Successful business owners and professionals often have maxed out the tax deductible and elective deferral contributions to their qualified retirement plans, such as profit sharing, 401k, or Simplified Employee Pension (SEP) type plans. Often, this prompts questions to their financial professional on whether there are plans that could provide additional supplemental retirement income.  Is there a simple plan that can be offered selectively to S Corp, C Corp, or LLC shareholder-employees that can provide a special benefit plan just for the business owners on a tax-favored basis?

Yes. A non-qualified benefit that can be offered selectively, may provide a valuable retirement supplement to the business owner.  For instance, the business owner may have reached the 2016 limit of $18,000 for contributions to the company 401k plan.  Participants age 50 and over can increase their contribution limit to $24,000 by taking advantage of the $6,000 catch-up provision.  What else can be done for this business owner without including employees in the plan? 

The plan that could be attractive is known as a Section 162 Executive Bonus Plan which can be selectively provided to the business owner.  The financial product that may provide the best accumulation vehicle for a supplementary retirement benefit is a specially designed life insurance product that takes advantage of the tax-favored benefits of life insurance found in the Internal Revenue Code (IRC).

IRC Tax Benefits Available to Life Insurance

The IRC offers a number of income tax benefits to life insurance that are not available to other financial products like stocks, bonds, bank accounts, U.S. government securities, and non-qualified annuities.  These other financial products will have income or capital gains taxation on yields or gains as the asset grows in value or as gain amounts are withdrawn.  The taxation of gain amounts will diminish the after-tax amounts available to provide future retirement income.  Here are some life insurance tax advantages that are not available to these other financial assets:

• Death benefits of life insurance are income tax-free under IRC Section 101(a)(1).  The death benefit will self-complete the retirement plan for the family if the business owner dies prior to retirement.
• The annual cash value growth of any type of permanent life insurance product grows tax deferred.  This is the same tax deferral available to non-qualified annuities and stocks or equity mutual funds.
• Most importantly, life insurance withdrawals of the cash value up to cost basis can be made tax free on a first-in / first-out (FIFO) basis under IRC Section 72(e)(5)(A) and (C).
• Loans from life insurance cash value can also be made tax-free under IRC Section 72(e)(5)(A).

To obtain the tax-free withdrawal and loans from a life insurance policy, the policy must NOT be classified as a Modified Endowment Contract (MEC), where too much premium is paid into a life insurance policy for a given face amount.  A MEC can result by a failure to meet the so-called 7-pay test of IRC Section 7702A.  IRC Section 72(e)(10) states that both withdrawals and loans from a MEC in a gain position will be taxed on a last-in / first-out (LIFO) basis.  In other words, gain amounts come out first as taxable income in the same way as a withdrawal of LIFO gain amounts from non-qualified annuities are taxed.

So, based on the IRC income tax rules for life insurance listed above, how might we design a selective Section 162 Executive Bonus plan funded with life insurance?  How can we efficiently accumulate the most cash value for a given amount of life insurance death benefit while still maintaining the tax-favored non-MEC status of the policy?  Let’s take a look at the following case study of a successful small business owner who has maxed out contributions to the company 401k plan.

Case Study of S Corp Owner-Employee with Maxed-Out 401k Plan Contributions

Mr. Wilson is a successful 100% shareholder-employee of an S Corp and is currently 50 years old and is in a 40% federal and state income tax bracket.  His company provides a 401k plan to its employees.  He plans on making the maximum $24,000 contribution to his 401k plan account in 2016 which includes a catch-up amount for the first time.  He asks if there is anything else he can do for his own retirement that will provide good tax benefits while accumulating a supplementary retirement account.  The company can afford to allocate $80,000 of cash flow to a selective benefit just for this purpose.  Here is a plan design that may interest him:

IRC Section 162 Bonus Plan Funded by Minimum Death Benefit Non-MEC Life Insurance

His S Corp pays a tax-deductible bonus of $80,000 to the S Corp owner (Mr. Wilson).  In a 40% tax bracket, the S Corp owner uses $32,000 for income taxes and allocates $48,000 per year into a personally owned Indexed Universal Life (IUL) policy from a competitive carrier.  His net after-tax outlay is $0 because the extra taxable bonus provides enough cash flow to pay both the personal income taxes and the annual premium outlay.

