Estate taxes are just one component of the estate-planning process. That fact seems to have gotten lost since the estate tax exemption was raised to more than $5 million for individuals and more than $10 million for couples.
This does not take into account the possibility of estate tax changes in the future and, generally speaking, the most efficient ways to transfer wealth from generation to generation. The Wealth Replacement Trust (WRT) remains an effective estate-planning technique for your most successful clients. This is for clients who have built substantial net worth and are now concerned with creating and maintaining their financial legacy.
The idea works hand in hand with the financial life cycle concept. Individuals can accumulate assets more aggressively when they are younger (such as in qualified plans, individual retirement accounts, their businesses, etc.) because they have the time to recover from possible losses. As people move into middle age, they typically need to become more conservative with their investments. Eventually they should move out of growth and other instruments with larger risk components, and into income and guaranteed financial vehicles.
Finally, if clients will not need some of their money for their remaining years, optimum legacy planning dictates that they seek the most tax-efficient method of transferring that wealth to the next generation.
Qualified plans (QPs) and annuities are often the assets of choice when it comes to the wealth transfer concept. Although both are excellent accumulation vehicles, they are not particularly effective assets to hold until death. Neither asset is eligible for a “step-up in basis” at death. Further, both are subject to income taxes and will be included in the decedent’s final estate calculation. There is the potential for Income in Respect of Decedent (IRD) as well.
A strategy for wealth replacement starts by identifying assets your clients will not need during their retirement and will most likely be passing on to their direct beneficiaries. These assets are converted into income streams via single premium immediate annuities (SPIAs). Using a life-only payout option eliminates the asset from inclusion in the final estate tax calculation. All taxes should be appropriately netted out of the transaction, including the taxes due on the annual payment and any taxes due on the sale of the asset prior to its conversion to an SPIA. This is another reason why funds from qualified plans and annuities are so well-suited for this process – they can be transformed directly into income streams without having to recognize any tax until the distributions are received, while at the same time satisfying minimum distribution requirements.
Any remainder of the SPIA distribution is gifted to a trust with appropriate gift tax recognition as necessary. The trust purchases a life insurance policy to replace the asset. So what has happened here? The asset has been removed from the clients’ estate and, through the wording of the trust, the clients have gained post-mortem control over the benefits it provides. Consider this scenario.
Scenario 1:The Gift That Keeps on Giving – Tax-free
Josephine Smith is 72, in good health and lives in Colorado. She’s in the 33 percent tax bracket. She has three children and four grandchildren. She has funds in several nonqualified annuities, which total $1 million. Her total basis in the annuities is $500,000. She intends to pass these funds to her heirs, and she wants to distribute them in the most tax-efficient manner.
She can take the balance of her nonqualified annuities and effect a 1035 exchange into an SPIA. If she chooses a life-only payment option for the SPIA, she will receive an annual income of $73,787.72.
Based on her tax bracket, she will owe $14,229.96 on the nonexcluded portion. This leaves her with annual after-tax income of $59,557.76.
Josephine can establish a trust and gift a portion of her annual payment to the trust. Because her trust has seven potential beneficiaries (Crummey beneficiaries), she could choose to gift the entire after-tax amount to the trust each year. However, she has other plans. The trust would need to spend only a portion of the annual gift ($25,209.20) to purchase a $1,000,000 policy on her life in order to replace the value of her annuities. She decides that she will fund the trust at $25,500 per year and will retain the remaining $34,057.76 and spend it as she wishes.
Of course, the proceeds from the trust will pass on to her beneficiaries, estate tax-free. Following this strategy, Josephine is able to achieve a number of goals. She has
» Avoided gift taxes.
» Spread the income taxes on her annuities over the remainder of her life.
» Passed the total equivalent of her annuities to her heirs, both estate and income tax-free.
» Created a substantial after-tax income stream that she can use to enhance her lifestyle.
The trust document can also control how and when assets can pass on to a clients’ heirs. For example, incentives can be added to the trust so that assets allocated for the children and/or grandchildren are only distributed at attainment of a specific landmark in their lives such as graduation from college or reaching a specific age. The trust provides post-mortem
control of the asset, which truly establishes your clients’ legacy.
The obvious downside to this plan is the possibility that a portion of the asset will be needed at a later date for something such as unforeseen medical expenses. This specific issue can be mitigated by factoring a long-term care insurance (LTCi) premium into the income stream (and the advisor picking up another sale along the way). It is important to keep in mind that you are looking for a client who can say “I’ve been so financially successful during my life that I won’t need my IRA, QP or whatever asset in order to maintain my standard of living. I want it to go to my children or grandchildren or charity, etc.” This is simply a repositioning of your clients’ assets that they will not need in retirement so they can be transferred to the next generation in a more tax-efficient manner. Also, because we are using an SPIA, if the client needs money, the trustee can always take a reduced paid-up policy and the client can then redirect the income stream wherever desired. Take this scenario.
Scenario 2: More Income and Less Tax
Josephine has suggested that we speak to her friends Kent and Kathi. Kent is 72 years old. His wife, Kathi, is 70. Both are in good health for their age and can qualify for preferred non-tobacco underwriting. They also reside in Colorado and are in the 35 percent tax bracket. They have five children and enjoy being the grandparents to two grandchildren. They have $1 million in several qualified plans comprising just a fraction of their joint estate. Kent is concerned about estate taxes and wants to take steps to minimize their impact.
The couple can purchase an SPIA with these funds. They can effect a 1035 exchange and elect a joint survivor payment option. They will receive an annual income of $62,081.94. They will owe $21,728.68 in taxes on each annual payment.
Kent and Kathi use a portion of the remainder ($20,000) to fund an irrevocable life insurance trust (ILIT). Since they have a potential total of 14 Crummey beneficiaries, they have no problem avoiding gift taxes. In turn, the ILIT uses a portion of the gifted funds ($19,662.03) to purchase a $1,000,000 survivorship contract on the couple.
Kent and Kathi still have an after-tax balance on their annual annuity payment of $20,353,26. They could use this sum of money for just about anything – to purchase a new car or help pay for a cruise; Kathi has a list of ideas.
Kent is still worried about conserving his assets. He could purchase a pair of long-term care policies. The policies they select have a 90-day elimination period for both home care and facility care. In addition to other benefits such as a payment for home modifications, this plan also provides a monthly pool of money to reimburse the clients for possible additional costs.
The cost to provide this coverage for both Kent and Kathi is $11,070.47, of which a portion may be tax-deductible in 2014.
In addition to all that, with this strategy, Kent and Kathi are left with $9,282 of additional income. We achieved a number of goals. We have
» Avoided gift taxes.
» Reduced the couple’s estate tax exposure by $1 million.
» Effectively doubled the amount of their qualified plan assets that will pass on to their beneficiaries (and it now transfers free of estate and income taxes).
» Spread the income taxes on the assets over the remainder of their lives.
» Protected the assets from the high cost of a long-term illness.
» Possibly created a tax deduction based on their LTCi premium.
» Supplied them with additional funds to enhance their lifestyle today.
Please keep in mind that whenever necessary, we should always work in concert with our clients’ qualified professionals, such as tax advisors and estate planning attorneys, as necessary. Additionally, while insurance products can play an important part in developing an effective estate plan, the products themselves are not “estate plans” and agents should not refer to their services as estate planning unless qualified to do so.
The bottom line is estate planning in terms of creating your clients’ financial legacy remains as critical as it has ever been. For your more successful clients, a wealth replacement trust may prove to be a viable option regardless of whatever future legislative changes may occur!