Your estate isn't likely to be subject to the federal estate tax, so you don't need life insurance. Right? Maybe not.
Permanent life insurance was a mainstay of estate planning when even most middle class families faced the federal estate tax. It ensured taxes were paid and loved ones had a legacy.
With estates valued at less than $5.49 million ($10.98 million for married couples) exempt from the federal estate tax, many people believe life insurance no longer has a role in their financial plans. Yet, life insurance can be a valuable wealth-building tool in a range of situations when estates aren't likely to owe federal estate taxes.
STATE DEATH TAXES. About 20 states still have estate or inheritance taxes or both. Some are especially onerous. You might want life insurance to cover these state taxes even when you're exempt from the federal estate tax.
MAXIMIZING CHARITABLE GIFTS. When you're charitably inclined, you can write checks to your favorite charities each year and leave them part of your estate in your will. But life insurance could increase the amount you give to charity.
You can take out a permanent life insurance policy on yourself (or jointly with your spouse) and name a charity or charities as beneficiaries. Pay the premiums and take charitable contribution deductions for the premium payments. Or have the charity own the policy and pay the premiums, while you make annual donations to the charity at least equal to the premiums.
Leverage your contributions with life insurance like this, and the charity is likely to receive far more money than when you give through the traditional route.
MAXIMIZING IRA'S AND OTHER RETIREMENT PLANS. There are disadvantages to leaving a traditional IRA to loved ones. During your lifetime, required minimum distributions (RMDs) must be taken after age 70½. Those increase your taxes and deplete the IRA. Plus, your heirs will owe income taxes on distributions from the inherited IRA, so they really inherit only the after-tax value. Still another problem is the emerging war on Stretch IRAs. There's a movement in Washington to require all IRAs to be fully distributed within five years after the original owners' deaths.
There are other potential problems with leaving an IRA as an inheritance. See our October 2016 issue for details.
We've covered in the past a set of strategies that overcome these problems. They're primarily for people who have substantial IRAs but also have other income and assets to support retirement. They consider their IRAs to be safety funds and legacies for heirs.
Some of these strategies involve permanent life insurance.
For example, you can distribute the IRA, either in a lump sum or over a period of years. Pay the income taxes on the distributions. Then, use the after-tax amount to pay premiums on permanent life insurance with your heirs as the beneficiaries.
They'll eventually inherit the insurance benefit tax free. The insurance benefit is going to be higher than the premiums you paid and likely will be more than the after-tax balance the IRA would have accrued to total over the years. Also, the insurance benefit is guaranteed. It isn't subject to market fluctuations the way your IRA would be. Plus, if you need cash during your lifetime you can take a tax-free loan from the cash value of the policy.
For details on these strategies, see our September 2016 issue.
WEALTH REPLACEMENT. Some income tax strategies cut your annual taxes but also reduce what's available to your heirs.
For example, there's the charitable remainder trust (CRT). Suppose you have property that's appreciated a lot, such as investment real estate, stock, or mutual funds. Selling would incur substantial capital gains and could boost your adjusted gross income and trigger the Stealth Taxes, such as the Medicare premium surtax, inclusion of Social Security benefits, and more. A better strategy might be to contribute the property to a CRT.
The CRT takes title, sells the property and reinvests the proceeds. The CRT pays you and your spouse income for life or a period of years, whichever you select. After you both pass away, the trust transfers the remaining property to the charity you named in the trust agreement.
Because the CRT ultimately benefits a charity, it is tax-exempt. You pay no income or capital gains taxes on the appreciation when you donate the property to the trust, and the charity pays no taxes when it sells the property. It reinvests 100% of the sale proceeds. You also receive a charitable contribution deduction for the present value of the estimated amount the charity will receive in the future. The older you are, the greater the percentage of the property's value you deduct.
But the property is out of your estate and not available to your heirs. To replace that wealth, you can buy a permanent life insurance policy to benefit your heirs. The income and estate tax benefits of the CRT often are great enough that you can pay the life insurance premiums and maintain your standard of living.