• The IUL policy is assumed to provide a hypothetical non-guaranteed indexed crediting rate of 6%.  The upper cap rate for this indexed product is 12%. This typical indexed life product has minimal downside risk of 0% subject to the annual cost of insurance charges.
• The minimum non-MEC death benefit for age 50 with preferred underwriting is $882,000.  The non-guaranteed death benefit grows to $1,268,000 by age 65 and then slowly starts to decline as tax-free distributions are made from the cash value.  By life expectancy (age 83 for current age 50), the non-guaranteed death benefit has declined to $768,000.  The Internal Rate of Return (IRR) on that age 83 death benefit is still a non-guaranteed 5.44%.  In a 35% tax bracket, the pre-tax equivalent IRR at life expectancy age 83 is 8.37%.
• The $48,000 annual premium is paid for just 7 years (age 57) so that the policy passes the 7-pay test to achieve non-MEC status under IRC Section 7702A.
• No additional premiums are paid from years 8-15 (age 65) to preserve non-MEC status.
• At age 65, the hypothetical non-guaranteed tax-free income stream of about $40,000 from the non-MEC will be paid from years 16-30 (age 80) to provide supplementary retirement income.  First, tax-free withdrawals of cash value up to the cost basis will be distributed.  When the cost basis has been adjusted down to $0, then a switch to tax-free policy loans will be requested.  Policy loan interest will be capitalized and added to the loan principal.
• In a 35% assumed tax bracket, the $40,000 of non-guaranteed tax-free FIFO policy distributions are equivalent to $61,538 of taxable income.
• The cost-of-insurance (COI) charges are minimized by the minimum death benefit non-MEC design.   This allows for a maximum non-MEC outlay into the policy to accrue cash value as soon as possible in the first 7 years.
• Depending on future business and personal circumstances, another 7-pay minimum death benefit non-MEC could be underwritten at age 57 to further supplement retirement income.
• Depending on future retirement and estate planning circumstances, the accumulated cash value of the indexed UL policy could be part of a future tax-free Section 1035 exchange to a no-lapse UL policy to provide a much larger tax-free death benefit.  This may be the case if future circumstances determine that any supplementary retirement income is not needed because other income sources are available.  Of course, new medical underwriting would be needed to complete the Section 1035 exchange.

Indexed Universal Life Policy Must Be Monitored Closely and Kept In Force

Keep in mind that the 6% assumed rate of return on the indexed accounts is not guaranteed.  The policy must be kept in force all the way until a tax-free death benefit is paid.  If the policy lapses due to poor performance or excess withdrawals or loans while the insured is still alive, a significant taxable event will take place.  A lapse of a heavily loaned policy in a gain position will generate a taxable Form 1099-R from the insurance carrier.

Since the adjusted cost basis will have been reduced to $0 in our plan design, the outstanding cumulative loan plus unpaid interest will be taxable income to the policy owner upon a lapse.  So, the policy must be closely monitored to make sure it never lapses.  Certain carriers have so-called over-loan protection riders to make sure a lapse will not occur and preserve some smaller amount of income tax-free death benefit.  If this over-loan protection rider is triggered in the future, no more withdrawals or policy loans will be allowed.

Contact your BSMG Life Advisor to discuss the Section 162 Executive Bonus plan funded by a 7-pay minimum death benefit non-MEC.  BSMG provides IUL policies with over-loan protection riders for your business owner and professional clients seeking a non-qualified supplementary retirement benefit.

Russell E. Towers  JD, CLU, ChFC

Vice President – Business & Estate Planning

Brokers’ Service Marketing Group

russ@bsmg.net

The post Non-MEC Executive Bonus Plans for Business Owners appeared first on BSMG.

