Estate Settlement Advice: Good Planning Builds Client Loyalty

Financial advisors can also educate their clients about 2010 tax legislation governing the conversion of traditional IRAs to Roth IRAs. By doing such a conversion, clients can avoid required minimum distributions, allowing their savings to grow income-tax free. At conversion, clients will have to pay income taxes on accumulated earnings and tax-deductible contributions, but these taxes don’t become fully due until 2012 on conversions made in 2010. By paying the conversion tax, clients effectively prepay income taxes for their heirs without owing gift tax; and they reduce the size of their taxable estate.

Traditional IRAs can offer current tax deductions and tax-deferred growth. Withdrawals are subject to ordinary income taxes. Roth IRA contributions are not deductible, but qualified withdrawals and earnings are income-tax free, making Roths a superior choice for many from an estate planning perspective.

Irrevocable life insurance and credit shelter trusts

Estate taxes are assessed based on the value of estate assets. Many clients can benefit by rearranging them. One popular method uses an irrevocable life insurance trust. Created during a person’s lifetime, the trust is designated as trust property. Excluded from the grantor’s estate, the trust reduces clients’ taxable estates and potential estate tax liabilities. To prevent inclusion, grantors should avoid all incidents of ownership.

Clients are often unclear about funded versus unfunded ILITs. Funded trusts have income-producing assets transferred into them, which will pay the premiums on insurance policies from earned income. Unfunded trusts usually just own an insurance policy and the grantor makes annual gifts to the trust with which the trustee can pay premiums.

Contributions to the trust are future versus present interests and typically do not qualify for the $12,000 (2008) annual gift-tax exclusion. The Crummey provision grants beneficiaries limited power to withdraw certain sums from the trust for a short time after the grantor makes a contribution. Crummey holders should be actual trust beneficiaries; however, tax courts have allowed annual gift tax exclusions for contingent beneficiaries who were given withdrawal rights.

If the insured gifts an existing life policy to an ILIT and dies within 3 years of the transfer, the policy proceeds will be included in the insured’s estate. It is better if the trustee uses cash in the trust to purchase a new policy on the insured’s life, because the death benefit will generally be excluded from the client’s estate.

Second-to-die or survivor life policies do not pay proceeds until both spouses are deceased, which is when the death taxes generally become due. Premiums on a single second-to-die policy are generally lower than the combined premiums on two individual policies, allowing a couple to obtain a larger face amount of insurance. But a second-to-die policy should not be recommended if a surviving spouse needs the policy proceeds to live on.

The credit shelter trust leverages each spouse’s applicable credit amount, allowing the surviving spouse to use the assets. When the first spouse dies, that person’s applicable exclusion amount ($2 million in 2008) is placed in the credit shelter trust and is not taxed then or upon the surviving spouse’s death, even with appreciation. The surviving spouse has lifetime access to income. If the estate of a married couple is smaller than the applicable exclusion amount and is not likely to exceed this amount in the future, the estate will generally not benefit from a credit shelter trust.

The first step

Take time to educate clients about estate planning as a way to potentially avoid probate, pass on estates quickly, reduce taxes, protect assets from creditors, and provide for loved ones. Remember, for the majority of Americans, it will probably be their first step.