Life Insurance as an Estate Planning Tool

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Life Insurance as an Estate Planning Tool

Life insurance can create an immediate estate for the insured person and provide funds that will help preserve the greatest amount of value in the estate. The field of estate planning is very complicated. It requires expertise in the areas of wills, taxes, law and life insurance.

Federal estate tax is a tax on the right to transfer property. It is based on the fair market value of your property and is usually due within nine months of death. The tax must be paid before your ,beneficiaries receive their inheritance. (As we've seen before, this tax does not apply to insurance proceeds-only the rest of the things you leave to people when you die.)

The Role of Wills and Trusts

One of the biggest reasons that people create wills and trusts is to eliminate any family conflict regarding the distribution of money.

Example: Barry and Iris have children ages 2, 12, and 18. They are in their 40's. The distribution of, assets is needed to ensure that money will be available to the guardians monthly for normal expense and also, a lump sum for college. Monies remaining would be distributed equally when each child reached the age of 21. Iris was concerned that no one particular child feel less important than the others. She and her husband decided that, at age 21, the children were to receive 10 percent of their designated lump sum. This required a document which set out the terms for paying out the mpney in the right way. Simply said, that money is an estate and that document is a trust.

Distributing the Estate

The first step in the estate planning process should be an ongoing analysis of your needs and objectives with emphasis on the changing needs of your beneficiaries and what property is, was and will be part of the estate.

This process is important because the needs and objectives of an estate are constantly changing. What is true of an estate plan today may certainly not be valid tomorrow:

Inter vivos transfers are made while the estate owner is still alive. Testamentary transfers are made by will after the death of the estate owner. More specifically, transfers can be made as wills, gifts, trusts or policy ownership under rights of survivorship.

One objective of estate planning that may be lengthy and expensive is probate. Although most people have heard the term probate and some have experienced it, the definition eludes them. In its most simplified form, probate is the process of:

• viewing and understanding a will
• determining the location and valuation of all properties
• determining creditors and paying them
• determining the identity of heirs
• resolving controversy betWeen concerned parties
• paying the agent and attorney for probate fees
• filing and paying current and past tax returns
• appointing guardians, if necessary
• appointing money management necessary
• distributing any remaining property for minors

A Trust as Beneficiary

A trust is formed when the owner of property (the grantor) gives legal title of that property to another (the trustee) to be used for the benefit of a third individual (the trust beneficiary). This fiduciary relationship allows the trustee to manage the property in the trust for the benefit of the trust beneficiary only. The trustee legally must not benefit from the trust.

While there are many benefits in naming a trust as beneficiary of an estate or life insurance policy-particularly for minor children-there are drawbacks as well. A trustee may charge a fee for managing a trust.

The way the trust's property is managed is often left up to the trustee, leaving the trust beneficiary powerless to intervene if the trust is poorly managed. Also, the trustee may not provide resources for the trust beneficiary as he or she or even the grantor would have wanted. The trust beneficiary must request resources from the trustee. He or she cannot make free use of the property in the trust. Trusts frequently own policies, as well-especially when avoiding estate taxes is an important priority.

The Insured's Estate as Beneficiary

It is rarely advised that an insured person's estate be named as beneficiary of an insurance policy. An insured person who is also the policy owner may direct that the policy proceeds be payable to his or her executors, administrators or assignees. Such a designation might be made in order to provide funds to - pay estate taxes, expenses of past illness, funeral expenses, and any other debts outstanding prior to the settlement of the estate.

Making your estate the beneficiary of your insurance results in your insurance --being included,in your estate for estate tax purposes. Also, this subjects your insurance to being probated.

In addition, it's sometimes not desirable to name the estate as beneficiary because the insurance proceeds are then subject to the claims of creditors. This situation may not be what you intend when naming the estate as beneficiary:

One of the unique features of life insurance is that the life insurance proceeds are exempt from the claims of the insured person's creditors as long as there is a named beneficiary other than the insured person's estate. Even the cash value of a life insurance policy is generally protected from creditors.

Issues of Insurance Benefits Going to Children

The typical upwardly mobile family has several hundred thousand dollars of life insurance. If both parents were killed together, the children inherit the total estate and the life insurance cash on their eighteenth or twenty-first birthday, depending on the state.

Most children are not prepared for this responsibility, some of the typical problems young people fall into are that:

• they may squander the money
• they may marry, get divorced and lose half of the inheritance in a divorce settlement
• they may entangle the money in poor investments, judgments, IRS liens, etc.

To allow hundreds of thousands of dollars to be controlled by inexperienced decision makers is irresponsible estate planning. A better approach is to structure the distribution in a trust. This allows the inheritance to coincide with greater maturity.

If insurance proceeds are held in a trust and distributed over time, children are less likely to be included in a divorce settlement, bankrupcy or lawsuit. While these unhappy events can happen at any age, they're more likely to be more costly when they happen early. Hopefully, by the time a child has reached his or her 30s, he or she will become more aware of risks.

As we've seen, if you make arrangements for the proceeds of insurance or other assets to be put into a trust, a trustee will manage the funds.

Example: You designate your brother as the trustee of your estate because he is financially prudent and reliable. He will have a set limit (chosen by you) of monthly funds to distribute to the guardian to accommodate your children's personal needs and expenses. You can also designate other amounts to be used for special needs as the children growsuch as buying a car, going to college, or getting married.

The person you designate to manage the money is not necessarily the same person you must choose to raise your children. You may know a person who is great at financial matters but not good with children. You also may know someone who would be perfect with children but unable to afford it. You can solve this kind of problem by choosing different people for different tasks.