Since June 20th, 1988, life insurance policies that do not meet the guidelines of the “7 Pay Test” of IRC Section 7702A are classified as Modified Endowment Contracts (MEC).  As such, any lifetime withdrawals or loans from the cash value of a MEC in a gain position will result in LIFO (last in-first out) taxable income to the extent of the gain (IRC Section 72(e)(10)).

This LIFO method is similar to the way withdrawals from deferred annuities in a gain position are taxed.  Alternatively, withdrawals up to cost basis and/or loans from the cash value of a non-MEC FIFO (first in-first out) life insurance policy are income tax-free.

Given the LIFO taxation of MECs and FIFO taxation of non-MECs, are there situations where a MEC could be recommended to finance estate tax planning, non-qualified executive benefit plans, or the tax-efficient asset management desires of wealthy clients?

Yes, and we have outlined 5 different situations where a MEC can provide tax-free leverage to efficiently finance certain advanced planning objectives:

1)     Life Insurance Owned by an ILIT Funded by a Lump Sum Gift of any Amount Up to the Current Lifetime Gift Exemption of $5,450,000 for an Individual, or $10,900,000 for a Married Couple

• A single-pay MEC premium of up to $5.45 million / $10.90 million would buy a very large no-lapse Universal Life (UL) or no-lapse Survivorship Universal Life (SUL) policy owned by the ILIT.  For instance, a $5,450,000 single pay premium for a competitive no-lapse SUL on a Male 70 preferred / Female 70 preferred will purchase a guaranteed death benefit of $16,243,000.  The internal rate of return (IRR) at joint life expectancy (20 years) is a very competitive 5.61% in this continuing low-interest economic environment.  Assuming a 35% combined income tax bracket, the pre-tax equivalent IRR is 8.63%.

• This concept also works well for a Dynasty Generation Skipping type of ILIT where the estate owner can allocate $5,450,000 of generation-skipping exemption to the lump sum gift.  The filing of the 709 U.S. Gift Tax return form would concurrently allocate both the regular lifetime gift exemption and the generation-skipping exemption. Dynasty type of ILITs work well in states that have extended the rule against perpetuities far into the future and also have no state income taxes on trust income (i.e. Alaska, Delaware, Nevada, South Dakota).

• The cash value of the no-lapse SUL MEC will never get into a gain position so there is never any potential of lifetime LIFO taxation.  Also, the death benefit from the single pay MEC is also income tax-free and estate tax-free.

2)     Life Insurance Owned by an ILIT Funded by a Lump Sum “Private Split Dollar Economic Benefit” Transferred of Cash from the Estate Owners to the ILIT

• A single pay MEC premium to purchase a no-lapse UL or SUL policy will provide an income and estate tax-free death benefit.  The policy may have growing cash value for a period of time before the cash value starts to trend downward and eventually falls to zero.

• The private split dollar interest of the estate owners will typically be defined in the written agreement as the GREATER of the cash value or the cumulative premiums paid.  For a typical no-lapse UL or SUL policy design, the interest of the estate owners will be the lump sum premium paid.  At death, this lump sum amount will be returned to the estate of the deceased and included in the gross estate at a 40% estate tax rate.  The remaining net death benefit paid to the ILIT will be estate tax-free.

• During the lifetime of the insured(s),  the only reportable gift for gift tax purposes are the low Table 2001 economic benefit rates for single life policies and the super-low joint life Table 2001 economic benefit rates for survivorship policies.

• This very low reportable value for gift tax purposes is ideal for estate owners who have used most of their $5.45 million / $10.90 million lifetime gift exemptions on prior gifts and don’t want to make any taxable gifts resulting in lifetime gift taxes at a 40% rate.

• Keep in mind that the current lifetime gift exemption of $5,450,000 is indexed each year and has been growing by a rate of 1-2% since 2012 when indexing became permanent.

