Neglecting to update beneficiaries, or failing to name them, may leave life insurance and retirement accounts to unintended recipients, create probate expenses, and cause tax problems. Having a Will does not avoid these issues. The best prevention is having updated beneficiary designations.Continue Reading...
North Carolina estate planning discussions usually put an individual’s assets under the microscope. What trusts would avoid taxes best? How much should be designated for charitable contributions? Are my advance directives up-to-date? Most people are concerned about preserving inheritances for beneficiaries instead of understanding how inherited debt may affect their loved ones.Continue Reading...
Dynasty trusts, which help families legally avoid estate taxes and preserve assets for heirs of future generations, are the target of new legislation that could significantly limit their value. A proposal in the Obama Administration’s 2012 budget is slated to limit dynasty trust terms to 90 years. (North Carolina law allows dynasty trusts to be perpetual.) The Wall Street Journal reports, “the change would apply to new trusts or additions of money to existing ones, but not those already funded.”Continue Reading...
When administering an estate, determining the date of death values of the decedent’s assets is essential. Filing federal and state estate tax returns and paying any taxes due can only be done when the value of all the decedent’s property is known. In addition, the date of death values establish the new cost basis for capital assets. Delays in probate may stem from valuation complications since the methods to determine date of death values is different for each asset.Continue Reading...
It's Halloween, and tonight kids of all ages will be dressed in an assortment of costumes, many designed to frighten. What frightens an estate planner? Here are a dozen examples of scary planning (or lack thereof) with regard to life insurance and retirement plan beneficiaries:
- Not naming a beneficiary at all (usually defaults to estate or next of kin).
- Naming your estate as beneficiary of your IRA or retirement plan.
- Naming a trust as beneficiary of your IRA or retirement plan (unless the trust is specifically drafted for that purpose).
- Not changing your beneficiary designation when you divorce.
- Not changing your beneficiary when your original beneficiary dies.
- Naming minor children as beneficiaries.
- Naming a beneficiary who is unable to properly manage money.
- Naming a beneficiary who is receiving needs-based governmental benefits.
- Naming a bankrupt beneficiary or one who has creditor problems.
- Naming a relative to take care of and use the money for another relative (instead of using a trust).
- Thinking your Will or Trust will control your life insurance or retirement account (it does not unless you specify it in the beneficiary designation.
- Failing to get confirmation of any change of beneficiary from the financial institution.
Talk to your estate planning attorney to make sure that your beneficiary designations are properly coordinated with your estate plan/ This will best protect your family, preserve your assets and save taxes.
Just As the Name Implies
Second-to-die life insurance doesn't pay off until the death of the second policyholder. Why is it needed? Let's say you own several million dollars worth of assets. By law, you can leave the entire amount to your surviving spouse with no estate tax consequences. But those assets then become part of your spouse's estate and could be taxed after death at rates of up to 35 percent in 2011 and 2012.
Unfavorable Rule for Corporate-Owned Life Insurance
For corporate owned life insurance (COLI) issued after the August 17, 2006, enactment of the Pension Protection Act, an unfavorable provision generally requires businesses to include death benefit proceeds (in excess of premiums paid) in taxable income.
But second-to-die insurance can also be used by the co-owners or partners of a business operation. In this scenario, the insurance proceeds are paid upon the second owner's death.
One IRS ruling gives a little more flexibility to policyholders of second-to-die insurance, which is also called "survivorship insurance" in some circles. Specifically, the ruling may allow you to transfer ownership of your policy and get the proceeds out of your taxable estate.
Generally, life insurance proceeds paid directly to you because of the death of the policyholder are not taxable. However, your taxable estate will include proceeds from a life insurance policy on your life if the money is paid to the estate (or if it's received by someone else for the benefit of the estate). Also, the proceeds are included in your taxable estate if you possess any "incidents of ownership" in the policy, such as the right to change the beneficiaries or borrow against the policy.
If you want life insurance proceeds to avoid federal estate tax, you may want to transfer ownership of your life insurance policy to another person or entity. (See lower right-hand box if the entity is a corporation.)