You may have three different people for these tasks:

• The trustee executes the terms of the trusts.
• The guardian takes care of the children.
• The money manager manages the money.

In most states minors are under court supervision until they reach a legal age. In some states, the proceeds of your estate may be inlaid in a court imposed custodianship until your child teaches 18 or even 21 in some state. To avoid this, you may leave your proceeds to a living trust created for the dependent of your beneficiaries. By designing and imposing this trust your proceeds will avoid probate.

Three Rules to Save Millions

Ru1e #1: Gifts that reduce the size of your estate are reducing the tfIX. Therefore, gifts are estate tax deductible.

Conclusion: Give away as much as you can comfortably afford during your lifetime as gifts and annual gifts.

Rule #2: Pre-paying estate tax using tax-advantaged life insurance is substantially more cost effective and lower risk than' deferring the tax.

Conclusion: Purchase estate tax free life insurance-the earlier the better.

Ru1e#3: Relinquishing control through various asset transfers and trust planning is a necessary shift in thinking in order to get the full benefit of rule number 1 and rule number 2.

Sam and Ida Billings are approaching a successful real estate investment careers, they have decided to focus on maximizing their children's and grandchildren's inheritance.

They estimate their net worth to be $6,000,000-and most of this is tied up in real estate. They believe the value of their holdings will increase and they have plenty of cash flow to retire. They want to apply rule number 1 to reduce their estate through lifetime and annual gifts.

Sam and Ida can give $600,000 in non-cash assets each during their lifetime-for a total of $1,200,000. They decide to . gift (this is a common estate-planning term) real estate property with the greatest potential for appreciation.

They had recently purchased an apartment building valued at $1,200,000. By giving their children the property, they have shifted $1,200,000 out of their estate and shifted all of the future growth to their children.

In the years after Sam and Ida started their estate planning, local commercial real estate tripled in value. The $1,200,000 million in property was soon worth $3,600,000, and the rental income going to their children kept pace with inflation. What's more, the gift of $1,200,000 million reduced the growth of Sam and Ida's estate by $ 2,400,000- that meant more than $1,000,000 of estate taxes saved.

Any individual can gift up to $10,000 per year per person. Gifts in excess of this $10,000 annual capital require that a gift tax return be filed.

Therefore the Sam and Ida may give $10,000 each to each child for a combined gift of $20,000 per child. With two children, the Billingses can gift $20,000 times two-for a total of $40,000 annually-without incurring any gift tax. And gifts are not restricted to children. They can be . made to family members, friends, enemies, grandchildren, charities, etc.

Sam and Ida were ready to begin their annual gifting program when their attorney suggested that they could leverage the gifts with life insurance.

Their attorney estimated that the estate taxes on a $6,000,000 estate would be approximately $3,000,000 (since they had already gifted the $1,200,000 asset, the tax was applied to the full $6,000,000). He posed three options to pay the taxes:

• Forced Sales to Raise Cash for Taxes. In order to get $ 3,000,000 of cash for taxes, they would be forced to sell more than half of their entire real estate holdings. He explained that if the market was depressed, it could be even more costly to sell. In addition to the forced sale of prime properties, Sam and Ida would lose the future income on real estate, the depreciation and future appreciation for their children. This was quite upsetting since they had planned to pass the real estate to their children for their future.
• Borrow to Raise Cash for Taxes. An alternative to selling the properties would be to borrow at current rates. The Billingses calculated the cost of borrowing the long-term debt service and lost income and did not like that option.

Pre-pay Estate Tax with Annual Gifts to Children. The third alternative was to use the gifts to the children for purchasing life insurance to pay the inevitable tax. The gifts reduced the estate, and by having the children purchase the life insurance on Sam and Ida, the proceeds of the insurance would be income tax free and estate tax free. This was their best solution.

Isn't Life Insurance Always Tax Free? Despite what we've said before, the answer here is only a qualified yes. There are some frequent basic misunderstandings about the tax free nature of life insurance.

Death proceeds pass to a spouse income and estate tax free (as can all other assets). If the insured person owns the policy upon death, the death benefit is included in the taxable estate (just like all other assets). If children or a trust own the policy, then neither the policy, cash value, nor death benefit is included in the taxable estate.

Probate can also be avoided by properly owning assets, by properly designating life insurance proceeds, by properly designating the beneficiaries of employee fringe benefits, and by creating and funding a living trust.

The Unfunded Irrevocable Life Insurance Trust

The unfunded irrevocable life insurance trust is an estate and income tax planning tool for use in solving a variety of problems. It can be used to:

• protect and preserve assets
• manage assets professionally where the beneficiaries may be unable, by way of disability, minority, or lack of expertise, to manage the assets adequately
• avoid probate (court supervision of the property)
• provide a source of estate liquidity by allowing the trustee to buy assets from or loan assets to the grantor's estate
• create tax exempt wealth
• save taxes in general

It accomplishes the last two points by:

• lowering or freezing the value of an estate by the grantor divesting himself of ownership of the property
• passing estate taxes by keeping the principal out of the estates of grantor and the grantor's spouse

Living Trusts

Historically; trusts of any kind were considered a tool for the rich to avoid tax burdens. But living trusts have become a standard planning technique for millions of Americans to avoid probate and organize their affairs.

If you complete the beneficiary portion of your insurance application as estate, your insurance proceed§ will go through probate. However, life insurance proceeds that are payable to adult beneficiaries or, living trusts escape the process of probate.

Conclusion

A simple estate with limited assets and one with no controversy may be probated in one to two years. However, properties, businesses, multiple beneficiaries and family conflicts cause probate to be an expensive, long and drawnout process. The primary complaints against the probate system are that it is public, time consuming, expensive, and puts control in the hands of the courts.