The Internal Revenue Code, revised two years ago as part of a down-to-the-wire tax bill, made the estate tax a non-issue for all but the most affluent individuals. But the legislation incentivized charitable planning for those endeavoring to avoid higher taxes on income, capital gains and dividends; and to dispose of policies rendered unnecessary by the new tax regime.
Historically low interest rates now favor certain planned giving techniques over others. The low rates have also prompted policyholders to revisit interest-sensitive life insurance contracts, notably conventional universal life insurance policies, purchased to fund philanthropic objectives.
For advisors knee-deep in charitable planning, one thing has not changed: the need to encourage affluent clients not otherwise disposed to making a planned gift to add a charitable component to their estate plans.
“From a motivational standpoint, demand is never high for planned giving,” says Scott Keffer, founder and president of Scott Keffer International.” As with life insurance, you have to create the demand.”
The new tax regime
For advisors serving clients whose estate planning is chiefly driven by tax considerations, generating that demand could, depending on the objective, be made easier or harder.
The American Taxpayer Relief Act of 2012, passed to avert the “fiscal cliff,” set the gift and estate tax exemption levels (unified credit amount) at $5 million for individuals and $10 million for couples. Indexed to inflation, the unified credit has since risen to $5.34 million and $10.68 million respectively — levels far above those in force at the start of the last decade.
For those whose estates are valued at levels below these exclusion amounts, there’s little reason to engage in estate tax-driven charitable planning. But the higher exemptions levels are helping to fuel one trend among the affluent: gifting large life insurance policies purchased to pay an anticipated estate tax tab when the estate tax tab was lower.
“We’ve seen a big uptick in people wanting to make gifts of existing life insurance contracts,” says Randy Zipse, a vice president of advanced markets at Prudential Financial.Many people who bought life insurance to pay estate taxes now won’t have an estate tax bill. Others are looking to dispose of policies no longer needed because they’ve sold their business or because their kids have moved away.”
Typically, existing permanent life contracts are surrendered in exchange for their cash value or (for those over age 65) a more cash-rich life settlement. But if the cash isn’t needed, a more attractive option may be gifting the policy to a charity.
Donors can secure an income tax deduction on the gift. And for those already disposed to philanthropy, gifting a life policy can yield more cash for the charity — and at lower cost to the donor — than gifting other assets.
“If you want to gift a quarter of a million dollars, it costs a lot less to do so with a life insurance contract than with other assets because the donor is funding the policy premiums for pennies on the dollar,” says Herbert Daroff, a financial advisor at Baystate Financial. “And you get the charitable deduction to boot.”
Or, if the policyholder isn’t careful, a tax bill. Prudential’s Zipse cautions that policies gifted with outstanding loans on them can cause a taxable event to the insured if the loan is valued at an amount greater than the premiums paid into the contract.
A shift in the tax focus
Though fewer people are turning to life insurance-funded planned giving techniques for estate tax-avoidance purposes, such strategies remain favored among high net worth clients for purposes of (1) mitigating income tax; and (2) advancing non-tax-related estate planning objectives.
“The power of planned giving is two-fold, says Keffer. “It allows for the reduction or elimination of taxes, in part by generating a current income tax deduction. And it creates a predictable income stream, thus addressing a chief fear or clients today: running out of money.
For the affluent, the first item is a growing bigger concern than ever. The Tax Relief Act boosted the tax burden for individuals and married couples with taxable incomes exceeding $400,000 and $450,000, respectively. The top marginal tax rate now stands at 39.6 percent, up from the 35 percent in force between 2003 and 2012. The top marginal rate on capital gains and dividends applying to these high-income earners was set at 20 percent, up from 15 percent for the 2003-2012 period.
A widely used strategy for addressing tax and retirement income objectives is the charitable remainder annuity trust, or CRAT. In a typical scenario, a couple transfers property — real estate, stock, collectibles or other highly appreciated assets — to the tax-exempt vehicle, and thereby generates an income tax deduction, which is to be spread over five years.
The trust sells the property for cash, then distributes income generated by the sale to the couple for a term of years or for life — the amount and duration determined by the couple at the time they create the CRAT — free of capital gains tax. When they pass away, the trustee distributes the balance of assets (the remainder interest) to one or more designated charities estate tax-free.
If giving away assets (as opposed to securing a tax-advantaged retirement income stream) is the primary focus, then a donor may alternatively opt for a charitable lead annuity trust, or CLAT. The opposite of the CRAT, this split-interest vehicle provides a fixed income stream to a favored charity for a term of years or for the life of the trust grantor, then a remainder interest to designated beneficiaries.
Assuming the high net worth client desires to also establish a legacy for heirs, assets gifted to charity can be replaced using life insurance. Should the donor’s estate fall below the unified credit amount, the policy can be owned by the donor outright. Otherwise, the policy can be transferred to an irrevocable life insurance trust (ILIT), thus exempting policy proceeds from both income and estate tax.
Life insurance, paired with a variable annuity, can also tax efficiently boost retirement plan assets gifted to a charity. For one client, Daroff says he placed $250,000 of a $1 million individual retirement account into a separate IRA, naming the client’s spouse as the beneficiary and a charity as the contingent beneficiary.