I just finished watching a program presented by Ed Slott on PBS television about tax reduction and avoidance. Although he concentrated most of his talk on the pitfalls in IRAs and conversions to Roth IRAs, he said that life insurance was one of the few ways to avoid federal income tax.
It was not clear to me just how life insurance fitted in with his program to provide an estate with minimum tax liability. How can life insurance be used in a way to enhance the value of an estate's portfolio while not generating tax liability. I can see how the death benefit can be tax free. But I always thought that life insurance was useful for providing protection to a family in which the primary bread winner dies unexpectedly. I have always looked at life insurance as a poor investment vehicle. It does not seem reasonable to use life insurance just because it can be tax free. What am I missing?
Life insurance is generally free from income tax, but is generally subject to estate tax. However with a proper life insurance trust, the death benefit can be free of estate tax as well.
Someone with a large estate is looking at a marginal rate of up to
50% or perhaps even more. Money spent on life insurance premiums are out of the estate. So even if more money is spent on insurance than the death benefit, it can result in a net gain after taxes.
Example: A buys $1,000,000 of life insurance and pays $100,000 per year. He lives another 15 years, paying a total of $1.5 million, while his estate gets a death benefit of $1 million.
However his estate is $1.5 million lighter as a result of the payments, saving his estate half, meaning an effective cost of $750,000. The death benefit is free of income tax and estate tax, so there is a net benefit of $250,000.
As you alluded, life insurance death benefits are, typically, income tax free to the recipient. There are some unique situations involving qualified plans and/or corporate ownership that makes life insurance partially income taxable, but that is probably not what you are referring to. However, if the deceased was also the owner, or exercised any incidences of ownership, then the death proceeds are includable in the gross estate of the deceased and possibly subject to estate taxation. I THINK this is what you are referring to in your post.
However, there is no rule that says the owner of the policy MUST be the insured. By using an irrevocable life insurance trust, or some similar vehicle, it is possible to have an insurance policy that is both free from income AND estate taxes. Not having seen Mr. Slott's presentation, I can only guess that this is what he was speaking about.
And as you state, I too think that life insurance MIGHT BE a poor investment vehicle although I can make arguments for each side. Typically the ROI on a permanent insurance policy for the average person (i.e. living a normal life expectancy) is somewhere in the neighborhood of 4-6%. But keep in mind that is both tax-free and tax- deferred. At the same time, the S&P 500 has historically returned an average ROI much higher than that. However, investing in the S&P also entails accepting significantly more risk and many people are beginning to think that the US economy is entering a phase in its growth cycle in which those historical averages may not be sustainable anymore. But that's all just speculation...
After thinking about this a while, I might have an idea on how life insurance is to be used.
Slott was pushing the idea of using non-IRA funds for paying taxes for the Roth conversion. Doing that allows to maximize the principle that accumulates a tax free investment return. Life insurance provides a tax free source of funds to heirs to use to extend the length that the inherited IRAs can work.
I will admit to not understanding this completely. Because I was so impressed by Slott's presentation, I made a donation to the PBS station that broadcast Plott's presentation. I donated enough to obtain Plott's DVDs and other tax planning materials as a membership premium. Now, I will be able to give full attention to what he said.
One thing Plott said that would be of interest to this group is to avoid handling funds being transferred from one IRA to another. I was thinking of doing the exact same thing by making use of the 60 day window available to do so. He pointed out that such a transfer can be made only once per year while IRA transfers between financial institution are not limited by those requirements. He also said that many things can happen during those 60 days to void the tax free transfer.
Hint: Life insurance is estate tax free if the person who pays the premiums is NOT the decedent (therefore, it doesn't get included in the estate). Spouses should pay each OTHER's policy, not their own.
(Or at least, that's the way it used to work. I haven't dealt with this issue for over a decade.)
It's more complicated than who pays the premiums, though that is a rule of thumb. It's who the owner of the policy is. There are many incidents of ownership, and whoever can exercise any of them (e.g. right to change the beneficiary, right to borrow against the cash value etc.) is considered an owner for this purpose.
Going through all the trouble of making sure a spouse has all incidents of ownership for a policy that she will be the beneficiary of is a waste of time. Since there is an unlimited marital deduction, you shouldn't bother. In fact, it would be best for the death benefit, if it is to benefit the other spouse, to be included in a testementary trust that has a marital deduction trust included.
One never knows when Congress will pull or limit the marital deduction. Why not protect against that too? Also, it keeps the insurance out of the estate to begin with - which may have other effects (either now or in the future).
Cool. How will you determine the FMV of the DVD? Your donation minus the DVD (and minus other goodies they sometimes give you like a magazine subscription) are deductible on Schedule A.
Is the value of the trust included in the decedent's estate? Maybe it depends on whether the trust is revocable or irrevocable. If the value of the trust is not included in the decedent's estate, it looks like a loophole -- another source of tax revenue to fund laws like "The Education Jobs and Medicaid Assistance Act of 2010".
Just read up on revocable versus irrevocable trusts. They say value of irrevocable trust is not included in estate. Out of curiosity, when you transfer money to such a trust, does the gift tax apply?