You can transfer the ownership rights in an existing policy, but the proceeds are still taxable under federal law if you die within three years of the transfer -- and possibly under state law too.
In the IRS private letter ruling, a couple transferred a second-to-die life insurance policy to an irrevocable trust and named their daughter, who is executor of their estate, as the trustee. They also granted their daughter discretion to use the proceeds to pay estate tax, inheritance tax and other taxes due because of death, but she is under no compulsion to do so.
Result: The IRS said that the life insurance proceeds will not be included in the estate of the second spouse to die, even though the funds could be used to pay estate tax. (IRS PLR 200147039)
Check with your estate-planning attorney to learn whether second-to-die insurance is right for you or whether transferring ownership of a policy is a smart move. Keep in mind that transferring ownership may also have gift tax consequences.
Most people know that the proceeds of a life insurance policy are generally free of income taxes. What many don't realize, however, is that the same proceeds are included in one's estate for estate tax purposes.
The federal estate tax will be back next year with a rate of 55% for amounts over $1 million. This will mean that many folks who do not think of themselves as wealthy will have a significant estate tax problem in the event of their death.
However, this is an easy problem to fix. By creating an Irrevocable Life Insurance Trust (ILIT) and transferring the ownership of the policy to the trust, estate tax at the death of the insured (and the beneficiaries) can be avoided. For a transferred policy, the insured must survive by three years for the proceeds to escape taxation, but a newly issued policy in the name of the trust is immediately exempt.
I see a lot of clients who are reluctant to set up an ILIT because of the cost (usually $1,000 to $2,500 or so). Not chicken feed, but not much compared to the hundred of thousands of dollars the ILIT will save. People don't think twice about spending $500 a year to insure a $20,000 car, but can't justify a one-time expense of a couple of thousand dollars to save a couple of hundred thousand for the benefit of their family. Not logical.
That's why I call the failure to create an ILIT estate planning's costliest mistake. An ILIT is quickly and easily implemented by an experienced estate planning attorney, will not limit or complicate the ownership of your assets, and is a veritable bargain in comparison the benefit it will provide.
With the federal estate tax returning next year at a rate of 55%, with only a $1 million exemption, planning to reduce estate tax should be on the forefront of the minds of those fortunate enough to have assets in excess of that amount.
One technique that was shared with me recently by Chad Virgil, CFP, works as follows (example scenario):
- 75 year old man in standard health
- $500,000 IRA
- Taxable estate
- The IRA is converted into a $500,000 single-life qualified annuity, which generates $48,145 annually for life, with no residual estate tax value.
- After income taxation at the highest rates (35% federal, 7.75% NC), the net income per year is $27,563.
- An irrevocable life insurance trust (ILIT) is formed, and purchases a $500,000 single person guaranteed universal life policy - premium is $24,058 per year. This amount would be covered by the gift tax annual exclusion of $13,000 for just two beneficiaries of the ILIT (e.g two children). The ILIT means that the $500,000 will be received estate tax-free by the children.
- $3,505 of net income is left over each year - enough for a nice trip to the Caribbean!
Note: the numbers used in this illustration are from March, 2010, with a MetLife annuity and Hartford life insurance policy.
One common oversight I see when reviewing new clients’ financial status is failure to consider the estate tax impact of large life insurance policies. Most people know that life insurance proceeds are received free from income tax. What most don’t know, however, is that the proceeds are part of the insured’s estate for estate tax purposes if:
- The proceeds are payable to the insured estate, or
- The insured has any “incidents of ownership” of the policy, such as the right to change the beneficiary or access the cash value.
Life insurance proceeds of any amount can be paid to a U.S. citizen spouse free from tax. But – those same proceeds, or the value of items purchased with the proceeds, will be included in the taxable estate of the surviving spouse.
This may not be a problem for most of us at the current $3.5 million estate tax exemption. However, barring a change in the law, in less than 14 months the exemption will revert to $1 million, and the rate will increase from 45% to 55%. North Carolina adds another 16%.
