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.
He then wrapped a VA carrying a 5 percent guaranteed minimum income benefit (GMIB) rider around this second IRA. The VA’s 5 percent income funded a $ 1 million survivorship life insurance policy owned by the charity, making the premiums tax-deductible. Result?
“When the client dies, the charity gets a $1 million second-to-die policy, plus the $250,000 IRA,” says Daroff. “We increased the amount gifted to the charity from $250,000 to $1,250,000 — a five-fold increase. And it didn’t cost the client a dime.”
Determining the policy type
High net worth clients can potentially multiply their gifts even more by incorporating market-sensitive variable or variable universal life insurance policies into the charitable plan. The downside is that if the equity markets turn south, the value of the policy also declines — a key consideration for older and less risk tolerant investors.
“I’ve never been a fan of variable policies,” says Don See, president of Pass It On, Inc., a Colorado-based firm specializing in estate planning for family-run businesses. “I don’t know how to explain to an 85-year-old that he just lost half of his policy’s cash value. If the policy is for estate planning purposes, you’ll want a policy guaranteed to maintain or grow its value for as long as you live.”
Hence a preference among advisors engaged in charitable and estate planning for the tried-and-true: whole, universal and fixed indexed universal life products. Indeed, many advisors stick with just one policy type.
Baystate’s Daroff believes, however, that advisors should apply a portfolio strategy to insurance policies, just as they do other investments. By diversifying among multiple policy types, donors can potentially secure a superior outcome. To diversify further, they might also purchase the policies from different carriers.
Product type aside, life insurance can be also be used with another technique popular among the philanthropically inclined: donor-advised funds. Akin to a charitable savings account, DAFs let donors contribute to the fund as often as they desire and then recommend grants to one or more favored charities. In addition to their flexibility, the vehicle avails donors of multiple tax benefits: a current income tax deduction when the fund is established; and the ability to reduce or eliminate estate and capital gains tax (as, for example, when transferring ownership of a business to children).
Among See’s clients, many have employed DAFs to secure both tax advantages and retain control of a company when instituting a succession plan. Example: using a DAF to receive and hold that portion of company stock exceeding in value an owner’s unified credit amount. The DAF is supplemented by a life insurance policy owned by, and payable to, the owner’s children. When the owner dies, the children receive income tax-free policy proceeds with which to buy back a controlling interest in the company stock from the fund.
“We have a significant number of clients who have set up donor-advised funds,” says See. “Life insurance isn’t necessarily a component. But those who are transferring several hundred thousand dollars into a DAF often buy a policy to replace gifted assets for the benefit of heirs.”
More than a few of See’s clients have the wherewithal to gift such eye-catching sums. His practice caters to people in their mid-40s to their late-70s, most of whom have a net worth of $5 million-plus. And some are looking for charitable solutions off the beaten path.
Case in point: A client who established a CRT to secure supplemental retirement and, at his passing, provide a charitable gift to a foundation. To guarantee the gift would not fall below $1 million, the foundation bought a life insurance policy owned by, and payable to, the CRT. The foundation client thereafter funded the policy’s premium from the CRT-funded retirement income.
“I call this strategy charitable trust fulfillment,” says See. “If the client lives a long time, they risk drawing down the trust asset value to below the $1 million benchmark. A $1 million life insurance policy guarantees that if they trust value declines to, say, $120,000, then at their death there will be $1.2 million in the trust.”
Making the sale
Finding the means to fund a client’s philanthropic and other financial planning objectives is one measure of an advisor’s skill. The other, more difficult test is the ability to frame solutions in ways that speak not to the financial professional’s technical expertise, but to the hopes and aspirations of the high net worth client. This latter talent — one that can take years to hone — may ultimately determine the success or failure of the advisor’s practice.
“The planned giving world represents a huge opportunity for advisors, but one that comparatively few are well versed in,” says Keffer. “You need to be able to put aside the acronyms and technical jargon and focus on what’s most important to prospects, such as creating a legacy and an income they can’t outlive. You have to take a complex solution and make it simple.”
Interest rate impact on charitable trusts [sidebar]
Just how well are CRTs and CLTs fairing in today’s marketplace? Tax, retirement and philanthropic objectives aside, interest in the vehicles is being guided in part by interest rates. And current low interest rates favor CLTs over CRTs.
The IRS’ Section 7520 rate, published monthly and determined by prevailing market interest rates, determines the value of a trust’s remainder interest. The longer is the term of the trust and/or the lower the Section 7520 rate, the lower will be the present value of the remainder interest.
In respect to CRATs and charitable remainder unitrusts or CRUTs (vehicles that distribute income based on a fixed percentage of the fair market value of trust assets, as opposed to a specified term) the result is a lower charitable income tax deduction, and a correspondingly higher taxable gift for the donor. Conversely, CLATs and charitable lead unitrusts (CLUTs) a low Section 7520 rate reduces the taxable portion of a gift to non-charitable beneficiaries.
“There is still a strong demand for CRATs and CRUTs, but they don’t work as well as they when we had higher interest rates,” says Herbert Daroff, a financial advisor at Baystate Financial. “Nearly all CRTs that I have been involved in have been motivated by a liquidity event, such as the sale of a business, that could yield substantial income and capital gains tax. We’re still doing CRTs; they’re just not as lucrative for donors.”
Clients who favor charitable leads trusts in the current low interest rate environment might, adds Daroff, opt for a particular variation of the vehicle, dubbed the “shark-fin CLAT.” The vehicles are so named because the visual depiction of distributions resembles a shark fin: They make minimal payments to the charity annually, then a large balloon period in the final year of the annuity term.