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Financial Planning > Trusts and Estates > Estate Planning

Adding flexibility to estate plans

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It’s commonly known that the best time to go to the zoo is feeding time, when the animals are active, collecting food for themselves and their young ones.

Well, watching how busy fellow financial professionals have been these past several months, I feel like I just got home from a long trip to the zoo. As the end of 2012 drew near, it made for an interesting — if not entertaining and even historic — era for our profession. Not that we are animals, but we sure were active as we stayed busy fulfilling the needs of those who depend on us — our clients.

The end of 2012 meant the end of a two-year period where the estate tax (or death tax) rate was 35 percent with an exemption for estates up to $5 million in value. We saw on the horizon that the tax rate was scheduled to jump to 55 percent this year, with the exemption dropping all the way down to $1 million. As most of you know, while $1 million still sounds like a big number, the reality is that many of our neighbors and clients are fully capable of amassing that type of wealth over a lifetime of work and preparing for retirement — even people who aren’t college educated or who are considered blue collar and/or middle class.

The result was a bit of a zoo-like frenzy, due to the uncertainty of what lay ahead. Clients who had decided to forgo preparing for estate taxes (because they weren’t going to meet the $5 million threshold) saw the impending drop of that threshold to a more pedestrian $1 million and decided they needed to do something.

The truth of the matter is 2012 was all about moving money out of estates to help avoid being slammed with whopping estate tax bills. Hopefully, now that we know the structure of the compromise reached on the estate tax at the beginning of the year, the work of actually thoughtfully preparing for the future will come back and replace the jettison mentality of 2012. And believe it or not, there will be more options.

The trouble with traditional

For the last several years, the most popular and traditional estate tax option hasn’t been all that attractive to people, frankly. This option involved the creation of an irrevocable life insurance trust (ILIT), gifting money from the estate into the trust and having the trust purchase secondary guarantee survivor universal life insurance.

In the era of lower tax rates and $5 million exemptions, this option, while workable, hasn’t been too appealing for a couple of reasons. First of all, it required a commitment to pay premiums until the second death — which could mean decades of monthly payments — even if the first death creates a financial crisis. The surviving spouse is still stuck with a monthly premium bill and wouldn’t be able to access money from the policy, even for burial expenses or other needs. If premiums go unpaid, the policy could be canceled.

See also: Outlook 2013: Expect more tax-wise advanced markets sales

Perhaps the most concerning issue from an estate tax preparation standpoint is the fact that survivorship policies are level death benefit policies. While this is fine for a few years, with normal estate value growth and inflation factored in, over many years, the policy value wouldn’t likely be able to keep up with estate value.

With this traditional type of approach, there’s not enough control over external factors like inflation, taxes, health and family status, needs, etc. Even if policyholders keep their end of the bargain and pay premiums until the second death, inflation could make the best of estate planning intentions all for naught. The irony is that the better the client fares in growing the estate, the worse the estate tax situation becomes.

With this type of commitment, mixed with uncertainty and lack of control, it’s no wonder people want to put off addressing their estate issues — often until it’s too late. People like control and certainty. Traditional methods make you lock assets in a box and commit to continue putting money in the box. Period. This is why we all face the challenge of getting people to take action.

The SPO option

One option for 2013 and beyond is to use traditional whole life insurance and attach a survivor purchase option (SPO) rider. This method allows policy owners to have access to their policy cash value and control how they use that capital.

The SPO rider gets its name from perhaps its most important feature: the flexibility it offers to a surviving spouse (assuming the spouse is the insured beneficiary) at the time of the insured policyholder’s death. The surviving spouse can decide then, in consultation with his or her financial strategy team, how best to use the life insurance proceeds from the policy — not years earlier when the decision would be made without the ability to assess current circumstances. If the funds are needed at that time, they are available. But for further estate preservation purposes, the SPO rider may allow for the purchase of up to 10 times the face amount of the underlying policy on the life of the surviving spouse within 90 days of the death of the first spouse.

One strategy is for the spouse to disclaim the proceeds of the death benefit of the policy on the deceased, at which time it is paid to a contingent beneficiary, which could be a trust outside of the estate of the surviving spouse. The trustee would then exercise the SPO and could use the proceeds of the policy from the deceased spouse to purchase a policy on the surviving spouse for a multiple of the face amount of the first policy. This could be a whole life policy at attained age with ongoing premiums or a single-premium, paid-up whole life policy at the attained age. It could also be a whole life policy at the original issue age when the rider was purchased and would have values as if it had been in force since the original issue age. (In order to activate this option, the premium rate is based on the original age and underwriting class. The cash value, effective the anniversary following the primary insured’s death, must also be paid. This cash value is known as point-in-scale cash value.)

The new policy would be outside the estate for estate tax purposes but would be in place to provide the funds needed to pay estate taxes when they are due after the second spouse dies.

Under each of the above options and regardless of how much time has elapsed, the insured beneficiary receives the same rating classification determined at the time the original policy was issued. Changes in health status cannot adversely affect premium amounts due, and there is no additional underwriting.

Such a policy and rider combination has benefits that can address your clients’ needs now as well as in the future. This strategy addresses the main reasons why people are reluctant to engage in estate planning.

  1. The money is not locked outside the original estate. This can be very appealing to clients concerned about giving up access to their funds.
  2. The policies can pay dividends, and these dividends, while not guaranteed, can purchase additional insurance, increasing the face amount of the life insurance over time. This helps protect against inflation concerns.
  3. The surviving spouse has the option, at the time of the first death, of either taking the death benefit, if needed, or purchasing additional insurance with an eye toward future estate taxes.

Be aware that creating any estate tax strategy for your clients will require that you work with additional advisors, such as CPAs and attorneys. These professionals can add value for your clients.

See also: The prospecting power of the new estate tax

While 2012 was action-packed for estate planners, tax professionals and those in financial services, the challenge remains to get people to take action. Too many people feel they are capital-constrained, and it is difficult to convince people to make a lifelong commitment to locking their money up in a trust. Presenting your clients with an alternative strategy, such as whole life with a survivor purchase rider, could help them feel more comfortable and secure.

We don’t have a crystal ball. We don’t know what’s going to happen to our clients or to estate tax laws over the next 20 years. What we do have, with a survivor purchase option, is flexibility.

Let the next feeding frenzy begin.

For more on estate planning, see:

No more estate planning excuses

5 estate planning black holes

The $5.25 million question


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