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

“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.”