How does this matter? Say husband and wife both have life insurance policies worth $500,000. Say husband owns wife's policy, and vice versa. Say wife dies. Then her estate will include her husband's life insurance policy as she was the owner of it. And when the husband dies, his wife's insurance policy will be included in his estate. There's no avoiding adding $500,000 to the estate.
If the beneficiary of the life insurance is not the surviving spouse but instead are the kids, then it does matter. But in 2010 there is no estate exemption, so it does not matter.
When they pull the plug, then we can deal with it. Dealing with the issue prematurely may cause complications. Anyway, there's probably more chance of section 121 being repealed than the marital exclusion going away.
Off the original topic, but - Charities will give you a receipt. It will state "no item of value were given" or FMV of the gift. They value at full value. My Lake Wobegone mug which I treasure, basically cost me $13. The DVD is not the 50cents it cost to stamp out, but likely $49 or so. (I am a Slott fan, but I'd have DVR'd a show that was broadcast) Joe
... I didn't see the program (thanks to the digital conversion "help", we can no longer receive a PBS signal) so can't comment on it directly.
Thus don't know if it was part of the presentation and/or strategy but another possibility is the use of "second-to-die" insurance for estate planning.
Having your spouse own your policy still causes a problem if they die FIRST. The policy on your life will be included in the spouses estate which means that any cash value (or the interpolated terminal reserve) will ge added to THEIR gross estate. In spite of the uniform simultaneous death act, it still gets pretty hairy if both spouses die at the same time as well (e.g. a car accident).
Like Stuart said, as it currently stands the unlimited marital deduction would still save the day. But to turn your own argument against you, "One never knows when Congress will pull or limit the marital deduction. Why not protect against that too?"
Again, an irrevocable trust avoids all of the, thus far mentioned, problems and is low cost, low administration relative to the sums of money involved.
No, it's the death benefit that's included in the estate. However if it's a community property state and the deceased is married, only half may be included in the estate.
Insurance trusts are irrevocable. But there is a whole lot more to them than that. If they are not precisely drafted and carried out, the death benefit will again be taxed in the estate.
Again, it's a lot more complicated that that. Whether a trust is revocable or irrevocable is only one of many issues that must be determined. If a trust is revocable it is certainly included in the estate. But if it's irrevocable, it may or may not, depending on several other factors.
That's why it's better to use a trust, and keep the death benefit out of both estates.
...But the policy isn't actually worth $500k as the husband hasn't yet died. It may be worth ONLY its paid-in premiums (i.e. liquidation value). It's a contingent asset where the contingency was not realized during the decedent's death (therefore, face value doesn't apply), especially if the policy is non transferable.
The estate includes the liquidation value of the wife's policy covering the husband.* The husband gets $500k for his policy covering the wife income and estate tax free (with respect to her death). (At this point, there are no existing policies that continue forward.)
That's the magic of life insurance.
Yes, the estate of the latter to die may include (what's left of) the policy payout of the former to die. However, if it has been spent on non-assets and non-liabilities(i.e. living expenses, etc.), there may be nothing left to tax when the latter dies.
For transferable policies, then one pushes the payout of the surviving spouse to the children in order to keep it out of the latter's estate.
What matters is that there are ways of legally making the payouts free from both taxes, if properly planned and designed.
- If they had not bought the insurance policies, this is the amount of cash/equivalent that would otherwise be sitting in her estate anyway.
But it is not only worth its paid-in premiums. Depending upon the type of policy, it could be worth nearly nothing (e.g. term) or it could be significantly more valuable than not only the premiums paid in, but the cash surrender value as well. For years now, the IRS has been favoring the interpolated terminal reserve formula for determining a policy's true "worth" at any given time prior to maturity. In the past, the cash surrender value was used, which was still often much higher than the value of the premiums paid in.
Again, it's incorrect to assume that the policy's worth is the summation of premium paid-in.
Why bother with the "IF"? Using an ILIT, the spouse doesn't have to spend it all. Most of the families I work with actually want to pass on as much to their children as possible, not spend the last dollar on their death bed.
An ILIT will also shield both the policy (prior to maturity) and the proceeds (after payout) from creditors. Having the spouse own the policy does not accomplish such as it is still exposed to the spouse's creditors and potential even the insured's creditors (each state's exemption laws are unique and should be researched independently).
And, as previously mentioned, dual death situations (e.g. car accidents) can be an absolute mess in spouse-owned policy arrangements.
Nevermind the potential spendthrift provisions that can be included in an ILIT. Too often, one member of the marriage manages all the financial affairs and the other spouse is clueless as to how to manage finances. Or try dumping a couple million bucks on a, legally adult,
20 year old. But all that is outside the scope of the insurance aspect.
Again, why deal with the potential risks? Life insurance is subject to the "3 year look-back in anticipation of death" rules. Any transfer of a policy without adequate consideration within 3 years of death is brought back into the decedent's estate for estate tax purposes.
Then again, any transfer of an insurance policy to your children FOR adequate consideration violates the transfer for value rules and thus the policy loses its "income tax free" status. Damned if ya do, damned if ya don't....
Agree completely. And I'm all for DIY. Heck, I just changed out all 12 spark plugs in my car last weekend. But, IMO, some things are too important to DIY. Estate planning is usually one of those things. A couple thousand of dollars in good estate planning can literally save millions in future taxes. I just don't get why people fight it so much.
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