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Financial Planning > Tax Planning

Death and Tax Hikes Both are Inevitable... But One is Really Going to Hurt

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Many among the affluent are looking ahead to January 1, 2011 with a sense of dread. But for insurance and financial service professionals engaged in wealth transfer planning, the New Year carries a silver lining.

Why the contradictory reactions? In a word: EGTRRA. The Economic Growth and Tax Relief Reconciliation Act, the sweeping tax legislation passed by Congress in 2001 under President Bush, provides for the expiration of tax provisions that, without leveraging the risk management products and knowledge of an advisor, could negatively impact clients’ estate plans.

“With the reinstatement of the estate tax system, those who are impacted will be paying much more in tax,” says Michael Krupin, a principal of Gilbert Krupin LLC, Beverly Hills, Calif.

More importantly, reverting to the old tax regime, will cause life insurance sales are sure to skyrocket,” a view are shared widely among experts interviewed by NU, who uniformly anticipate a rise in tax rates next year.

Absent Congressional action, the top estate tax rate and the generation-skipping transfer tax are due to increase from 45% to 55%, with an additional 5% for estates over $10 million to eliminate the benefit of the lower estate tax brackets. The applicable federal exclusion amount–a “unified credit” that provides an exempted value covering the sum of one’s taxable estate and lifetime taxable gifts–will be pegged at $1 million.

Also, tax reductions enacted in 2001 and accelerated in 2003 will expire in 2011. The top tax rate for married couples earning more than $373,650 is due to rise from 35% to 39.6%. The 25%, 28% and 33% tax brackets for household incomes ranging from $68,000 to $373,650 will also ratchet up to 28%, 31% and 36%, respectively.

EGTRRA’s sun-setting provisions will thus place in Uncle Sam’s cross-hairs high net worth individuals who will have to pay increased income tax on assets intended for heirs. Until recently, HNW individuals had hoped to escape the estate tax under a widely anticipated–but as yet unrealized–Congressional compromise: the setting of the top estate tax rate at 45% and the lifetime exemption amount at $3.5 million.

Enter life insurance, which offers multiple tax benefits for the tax-averse: tax-deferred growth of a policy’s cash value; income tax-free distribution of death benefit proceeds; and, when owned by an irrevocable life insurance trust, estate tax-free distribution of the death benefit.

Pending tax law changes aren’t the only factors expected to fuel life sales. Many high net worth clients, observers say, are looking to the product to help them replace or supplement illiquid assets that plummeted in value during the recent downturn–real estate properties, stocks, mutual funds, business holdings, etc.–and to provide the cash needed to pay estate tax and cover other wealth transfer costs.

“The public is now keenly aware that liquidity is not something to be taken for granted in this new economic climate,” says Krupin. “Every estate planning technique relies upon two things–market performance and longevity–neither of which anyone has any control over. Life insurance eliminates both risks, providing the means to replenish one’s resources.”

And, when purchased with an income annuity, life insurance can also secure a retirement income stream while preserving assets for the next generation. Clinton Brown, a retirement planning specialist for AXA Advisors LLC in Redlands, Calif., says he frequently recommends such a combo approach.

A client with $1 million to invest can convert liquid estate assets into a single premium immediate annuity to provide a lifetime income stream. Because the product is annuitized, the invested funds are removed from the client’s estate. Separately, the client can purchase a $1 million life policy from other assets to provide for intended heirs.

When estate assets aren’t needed to fund a retirement income, they can be devoted entirely to legacy planning. Example: using a SPIA’s payouts to fund insurance premiums on a life contract held inside an ILIT.

For IRA owners who likewise don’t need the income but must begin taking required minimum distributions, the challenge next year will be how to insulate the accounts from an income tax bite. Because RMDs increase over time–starting at 3.65% of an IRA’s account value at age 70 1/2 and climbing thereafter, the distributions can potentially put the client in a higher income tax bracket.

To avoid this outcome, Frank Laise, a principal of Capital Wealth Advisory, LLC, Tacoma, Wash., advocates a “strategic IRA rollout” or converting a traditional IRA into a Roth IRA. Though income tax is paid on the conversion, the Roth account grows income tax-free. If used to fund a joint-and-survivor (second-to-die) policy, the Roth IRA could yield for heirs a death benefit between “two and four times” the amount held in the retirement account.

Bradley Berger, a financial planner and managing partner at Cornerstone Financial Strategies, University Place, Wash., says the Roth IRA is equally powerful when used as a wrapper for a variable annuity (i.e., registering an annuity as a Roth IRA). If the VA is purchased with a guaranteed minimum income benefit (GMIB) rider, the client can be assured not only of tax-free distributions upon making withdrawals, but also an income base protected again against fluctuations in the equities markets.

But Berger cautions that an IRA-to-Roth IRA/annuity conversion is only suitable as a legacy planning technique.

“Roth conversions generally are not appropriate for individuals who will need the IRA income anyway in retirement,” says Berger. “If they’re in a low tax bracket, then converting is not a wise move because of the tax to be paid on the transaction. Yes, they can withdraw funds tax-free. But the real benefit is for heirs, who will be able to take their lifetime RMDs tax-free.”