• See Treas. Regs. 1.61-22(d) for detailed tax rules for split dollar economic benefit regime plans.

3)     Life Insurance Owned by an ILIT Funded by a Lump Sum “Private Split Dollar Loan” Transfer of Cash from the Estate Owners to the ILIT   

• A single pay MEC premium for a no-lapse UL or SUL policy will provide an income and estate tax-free death benefit.  The estate owners execute a written private split dollar loan agreement locking in the current long term AFR rate as the interest rate for the lump sum loan.  The current long term AFR rate is 1.90% and will be considered an imputed gift to the trust each year.

• For example, if a $5,450,000 private loan is made to the ILIT, the annual imputed interest gift to the trust annually will be $5,450,000 x 1.90% = $103,550.  This imputed gift of $103,550 each year should be easily covered by annual gift tax exclusions and/or annual indexing of the lifetime gift exemption.  So, in most cases there should be little or no cumulative taxable gifts which would result in any lifetime gift taxes.

• At death, the $5,450,000 loan principal will be repaid to the estate from the total tax-free death benefit paid to the ILIT.  This amount will be included in the gross estate for estate tax purposes as a loan receivable and subject to estate taxes at a 40% rate.  The net death benefit remaining in the ILIT will be estate tax-free.

• See Treas. Regs. 1.7872-15(e) for detailed tax rules for split dollar loan plans.

4)    Corporate-Owned Life Insurance (COLI) to Fund a Cost-Recovery for a     “Non-Qualified Salary Continuation” Agreement for a C Corp Executive

• A single pay MEC premium will generally provide an income tax-free death benefit to the corporation to provide cost-recovery for the employer’s costs of providing the lifetime salary continuation benefit.  Rather than buying a cash accumulation type of non-MEC policy and making tax-free withdrawals and loans from the policy to pay the salary continuation benefits, the company buys a lower cost single pay no-lapse MEC.

• Instead the company will pay the tax deductible salary continuation benefits to the executive at retirement from the future operating revenue of the firm.  A single pay no-lapse MEC allows the company to recover its costs of providing the deferred retirement benefit to the executive.  These costs will equal the lump sum single premium paid plus the cumulative net after-tax cost of the annual tax-deductible salary continuation benefit payments.  These salary continuation benefits are taxable to the executive when received.

• The cost recovery death benefit paid to a C Corp may be subject to the corporate alternative minimum tax (CAMT) in the year of death.  However, the corporation will receive a dollar for dollar corporate tax credit on their Form 1120 in the subsequent tax year for any CAMT actually paid.  Thus the only financial cost is a minimal time value of money cost between the time any CAMT is paid and the time when the corporation receives the tax credit in the following tax year.

5)     “Private Placement Insurance” for Ultra-Affluent Clients Desiring to Make Their Asset Portfolio More Income Tax Efficient

• When ultra-affluent clients, including those with a Family Office wealth management structure, desire to make their asset portfolio more income tax efficient, then the cash-rich private placement MEC may serve to balance their portfolio.

• These types of clients may have assets which produce significant interest, dividends, capital gains, rental income, and K-1 pass-through income of S Corps, LLCs, or partnerships.  A Private Placement type of insurance policy that’s a MEC can give them tax-deferred growth.  Many of these mega-rich may not be too concerned about future LIFO taxable withdrawals or loans from a cash-rich MEC.  They may even decide to simply hold the MEC until death which would result in an income tax-free death benefit.

• In addition, the life insurance wrapper that holds the underlying private placement assets can be tailored to suit the risk profile of the client.  Private Placement insurance plans often require a minimum cumulative premium commitment upwards of $5,000,000 for wealthy individuals known as a qualified purchaser.

