Top 10 Uses of Life Insurance in Non-Taxable Estates

While there is a present lapse in the estate andpass to the other children.
generation-skipping transfer taxes, it's likely that7. Annuity Arbitrage.
Congress will reinstate both taxes (perhaps evenMany people, who are adverse to the stock market's
retroactively) some time during 2010. If not, on Januarydaily fluctuations, prefer to park their investments in
1, 2011, the estate tax exemption (which was $3.5municipal bonds or certificates of deposit (CDs). In
million in 2009) becomes $1 million, and the top estateexchange for this security, the yield on these
tax rate (which was 45% in 2009) becomes 55%.investments is quite low. A better alternative to
However, it is the author's opinion that the estate taxmunicipal bonds and CDs in many cases is a
exemption will be at least $3.5 million once Congresssingle-premium immediate annuity contract. Not only is
acts.the annuity a safe investment (based on the strength
Estate planners commonly use life insurance as aof the carrier), it invariably will produce a significantly
method of paying estate taxes. But, according to thehigher yield than muni-bonds or CDs. The problem with
Tax Policy Center, only 5 out of every 100,000 peoplean annuity is that the payments cease when the
have estates over $3.5 million. Thus, for mostannuitant dies. Accordingly, unlike the case with
decedents the federal estate tax has been repealed.muni-bonds or CDs, the annuity owner's children will not
Nevertheless, for the reasons described below, lifeinherit the annuity. The solution is to purchase a life
insurance can still play a significant role in a non-taxableinsurance policy to "replace" the wealth lost when the
estate.annuitant dies. The cash to pay the premiums is
1. Capital Needs.generated from the increased cash flow from
Life insurance has long been used to protect young"converting" the muni-bonds and CDs into an
families from the disastrous effects of a breadwinner'simmediate annuity.
untimely death. It is the only way to guarantee that the8. Medicaid Planning.
potential shortfall in a family's capital needs will beFor a person to become eligible for long-term care
covered in the event of a premature death.Medicaid benefits (i.e., nursing home care), the recipient
2. Wealth Replacement.must have income and assets below frightfully low
Charitable remainder trusts are often used by peoplelevels (i.e., as low as $2,000 in some states). But, what
who wish to sell highly appreciated assets withoutabout those persons with substantial assets who are
generating any capital-gains tax liability. The mainnot financially eligible for Medicaid? What options are
drawback of using a CRT is that upon the death ofavailable to them to protect their assets from the high
the donor and the donor's spouse, the assetscost of long-term care? First, at least 60 months
remaining in the CRT pass to charity. A life insurancebefore applying for Medicaid (or 36 months for those
policy can be purchased for the benefit of the donor'sstates that have not enacted the Deficit Reduction
heirs to "replace" the wealth passing to charity.Act of 2005), the recipient can "divest" himself or
3. Estate Equalization.herself by gifting away all of his or her assets to
Most parents want to treat their children equally whenchildren and grandchildren. Many people reject the idea
dividing up their estate. But, this may prove impossiblebecause of the loss of control and financial
with family businesses in which only the children activeindependence, among other disadvantages. Second,
in the businesses are to receive the businesses. If thelong-term care (LTC) insurance can be purchased to
business' value exceeds the active children's share ofpay for such care. LTC insurance premiums, however,
the estate, it is impossible to treat the children equally.increase dramatically for persons over age 65. A
A simple solution is to use a life insurance policy as anbetter answer may be to purchase life insurance. If the
estate equalizer. The non-active children (or a trust forinsured needs long-term care and, therefore, must use
their benefit) would be the beneficiaries of the policy.private funds to pay for such care, the insurance
4. Creditor Protection.proceeds will some day "replace" the assets spent on
The cash value of a life insurance policy and/or thelong-term care. Life insurance assures that the
death proceeds from a policy may be protected frominsured's heirs are not "disinherited" by the high cost of
creditors based upon state law. The amount protectedlong-term nursing care. In the event that the insured
varies from state to state, and may be dependentnever requires long-term care, then, upon the death of
upon who are the beneficiaries of the policy. Forthe insured, the heirs will receive a larger inheritance.
example, some states only protect a policy's cash9. Charitable Planning.