With a $1 million exemption even a $250,000 policy could be subject to estate tax when combined with the value of real estate, retirement accounts, and all the other assets of a decedent. Why take the chance of losing over half the proceeds to Uncle Sam? The solution is to create an irrevocable life insurance trust (ILIT) to own the policy. The proceeds will then escape taxation at the death of the insured, his or her spouse, and can be structured to avoid taxes at the death of the children or other beneficiaries are well. In addition, the proceeds are protected from creditors and mismanagement by the beneficiaries.
If an existing policy is transferred to an ILIT, the proceeds will still be included in the insured’s estate for estate tax purposes if he or she dies within three years of the transfer, so it's best not to delay planning for existing policies.
ILITs must be structured properly to take into account various estate, gift and income tax issues, as well as state law. Make sure you have an estate planning specialist prepare your ILIT and work with your life insurance agent. ILITs are not inexpensive to create, but your beneficiaries could easily save several hundred thousand dollars or more.
Second-to-die life insurance has long been used by married couples to provide liquidity to pay estate taxes at the death of the second spouse to die. Such insurance is less expensive and easier to obtain than two separate policies on the same individuals.
Now, life insurance that pays out at the first death is available. The Phoenix Companies, Inc., of Hartford, Connecticut, has released its Phoenix Joint Advantage universal life policy. A single policy will insure two lives, covering couples who need cash for support when the first of them dies, and small business owners who need funds to purchase a deceased owner's interest.
The product has several options, such as a survivor purchase rider, which enables the survivor to purchase a new policy without undergoing further underwriting.
Given the usefulness of this type of policy for estate and business planning, I predict other companies will follow suit.
A while back I blogged about the advisability of trustees of irrevocable life insurance trusts (ILITs) reviewing the policy owned by the trust to help ensure the policy is still a sound investment and won't lapse. Here's an article from the Wall Street Journal website covering a related topic, Keep Tabs on Insurance that Covers Estate Taxes. The article doesn't discuss the use of ILITs to avoid estate taxes on the life insurance proceeds and further protect the funds for the beneficiaries, but in my opinion an ILIT should always be used for life insurance in a taxable estate (over $3.5 million in 2009). ILITs are the best (estate) tax shelters around! Even for relatively "small" $1,000,000 policy, a $2,500 trust could easily save over $500,000 in estate taxes.
In a Private Letter Ruling issued late in 2007, the IRS approved a clever technique to leverage a gift to your favorite charity using your IRA and life insurance. Developed by Douglas Delaney, a CPA and attorney in South Carolina, the "CHIRA®" works something like this:
- The donor rolls over funds from a regular IRA to a self-directed IRA. The donor and the charity apply for the life insurance.
- An loan (with market rate interest due) is made to the selected charity from the donor's new IRA. The loan is secured by a new life insurance policy purchased by the charity on the life of the donor. The charity signs a promissory note payable to the IRA.
- The charity assigns to the IRA the portion of the death benefit equal to the outstanding loan from the IRA.
Here's an example for the CHIRA® website:
A 74 year old donor decides to loan $1 million from her IRA to her favorite charity. The charity uses $30,000 each year to purchase a $1 million life policy on her life. The death benefit is used to fully repay the loan. Today, the charity will have $970,000 to allocate to their charitable purposes as well as a prudent interest and premium reserve. Whether it is cash to sustain their budget for a few years, or to put shovels in the ground two years early, the CHIRA® plan provides immediate capital without income tax to the donor.
The IRS concluded that (1) this is not a prohibited transaction within the meaning of Section 4975 of the Internal Revenue Code which would terminate the IRA under Section 408(a)(3), and (2) is not a prohibited investment in life insurance by an IRA under Section 408(a)(3) of the Code. What this means is that this technique results in no taxable income to the donor.
However, this a complex, multi-step technique, and everything must be done correctly in order to achieve the intended consequences. If you decide that a CHIRA® makes sense for you, make sure that you consult with tax counsel to ensure that you will face no adverse tax consequences.
Click "Continue Reading" for the full text of PLR 200741016.Continue Reading...
