This article will discuss estate planning for people whose net worth exceeds the amount that may be protected by the estate tax exempt amount ($675,000 in 2001, $700,000 in 2002) but is less than, $3 million.
These taxpayers should be (although some are not) concerned about the effect of the federal estate tax on their estates (and ultimately their heirs), but may not consider themselves wealthy enough to utilize estate planning techniques that require their divesting themselves of substantial assets. Many estate-tax reduction techniques involve estate reduction-that is, getting rid of assets. The “rub” is that these individuals often rely upon the income from these assets to maintain their standards of living.
Many people may be in this $675,000-$3,000,000 “moderate estate” category, but may not realize it. Some clients do not know that life insurance policies over which they retain “incidents of ownership”, such as the right to designate or change the beneficiary-this would include many employer-provided group term policies– are includible in their gross estates. In some estates, the dramatic appreciation in many IRA and 401(k) portfolios-and the increased value of unexercised stock options– resulting from recent stock market advances has made millionaires of many people who consider themselves merely “working stiffs”.
Consider Mr. Hypothetical, whose wife has predeceased him and who owns a residence worth $500,000, a stock portfolio worth $500,000 and an insurance policy whose beneficiary he has just changed from his wife to his children. The total value of his gross estate is $1,500,000. Ignoring administration costs and assuming no debts, the federal estate tax liability on his death, assuming full use of the exempt amount and the state death tax credit, is $270,850. If somehow we reduce his gross estate to $1,000,000, the estate tax liability would be $92,050-a savings of $178,800, or just under 36%. If the asset values are increased to a total of $3,000,000, the federal estate tax is $888,250. A reduction in the gross estate by $500,000, to $2,500,000, would result in a federal estate tax of $666,450, for a savings of $221,800, or over 44%.
This article will briefly discuss one of the more common techniques that may be utilized to help taxpayers with life insurance achieve estate tax reduction without divesting themselves of assets necessary to preserve their standards of living.
Eliminate Life Insurance from the Gross Estate
Life insurance is an asset that generally is not utilized during the insured’s lifetime, when it has a relatively low asset value (the policy’s cash surrender value) and does not produce income-but it mushrooms into a full-blown (and fully taxable) estate asset upon the death of the insured. Although life insurance is generally not taxable for Pennsylvania Inheritance Tax purposes, a policy owned by the insured is subject to federal estate tax, at rates that may exceed 50%. If your client does not anticipate needing to borrow from her policy-virtually the only way to benefit from the policy while alive-she should consider divesting herself of the policy. While the client is alive, the amount of the transfer would be the relatively small cash value of the policy-or the paid but unearned premium in the case of group term policy. If she retains incidents of ownership over the policy until her death, the whole face amount will be includible in her federal gross estate and subject to tax.
Consider Mr. Hypothetical, whose wife has predeceased him and who owns a residence worth $500,000, a stock portfolio worth $500,000 and an insurance policy whose beneficiary he has just changed from his wife to his children. The total value of his gross estate is $1,500,000. Ignoring administration costs and assuming no debts, the federal estate tax liability on his death, assuming full use of the exempt amount and the state death tax credit, is $270,850. If somehow we reduce his gross estate to $1,000,000, the estate tax liability would be $92,050-a savings of $178,800, or just under 36%. If the asset values are increased to a total of $3,000,000, the federal estate tax is $888,250. A reduction in the gross estate by $500,000, to $2,500,000, would result in a federal estate tax of $666,450, for a savings of $221,800, or over 44%.
There are several ways to divest oneself of a life insurance policy. One is simply to give it away. This works best if the beneficiaries are adults. However, beware the results if a policy donee-a child of the insured, perhaps-predeceases the insured and the policy is left by the donee to a beneficiary the insured does not want to own the policy-maybe the child’s spendthrift spouse who will immediately borrow the policy’s entire cash value.
The solution-in this case and also in cases where some flexibility is desired, for example where the intended beneficiary is not competent, either by reason of tender age or other infirmity-is to gift the policy to a trust. In order to keep the death benefit from being included in the insured’s gross estate, the donor must live for three years following the transfer of an existing policy to a trust. A better alternative is, if possible, to have a new policy acquired by the trustee at the outset.
Gift Tax Ramifications
Making an absolute assignment of a life insurance policy to a third party is considered a taxable gift. If the insured policy donor continues paying the premiums to keep the policy in force, those payments are gifts to the beneficiaries. If the trust is structured properly, however, depending on the cash value, the amount of the premiums, and the number of beneficiaries of the trust, both the transfer of the policy to the trust and the premium payments may be gifts that qualify for the federal gift tax annual exclusion. As you know, the $10,000 annual per-donee gift tax exclusion is available only for gifts of “present interests” in property. The use of Crummey withdrawal powers and proper notices to the beneficiaries will convert a gift of a non-excludable future interest into a present interest gift qualifying for the annual exclusion, achieving true estate reduction without using any of the client’s available exempt amount. Clients of moderate wealth often do not make full use of the gift tax annual exclusion for the same reason they don’t give away assets: “That’s for rich people!”. This is a way to use those annual exclusions and achieve estate tax reduction.
Generation Skipping Transfer Tax Considerations
If a client names grandchildren or more remote descendants as beneficiaries of a life insurance trust, generation skipping transfer tax issues arise. The practitioner must recognize that even if insurance proceeds are not taxed in the insured’s estate, they may be taxable for GST purposes. There is a GST annual exclusion available to transfers to a trust only in the limited situation where the trust only has one beneficiary and the trust assets would be includable in the beneficiary’s gross estate if the beneficiary dies before the trust terminates. There is not room in this article to discuss the GST considerations, but practitioners should be aware that if distributions from an irrevocable life insurance trust will be made to “skip persons” (grandchildren or more remote descendants, or trusts for such individuals), GST tax will be payable unless the trust is exempt from the tax because GST exemption has been allocated to it. The GST exemption is currently $1,030,000 and is subject to indexing for inflation.
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