• Private Placement life insurance must be filed with and approved by state insurance departments and comply with the IRC Section 7702 definition of life insurance.  The policy is typically designed with a minimum death benefit to accelerate tax-deferred cash value growth.  The policy may even be owned personally by the client as part of the client’s overall asset portfolio.  Premium payments options for qualified purchasers include a single pay of $5,000,000 (MEC) or a 5-Pay of $1,000,000 per year (non-MEC) for those clients who want to preserve the option of tax-free lifetime withdrawals and/or loans from the cash value.

Contact your BSMG Life Advisor when considering lump sum premium advances to fund any of the MEC planning concepts described in this article.  BSMG has access to competitive carriers that still provide lump sum premium payment designs.

Russell E. Towers  JD, CLU, ChFC                                                                                     

Vice President – Business & Estate Planning  

Brokers’ Service Marketing Group      

russ@bsmg.net     

The post When To Recommend a Modified Endowment Contract (MEC) appeared first on BSMG.

Successful C Corp, S Corp, and LLC business owners often want to use the cash flow from their business to pay life insurance premiums.  These premiums may be for either employer owned polices or for personally owned policies depending on the specific insurance protection needed.

Tracking the income tax effect of your business’s cash flow is an important part of understanding how business dollars can be used to pay annual insurance premiums.  The summary below highlights important income tax and FICA tax considerations that producers should understand when selling business or personal insurance to business owner clients.

C CORPORATION (C Corp): SEPARATE TAX ENTITY (Form 1120)

• For policies owned by the C Corp or QPSC:  The premium is a non-deductible expense to the corporation (IRC Section 264).  Since the premium is non-deductible, the annual premium amount will be part of the C Corp profit each year.  This U.S. Form 1120 profit (net income) will be taxed to the C Corp as a separate tax entity at C Corp tax rates.  These rates range from a low of 15% to a high of 39% depending on the amount of taxable profit (net income).

• Cash flow #1 for policies owned personally by the C Corp owner-employee:  If current business cash flow is used to pay premiums, the amount is deductible to the corporation as bonus compensation paid (IRC Section 162).  This amount is taxable to the C Corp owner-employee personally as W-2 compensation received.  Bonus comp is considered “earned income” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching corporate level.

• Cash flow #2 for policies owned personally by the C Corp owner:  The C Corp owner can make dividend withdrawals from the balance sheet Retained Earnings to pay premiums.  This withdrawal is considered to be a dividend distribution which is not deductible to the C Corp.  The dividend is taxable to the C Corp owner as dividend income.  For tax year 2016, this dividend distribution is taxed at a rate of 15%-20% depending on the total taxable income of the business owner.

S CORPORATION (S Corp): PASS-THROUGH TAX ENTITY (Form 1120S)

• For policies owned by the S Corp:  The premium is a non-deductible expense to the corporation (IRC Section 264).  Since the premium is non-deductible, the annual premium amount will be part of the S Corp profit each year.  This U.S. Form 1120S profit (net income) will be “passed-through” as K-1 income to the S Corp owner personally on Schedule E of the Form 1040 U.S. Income Tax Return.

• Cash flow #1 for policies owned personally by the S Corp owner-employee:  If current business cash flow is used to pay premiums, the amount is deductible to the corporation as bonus compensation paid (IRC Section 162).  This amount is taxable income to the S Corp owner-employee personally as W-2 compensation received.  Bonus comp is considered “earned income” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching corporate level.

• Cash flow #2 for policies owned personally by the S Corp owner:  The S Corp owner can use some end of year distributed K-1 pass-through profit to pay premiums.  As stated just above, this K-1 profit is taxable to the S Corp owner personally.  However, this S Corp profit is generally considered to be unearned passive income and therefore, is NOT subject to the FICA taxes levied on earned income.

• Cash flow #3 for policies owned personally by the S Corp owner:  The S Corp may have a previously taxed profit account, known as the Accumulated Adjustments Account (AAA) for tax accounting purposes.  This AAA is the cumulative amount of any previously taxed S Corp K-1 profits from prior years that have been left in the S Corp.  A tax-free withdrawal can be made from this previously taxed AAA to pay for personally owned insurance of the S Corp owner.  The AAA will be adjusted downward by the amount of the withdrawal.  There are no FICA taxes on AAA withdrawals which have been previously taxed as unearned income.