Failure to update one's beneficiary designations for life insurance, annuities and retirement accounts is all too common. One of the more common problems stems from not changing beneficiary designations after a divorce. The law does not automatically cancel beneficiary designations in favor of a former spouse. This can cause a major disruption of one's estate plan, have unintended tax consequences and create conflict among family members.
Earlier this month the United States Supreme Court heard oral arguments in the case of Kennedy v. Plan Administrator for DuPont Savings. This case involves a deceased father who never changed his retirement plan beneficiary after his divorce, and has pitted daughter against mother (the ex-wife).
Here is an excerpt from the Legal Information Institute Bulletin at Cornell University Law School:
"[T]he Supreme Court will determine whether a divorcing spouse must obtain a Qualified Domestic Relations Order to waive the right to receive an ex-spouse's pension benefits under the federal Employee Retirement Income Security Act ("ERISA"). A decision upholding the Fifth Circuit will make Qualified Domestic Relations Orders ("QDRO") the only method by which an ex-spouse can waive rights to pension plan benefits, while a reversal would permit voluntary non-qualified waivers as well. In either case, the Supreme Court's decision will impact pension plans, their employee plan members, and beneficiaries. "
Other common problems are naming minor children as beneficiaries, or not naming a new spouse if such is desired.
So, please check all of your beneficiary designations, and update them if necessary. If you have any questions about the best way to handle the designations, consult with an estate planning attorney. And finally, make sure that your designations are acknowledged by the institution!
Life insurance trusts (ILITs) are a popular estate planning technique used to shelter life insurance proceeds from estate taxes, creditors and mismanagement by beneficiaries. While the insured is alive, generally the only asset of an ILIT is the life insurance policy. However, ILIT trustees have a duty to make sure that the policy is a sound investment, and may be liable to the beneficiaries if it is not.
So, for ILITs that have owned the same policy for several years, the trustee should ask the following questions:
- Is the policy performing as illustrated? If the policy was obtained when interest rates were high, the initial illustration probably assumed a relatively high interest rate for the life of the policy. However, in the last several years, interest crediting rates for universal life and participating life dividends have been lower. Market downturns have also adversely affected the performance of variable products. Failure to address this issues could cause polices to lapse.
- Is the policy sufficient for current needs? Changes in the insured lfe and beneficiaries lives, along with changes in estate tax and other laws, may make adjusting the death benefit advisable.
- Is there a more competitive policy available? Life insurance rates on similar policies tend to drop over time. Longer life expectancies, lower mortality costs, and improvements in underwriting all contribute to lower current costs.
- Do newer policies offer better features? Limited guaranteed policies are now available, along with riders for return of premium, accelerated death benefits, and long term care benefits.
- Is the insurance company financially strong? Life insurance companies are rated for financial strength and stability by ratings services such as Moody's A.M. Best , and Standard and Poors. Is your carrier's ratings decline significantly, consider switching to a stronger company.
Have an insurance professional conduct a few on the policy every few years to make sure that you are fulfilling your fiduciary duty and reducing the risk of future legal action by beneficiaries.
Suppose you could obtain the insurance now, while you are healthy, and let a lender pay the premium? With premium financing, using the life insurance contract as the primary collateral, that is possible. The result is significant life insurance coverage at very little cost.
After obtaining the insurance, you will have several options options available:
- Your health may deteriorate and the best course of action could be to pay off all the loans and keep all the insurance.
- Or you could keep some of the insurance and sell some of the insurance. Then you could use the proceeds from the sold insurance to pay for the insurance you keep.
- Or you could just sell all the insurance coverage and keep the proceeds for your heirs.
When done properly, the financing programs allow you to buy now and decide later, based on the circumstances, how much coverage you may want.
The exit strategy of selling the insurance allows you to profit, even though you keep none of the insurance coverage.
To avoid estate taxes, the policies are owned by an irrevocable life insurance trust.
Everyone’s situation is unique, of course, and these plans can be specifically tailored for your circumstances. However, premium financing is generally available only to those with multi-million dollar estates. Folks of more modest means must get life insurance the old-fashioned way - by paying for it.