From 2008 through 2010, individuals age 49 and below can contribute up to $5,000 annually into a Roth account; those 50 and older are restricted to $6,000 per year. Such clients, for whom a conversion is not a solution because of IRS limitations, might consider what Berger bills as a “super Roth”: funding a life insurance policy with RMDs from a traditional IRA. Like a Roth, the policy grows tax-deferred and distributes proceeds tax-free.

But contributions to a life insurance policy funded with after-tax dollars (IRA RMDs) can be substantially larger than for a Roth. Premium payments are limited only by a “7-pay test” used to determine whether an overfunded policy must be reclassified as a modified endowment contract (MEC), which doesn’t enjoy the same tax treatment as does a non-MEC life policy.

A client could also face an unwelcome income tax hit, adds Berger, because of the opposite problem: an underfunded policy that lapses. “You don’t want to trigger a lapse because you’ve potentially created a huge influx of income that you would have to pay income tax on,” says Berger. “And most people don’t plan for this.”

They may, however, plan for a modified endowment contract. An MEC, purchased as a single premium life insurance policy taxed as a MEC, may be a preferred alternative to a non-qualified, tax-deferred annuity by clients aiming to maximize the value of legacy assets for beneficiaries.

Withdrawals from both MECs and deferred annuities received the same tax treatment (withdrawals of earnings are taxable, but withdrawals exceeding earnings are a tax-free return of principal). But the MEC’s death benefit is income tax-free to beneficiaries while the gain in a non-qualified deferred annuity is taxable to beneficiaries as income-in-respect of a decedent or IRD.

Low interest rates are also likely to fuel interest in estate planning vehicles that are thriving in the current environment. Among them: grantor retained annuity trusts (GRATs), qualified personal residence trusts (QPRTs) and charitable remainder annuity trusts (CRTs).

Consider the GRAT, a vehicle that pays the person who sets up the trust (the grantor) an annual amount for a specified time, then passes remaining assets to trust beneficiaries. Assets the grantor transfers to the trust are (for amounts exceeding the lifetime exclusion amount of $1 million) a taxable gift, the size of the gift calculated using an interest rate provided by the IRS. Translation: lower interest rates yield lower taxable gifts.

Kevin Mikan, president of Western National Trust Company, a close affiliate of Contango Capital Advisors Inc., says the use of life insurance as a hedging strategy will increase if, as he predicts, Congress passes legislation that no longer allows so-called “zeroed out” GRATs: vehicles in which the annual payment to the grantor is sufficiently high to cause the present value of the taxable gift to be zero.

“If Congress mandates that a 10% remainder interest for beneficiaries be left in the GRAT, then I expect we’ll see a shift from short-term to long-term GRATs,” says Mikan. “But that’s a problem if the grantor dies before the GRAT runs its term, as assets remaining in trust will be pulled back into the client’s taxable estate.

“To hedge against the heightened mortality risk of the lengthier terms, clients can use life insurance to cover estate tax that might have to be paid,” he adds. “It’s is a great tool for providing needed liquidity.”

For other clients, Congressional action–in the form of EGTRRA–has already upset estate plans involving credit shelter trusts (a.k.a., credit equivalency, bypass, family or “B” trusts). The vehicles are normally used to transfer assets equaling the applicable federal exclusion amount to beneficiaries (e.g., children) upon the death of a parent/grantor, thereby escaping estate tax. But they also allow a surviving spouse during his or her life to invade the trust for health, education, maintenance and support.

The problem, observes Cornerstone’s Berger, is that many legal documents call for the trust to be funded up to whatever the federal exclusion amount is. Because EGTRRA has ratcheted up the exemption from year to year since the law’s passage, assets transferred to trust may exceed what clients had intended, leaving them with fewer assets outside of trust within their control.

As an alternative to the credit shelter trust, says Berger, clients might consider a disclaimer trust, which may be funded at a surviving spouse’s discretion. Thus, a spouse could “disclaim” $1.5 million of a $3 million inheritance, allowing him or her to retain control of half of a bequest; and to fund the credit shelter-like trust with the balance.

“In the work we do with attorneys, the disclaimer trust has frequently proved to be a viable alternative for many individuals who don’t want all of their wealth moved into a credit shelter trust,” says Berger. “The control afforded by the disclaimer trust may be important if the surviving spouse is relatively young and needs estate asset to cover lifestyle or other expenses. You don’t want to be hamstrung by a trust that only allows you to drawn income.”

More generally, sources say, clients don’t want to be bound by rigidly structured wealth transfer plans that could go awry because of changing tax laws, either at the federal or state level. And this speaks to the need for flexibility to accommodate the unexpected.

“If you put all of your property into a trust, that reduces flexibility because the asset transfer converts liquid into illiquid assets,” says Berger. “Advisors need to view the estate plan holistically, factoring in not only the potential tax savings, but also the clients’ freedom to access and use their money.”


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