
Also, be aware that market volatility can lead to the possibility of the need for additional premium in the policy. Be sure your clients understand that variable life insurance has fees and charges associated with it that include costs of insurance that vary with such characteristics of the insured as gender, health and age, underlying fund charges and expenses, plus additional charges for riders that customize a policy to fit your clients’ needs.
The survivor life policy pays an income and a capital gains tax-free death benefit when both Jan and Pat die, subject to the claims-paying ability of the issuer. The benefit is paid on the second to die, not the first. The death benefit can be used to help create an asset to financially protect the children before they turn 18 years old and beyond. The loss of two incomes to support the minor children is the weakness in this case. The survivor life policy that pays after both have passed away is a potential solution to this concern.
Tax-insulated retirement income
In this strategy, the couple uses the variable survivorship policy to create internal equity cash values, subject to market volatility, that could be used in their retirement as a supplemental retirement fund. By accessing the cash values through partial surrenders and favorable loan features in the policy, the couple can generate a supplemental retirement income that is free of 7 layers of tax attrition (net retirement income).
Taxes mitigated include:
? Federal, state and local income taxes
? Capital gains
? Alternative Minimum Tax
There is no effect on Social Security income in retirement, forcing the Social Security distribution into the couple’s 1040 form.
But be careful! This information assumes the life insurance is not a modified endowment contract (MEC). As long as the contract meets the non-MEC definitions of IRC Section 7702A, most distributions are taxed on a first-in/first-out basis. Surrender charges may apply to partial surrenders.
Loans and partial surrenders from a MEC will generally be taxable, and if taken prior to age 59 1/2 , may be subject to a 10% tax penalty. Loans and partial surrenders will reduce the cash value and the death benefits payable to your beneficiaries; and withdrawals above the available free amount will incur surrender charges. If the contract were to lapse with a loan outstanding, the loan amount in excess of basis will be treated as a distribution and all or a portion will be subject to income tax.
Withdrawals must be done wisely and with caution. It would be smart to consult a qualified tax expert to ensure everything is done properly.
Now that we have some tax insulated retirement income to the plan, where are the federal estate tax benefits?
Federal estate taxation
With the survivorship policy owned by Jan–the spouse most likely to die first–can we add an element of federal estate tax advantages? Absolutely!
In this case, the survivorship policy is created so that the contingent owner of the policy is the SOS Standby Trust. Remember, Jan is the spouse most likely to die first so Jan is the owner. When she dies, several things will occur.
First, Pat will receive the personal and group life insurance proceeds on Jan’s life to help him and the children financially. Second, the survivor life policy will pass into the SOS standby trust. In this case, the common transfer value of the policy for federal estate tax purposes is the cash value of the policy at the time of the transfer.
Pat would use up part of his credit exemption amount to effect this transfer into the trust. In reality, this is funding a part of Jan’s “B” or bypass trust with only the cash value amount, not the death benefit amount. The trust will become irrevocable at this point, funded by the survivor policy now covering the surviving spouse’s life.
The trust now operates like an irrevocable life insurance trust (ILIT). Although some of the credit exemption amount of the first spouse to die would be used to transfer the policy into the SOS, the net death benefit would now be out of the second spouse’s estate for federal estate tax purposes.
When Pat dies, the death benefit will be paid to the SOS trust and it will be free of estate taxes and free of federal income and capital gains taxes as well. If this occurs while children are still minors, the death benefit inside the trust can be used to support the children. If later, when the estate is in a federal estate tax position, the death benefit is available to offset tax losses without the death benefit being subject to the estate tax. This amount, which is income tax-free, capital gains tax-free, and estate tax-free, could be used to provide estate liquidity should federal estate taxes apply, as it is usually done by an ILIT.
If Pat dies first, Jan would have the proceeds of Pat’s personal life insurance and group coverage and may not need the survivor policy; and she could gift the policy to an ILIT at that time, should she wish. If retirement income is the major issue, Jan could keep the policy and use the cash values as a supplement to her retirement income.
Should estate taxes be eliminated while both are alive, the trust can be removed as contingent owner. If estate taxes go up and the children are older, they both could gift the policy into an ILIT. In other words: they have control and options.
Initial ownership with Jan means the couple retains a great deal of flexibility and control.
Many of the goals and objectives of Jan and Pat are covered by this variable survivor life policy and the SOS standby trust, including multiple tax advantages, elements of flexibility, and retaining ownership and control to permit changes for unexpected circumstances. In this specific case, variable survivor life insurance and the SOS trust can be an answer.
Donald G. Schreiber, JD, CLU, is a senior advanced sales consultant for Nationwide Financial Services, Inc. He can be reached at