Estate planners commonly use life insurance as a method of paying estate taxes, but according to the Tax Policy Center, only 5 out of every 100,000 people have estates representing more than $3.5 million. Thus, for most decedents, the federal estate tax has been repealed. Nevertheless, for the reasons described below, life insurance can still play a significant role in a non-taxable estate.
1. Capital needs
Life insurance has long been used to protect young families from the disastrous effects of a breadwinner's untimely death. It is the only way to guarantee that the potential shortfall in a family's capital needs will be covered in the event of a premature death.
2. Wealth replacement
Charitable remainder trusts are often used by people who wish to sell highly appreciated assets without generating any capital-gains tax liability. The main drawback of using a CRT is that upon the death of the donor and the donor's spouse, the assets remaining in the CRT pass to charity. A life insurance policy can be purchased for the benefit of the donor's heirs to "replace" the wealth passing to charity.
3. Estate equalization
Most parents want to treat their children equally when dividing up their estate, but this may prove impossible with family businesses in which only the children active in the businesses are to receive the businesses. If the business' value exceeds the active children's share of the estate, it is impossible to treat the children equally. A simple solution is to use a life insurance policy as an estate equalizer. The non-active children (or a trust for their benefit) would be the beneficiaries of the policy.
4. Creditor protection
The cash value of a life insurance policy and/or the death proceeds from a policy may be protected from creditors based upon state law. The amount protected varies from state to state, and may be dependent upon who will become the beneficiaries of the policy. For example, some states only protect a policy's cash value and death proceeds if the insured's spouse and/or children are the beneficiaries of the policy.
5. Second marriages
When children from a previous marriage are involved, estate planning becomes more complicated. Take the example of a second marriage in which the husband has children from a previous marriage. The husband establishes a living trust that, upon his death, provides his wife with income and principal as needed to maintain her accustomed standard of living, with the remainder passing to his children at his wife's subsequent death. This approach has two problems. First, the children have to wait until their stepmother's death to inherit their father's wealth. Second, as the remainder beneficiaries of the trust, the children have legal rights to challenge the distributions from the trust to their stepmother if those distributions exceed (in the children's opinion) the amount called for by the trust. A solution to these problems is life insurance on the husband's life. The policy beneficiaries can be either the wife or the children. If the wife is the beneficiary, the husband can leave his estate to his children (either outright or in trust). Alternatively, if the children are the beneficiaries, the husband can leave his estate to his wife outright. In either case, the second wife and the children from the first marriage will have no financial involvement with one another after the husband's death.
6. Special-needs children
A developmentally disabled individual is usually eligible for Supplemental Security Income (SSI), a federally funded program administered by the states, upon reaching age 18. Prior to age 18, SSI eligibility is dependent upon the parents' income and assets. SSI eligibility generally is accompanied by eligibility for Medicaid, a state-administered federal program which primarily provides medical assistance. Many parents are skeptical about the future and/or level of the SSI and Medicaid programs. As a result, they establish (at the death of the surviving parent) a "special needs" trust for the benefit of the disabled child. A special needs trust is designed to supplement SSI and Medicaid without disqualifying the child from any government assistance. Unfortunately, the special needs trust strategy provides little consolation to those parents who do not have funds to provide for their disabled child or for parents who eventually would have to disinherit their other children to provide adequately for the disabled child. A solution to both of these problems is for the parents to purchase a survivorship life insurance policy. The policy would be owned by the parents and payable to a special needs trust tor the benefit of the disabled child at the surviving parent's death. Upon the death of the disabled child before the complete distribution of the trust property, the assets remaining in the trust can pass to the other children.
7. Annuity arbitrage
Many people who are adverse to the stock market's daily fluctuations prefer to park their investments in municipal bonds or certificates of deposit (CDs). In exchange for this security, the yield on these investments is quite low. A better alternative to municipal bonds and CDs in many cases is a single-premium immediate annuity contract. Not only is the annuity a safe investment (based on the strength of the carrier), it invariably will produce a significantly higher yield than muni-bonds or CDs. The problem with an annuity is that the payments cease when the annuitant dies. Accordingly, unlike the case with muni-bonds or CDs, the annuity owner's children will not inherit the annuity. The solution is to purchase a life insurance policy to "replace" the wealth lost when the annuitant dies. The cash to pay the premiums is generated from the increased cash flow from "converting" the muni-bonds and CDs into an immediate annuity.
8. Medicaid planning
For a person to become eligible for long term care Medicaid benefits (i.e., nursing home care), the recipient must have income and assets below frightfully low levels (i.e., as low as $2,000 in some states). But, what about those persons with substantial assets who are not financially eligible for Medicaid? What options are available to them to protect their assets from the high cost of long term care? First, at least 60 months before applying for Medicaid (or 36 months for those states that have not enacted the Deficit Reduction Act of 2005), the recipient can "divest" himself or herself by gifting away all of his or her assets to children and grandchildren. Many people reject the idea because of the loss of control and financial independence, among other disadvantages. Second, long term care insurance (LTCI) can be purchased to pay for such care. LTCI premiums, however, increase dramatically for persons over age 65. A better answer may be to purchase life insurance. If the insured needs long term care and, therefore, must use private funds to pay for such care, the insurance proceeds will some day "replace" the assets spent on long term care. Life insurance assures that the insured's heirs are not "disinherited" by the high cost of long term nursing care. In the event that the insured never requires long term care, then upon the death of the insured, the heirs will receive a larger inheritance.
9. Charitable planning
Even without transfer taxes, many charitably inclined persons will want to make lifetime gifts to their favorite charities. The advantages of naming a charity as the owner, beneficiary, and premium payer of a life insurance policy are numerous. First, the insurance proceeds eventually will provide the desired capital gift for a comparatively small outlay in the form of premium payments. Second, each year the donor-insured will receive an income tax deduction equal to the premium payments gifted to the charity (subject to the 50 percent of adjusted gross income deduction limitation). Third, because only the purchase of life insurance is involved, there are no complex details to be handled. Fourth, if the donor is unwilling or unable to gift future premium payments to the charity, the charity can either continue to make the premium payments or surrender the policy for its cash value. Finally, during the donor-insured's lifetime, either in the form of a loan or a partial surrender, the charity can access the policy's accumulated cash values to meet an emergency need.
10. Avoiding income taxes on retirerment plans
Contributing to a retirement plan or IRA is perhaps the best way to accumulate wealth because of the combination of tax-deductible contributions and tax-deferred savings. Such plans, however, are the worst way to distribute wealth because of the double tax (estate and income taxes) imposed on the distributions. Even without an estate tax, upon the death of the surviving spouse the children must begin taking distributions and incurring income taxes. A better strategy for a charitably inclined IRA owner might be to withdraw cash from the IRA or pension plan, pay the income tax, and use the after-tax proceeds to purchase a life insurance policy for the benefit of the participant's heirs. The policy would have a face value equal to the IRA's projected value at the death of the participant. After the participant has died, the heirs would receive the insurance proceeds income tax free, and the balance in the retirement plan could pass to charity or to a private foundation -- income tax free. For a married participant, a survivorship policy can be used. The only "loser" in this scenario is the IRS.
While it is impossible to predict what lies in store for transfer taxes, for the many reasons described above, life insurance is uniquely suited to handle many non-estate tax issues commonly confronted in estate and financial planning.
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