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.