For more details about CRTs, see our November 2016 issue. For low-cost help establishing and maintaining a CRT or other charitable entity, contact Legacy Global Foundation at 480-505-6248 or www.legacyglobal.org.
ESTATE EQUALIZATION. Sometimes it's not practical for parents to leave an estate equally to their adult children. For example, a small business might make up a large portion of the estate, but only one child is interested in or suited to own or work in the business. It's usually not a good idea to make co-owners of siblings who won't be working in the business and don't understand it. Another case is when the children would have to be co-owners of an asset that has to be managed, but the children don't work well together.
In these and other instances, you might want to leave the asset to one adult child. To avoid short changing the other children, you buy permanent life insurance and name them as beneficiaries.
Of course, it's not a perfect solution. Someone always can question whether the value of the asset is similar to the insurance benefits, and you have to factor in the likely appreciation rate of the asset. Plus, you need cash to pay the insurance premiums. Often, though, life insurance is the best way to provide equal inheritances.
MODERN FAMILY SOLUTIONS. In a traditional family, it often makes sense to leave all or most of the estate to the surviving spouse (directly or through a trust) and have the children inherit the remaining estate after the surviving spouse passes away.
That's often not a good idea when the surviving spouse is not a parent of the children. Usually there are conflicts or potential conflicts between the children and the stepparent that are made worse by the standard estate plan. While the surviving spouse is alive, the children can complain that the estate is being misspent, and often have the right to sue about it. The children also might not like waiting for the inheritance while a stepparent is spending it.
A better idea often is to have a permanent life insurance policy pay benefits to the surviving spouse and have the children inherit the estate, or vice versa. You might want to reserve the surviving spouse the right to live in the residence for life or a period of years and make similar modifications. But the children receive the bulk of their inheritance right away and have fewer reasons to complain about the stepparent.
LEVERAGING ANNUITIES. I often recommend that immediate annuities generate part of your retirement income, because the amount of the payments is fixed and guaranteed for life.
One of the objections to annuities is that survivors receive nothing. But immediate annuities pay higher yields than safe investments, such as tax-exempt bonds and certificates of deposit. Someone who is invested primarily in those vehicles would increase income by purchasing an immediate annuity. A portion of that increased income could be used to pay life insurance premiums. The insurance policy ensures that the heirs receive something, no matter how long the insured lives.
LONG-TERM CARE PLANNING. There are a couple of ways life insurance can help pay for long-term care.
One strategy is to purchase a permanent life insurance policy and plan to use your assets to pay for any long-term care that is needed. If you don't need long-term care, your heirs inherit your estate plus the life insurance benefits. When long-term care is needed, the life insurance policy ensures a tax-free inheritance for your children, no matter how much you spend on long-term care.
Some people like this strategy, because life insurance generally is less expensive than long-term care insurance. Also, life insurance is guaranteed to pay benefits. With a long-term care policy, if you don't need long-term care, you receive no cash benefits from the policy. Yet, you might not want to use this strategy when you have a spouse who depends on you for support and might survive you. You don't want to leave him or her with no assets.
The other strategy is to buy a life insurance policy with long-term care benefit. For examples of how this works, see the article in this month’s Health Watch.
CREDITOR PROTECTION. The protection varies from state to state, but the cash value and death benefits of a permanent life insurance policy might be safe from your creditors.
CLASSIC USES. One classic use of life insurance is to pay debts and replace lost income for dependents after the insured passes away. For many people this isn’t a permanent need. They buy term life insurance when they are young and let it expire after they’ve built up their estates. For others, permanent life insurance is a good idea.
Another classic use is to provide for a special needs child or other person who needs permanent support and aid. Usually, it is best to have the policy payable to a special needs trust. When the trust is properly structured, the special needs child qualifies for government benefits while also receiving support from the trust.
To learn more about different types of life insurance policies and how they can improve your estate plan, contact David Phillips of Estate Planning Specialists at 888-892-1102.