 
LIMITED LIABILITY COMPANY (LLC): PASS-THROUGH TAX ENTITY (Form 1065)

• For polices owned by the LLC: The premium is a non-deductible expense to the LLC (IRC Section 264).  Since the premium is non-deductible, the annual premium amount will be part of the LLC profit each year.  This U.S. Form 1065 profit (net income) will be passed-through as K-1 income to the LLC owners personally on Schedule E of the Form 1040 U.S. Income Tax return.  LLCs are generally treated as partnerships for income tax purposes.

• Cash flow #1 for policies owned personally by the LLC owners:  If current business cash flow is used to pay premiums, the amount is deductible to the LLC as guaranteed payment compensation.  This amount is taxable income to the LLC owners personally as compensation received.  Guaranteed payment comp is considered earned income and therefore, subject to self-employment FICA taxes. Keep in mind the OASDI earned income limit for self-employment FICA purposes.

• Cash flow #2 for policies owned personally by the LLC owners:  The LLC owners can use some of the distributed K-1 pass-through profit to pay premiums.  As stated just above, this K-1 profit is taxable to the LLC owners personally.  However, LLC profit is generally considered to be unearned passive income and therefore, is not subject to FICA taxes levied on earned income.

• Cash flow #3 for policies owned personally by the LLC owners:  The LLC may have a previously taxed profit account, known as the Capital Account for tax accounting purposes.  This Capital Account is the cumulative amount of any previously taxed LLC K-1 profit from prior years that have been left in the LLC.  A tax-free withdrawal can be made from this previously taxed Capital Account to pay for personally owned insurance of the LLC owners.  The Capital Account will be adjusted downward by the amount of the tax-free withdrawal.  There are no self-employment FICA taxes on Capital Account withdrawals which have been previously taxed.

As a general rule, it is important to ask business owner clients for permission to see their business tax returns so that sources of business cash flow can be identified to pay for insurance premiums.  These tax returns are:

(1) the Form 1120 U.S. Corporation Income Tax Return for C Corps

(2) the Form 1120S U.S. Income Tax Return for an S Corporation and

(3) the Form 1065 U.S. Return of Partnership Income for LLCs.  These returns can reveal potential tax accounting sources of cash flow described above to fund annual premiums for business or personal life insurance.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post Tracking Business Cash Flow to Pay Life Insurance Premiums For C Corp, S Corp, and LLC Owners appeared first on BSMG.

Many closely held businesses operate as S Corporation “pass-through” entities for federal income tax purposes. Some S Corps started out as C Corporations and converted to an S Corp a number of years ago. Often, questions arise on the income taxation of distributions of cash or assets from S Corps to the shareholders of those S Corps personally.

These S Corp shareholders often will need to use these S Corp distributions to fund personal financial objectives … like personally owned or trust owned life insurance to finance their personal protection, retirement income, or estate planning objectives.

A specific sequence and protocol must be followed under IRC Section 1368 when S Corp cash and/or assets are actually distributed to S Corp shareholders. Each “tier” of distribution must be reduced to zero before moving into the next tier of distribution. Here is the sequence of taxation that must be followed when these distributions take place. For simplicity, assume the S Corp shareholder owns 100% of the shares of the company. S Corps are “pass-through” tax entities where K-1 net profits are taxed to the S Corp shareholder personally on Schedule E of their Form 1040 U.S. Income Tax return.