value and death proceeds if the insured's spouse andEven without transfer taxes, many charitably inclined
or children are the beneficiaries of the policy.persons will want to make lifetime gifts to their favorite
5. Second Marriages.charities. The advantages of naming a charity as the
When children from a previous marriage are involved,owner, beneficiary, and premium payer of a life
estate planning becomes more complicated. Take theinsurance policy are numerous. First, the insurance
example of a second marriage in which the husbandproceeds eventually will provide the desired capital gift
has children from a previous marriage. The husbandfor a comparatively small outlay in the form of
establishes a living trust that, upon his death, providespremium payments. Second, each year the
his wife with income and principal as needed todonor-insured will receive an income tax deduction
maintain her accustomed standard of living, with theequal to the premium payments gifted to the charity
remainder passing to his children at his wife's(subject to the 50% of adjusted gross income
subsequent death. This approach has two problems.deduction limitation). Third, because only the purchase
First, the children have to wait until their stepmother'sof life insurance is involved, there are no complex
death to inherit their father's wealth. Second, as thedetails to be handled. Fourth, if the donor is unwilling or
remainder beneficiaries of the trust, the children haveunable to gift future premium payments to the charity,
legal rights to challenge the distributions from the trustthe charity either can continue to make the premium
to their stepmother if those distributions exceed (in thepayments or surrender the policy for its cash value.
children's opinion) the amount called for by the trust. AFinally, during the donor-insured's lifetime, either in the
solution to these problems is life insurance on theform of a loan or a partial surrender, the charity can
husband's life. The policy beneficiaries can be either theaccess the policy's accumulated cash values to meet
wife or the children. If the wife is the beneficiary, thean emergency need.
husband can leave his estate to his children (either10. Avoiding Income Taxes on Retirement Plans.
outright or in trust). Alternatively, if the children are theContributing to a retirement plan or IRA is perhaps the
beneficiaries, the husband can leave his estate to hisbest way to accumulate wealth because of the
wife outright. In either case, the second wife and thecombination of tax-deductible contributions and
children from the first marriage will have no financialtax-deferred savings. Such plans, however, are the
involvement with one another after the husband'sworst way to distribute wealth because of the double
death.tax (estate and income taxes) imposed on the
6. Special Needs Children.distributions. Even without an estate tax, upon the
A developmentally disabled individual is usually eligibledeath of the surviving spouse, the children must begin
for Supplemental Security Income (SSI), a federallytaking distributions and incurring income taxes. A better
funded program administered by the states, uponstrategy for a charitably inclined IRA owner might be
reaching age 18. Prior to age 18, SSI eligibility isto withdraw cash from the IRA or pension plan, pay
dependent upon the parents' income and assets. SSIthe income tax, and use the after-tax proceeds to
eligibility generally is accompanied by eligibility forpurchase a life insurance policy for the benefit of the
Medicaid, a state-administered federal program whichparticipant's heirs. The policy would have a face value
primarily provides medical assistance. Many parentsequal to the IRA's projected value at the death of the
are skeptical about the future and/or level of the SSIparticipant. After the participant has died, the heirs
and Medicaid programs. As a result, they establish (atwould receive the insurance proceeds income tax
the death of the surviving parent) a "special needs"free, and the balance in the retirement plan could pass
trust for the benefit of the disabled child. A specialto charity or to a private foundation - income tax free!
needs trust is designed to "supplement" SSI andFor a married participant, a survivorship policy can be
Medicaid without disqualifying the child from anyused. The only "loser" in this scenario is the IRS.
government assistance. Unfortunately, the specialConclusion.
needs trust strategy provides little consolation to thoseWhile it is impossible to predict what lies in store for
parents who do not have funds to provide for theirtransfer taxes, for the many reasons described above,
disabled child or for parents who eventually wouldlife insurance is uniquely suited to handle many
have to disinherit their other children to providenon-estate tax issues commonly confronted in estate
adequately for the disabled child. A solution to both ofand financial planning.
these problems is for the parents to purchase aTO THE EXTENT THIS ARTICLE CONTAINS TAX
survivorship life insurance policy. The policy would beMATTERS, IT IS NOT INTENDED OR WRITTEN TO
owned by the parents and payable to a special needsBE USED AND CANNOT BE USED BY A
trust tor the benefit of the disabled child at theTAXPAYER FOR THE PURPOSE OF AVOIDING
surviving parent's death. Upon the death of thePENALTIES THAT MAY BE IMPOSED ON THE
disabled child before the complete distribution of theTAXPAYER, ACCORDING TO CIRCULAR 230.
trust property, the assets remaining in the trust can