Note: The S Corp distribution tiers described in this article are above and beyond any salary or bonus earned income paid to the S Corp shareholder as an employee.  Salary and bonuses are considered to be earned income subject to all FICA taxes for OASDI and HI.  S Corp tier distributions are not considered to be earned income and are not subject to FICA taxes.
S CORP DISTRIBUTION SEQUENCE WHEN ASSETS and/or CASH ARE TRANSFERRED TO THE
S CORP SHAREHOLDER PERSONALLY (IRC Section 1368)

Tier 1

All S Corp Net Profit (business income minus business expenses) for the current tax year is passed-through as K-1 ordinary income to the S Corp shareholder. For tax year 2016 and beyond, ordinary income may be taxed at a top federal rate of 39.6% for high income S Corp owners.  Plus, an additional 3.8% tax on passive interest and rental income as a result of the Affordable Care Act (ObamaCare) is still in effect for certain high earners.  The combined marginal tax rate on ordinary income for high income S Corp owners could be as high as 43.4%.

Tier 2

All S Corp Accumulated Adjustments Account (AAA) is distributed tax free to the S Corp shareholder. This AAA account is a tax accounting entry for all previously taxed K-1 income that has been left in the S Corp and was not distributed to the shareholder in prior tax years. Some professionals refer to this AAA account for S Corps as previously taxed profits or previously taxed income. This AAA tier of distribution is important to verify because it can provide a tax free technique to fund personal insurance needs. The most recent Form 1120S U.S. Income Tax Return for an S Corp would be a good source to verify the AAA account.

Tier 3

All locked-in retained earnings from S Corps that previously had C Corp status are distributed as a non-deductible dividend distribution to the S Corp shareholder. For tax year 2016 and beyond, qualified dividends are taxed at only a 15-20% federal rate.  Plus, an additional 3.8% tax on passive dividend income as a result of the Affordable Care Act (ObamaCare) is still in effect for certain high income earners.  The combined marginal tax rate on dividend income for high income S Corp owners could be as high as 23.8%.
To accelerate taxable dividend distributions from Tier 3 up to Tier 2, a tier switch under IRC Section  1368(e)(3) can be elected. Accordingly, S Corp owners can take advantage of this tier switch to unlock retained earnings from prior C Corp status and be taxed currently.

Tier 4
All Cost Basis which the S Corp shareholder has in the shares of the company is distributed tax free to the S Corp shareholder. This cost basis is the original capital with which the shareholder started the corporation PLUS any paid-in capital the shareholder added to the company over the years the company has been in operation. 

Tier 5
Finally, any additional asset value beyond Tier 4 cost basis is distributed as Capital Gain to the S Corp shareholder. For tax year 2016 and beyond, capital gains are taxed at a 15-20% federal rate.  Plus, an additional 3.8% tax on passive capital gain income as a result of the Affordable Care Act (ObamaCare) is still in effect for certain high earners.  The combined marginal tax rate on capital gain income for high income S Corp owners could be as high as 23.8%.

Example of S Corp Tier 1 and Tier 2 Distributions to Fund Life Insurance
Assume a 100% S Corp owner is 60 years old and is in the highest personal income tax bracket for 2016 (39.6%).  The S Corp has $400,000 of Tier 1 pass-through K-1 profit in the current year and $500,000 of Tier 2 previously taxed Accumulated Adjustment Account (AAA). The client wishes to make a tax free withdrawal from the AAA account to pay the taxes on the K-1 profit and use the full $400,000 of K-1 profit to fund personal financial needs using tax-favored financial products.

• Tier 1 K-1 Profit (Ordinary Income) … $400,000 x 39.6% = $158,400 tax.
• Tier 2 AAA … $500,000 – $158,400 withdrawal for tax = $341,600 remaining AAA

The $400,000 K-1 profit distribution can be placed in a personal side fund where annual withdrawals could be made to fund annual premiums for a non-MEC personally owned life insurance policy.  The policy could be no-lapse guaranteed UL policy, a current assumption UL policy, an indexed UL policy or a whole life policy depending on the retirement needs and risk tolerance of the S Corp owner.

Or the $400,000 K-1 profit distribution could be gifted using $400,000 of lifetime gift exemption to a no-lapse UL or no-lapse SUL policy owned by an Irrevocable Life Insurance Trust (ILIT) if estate tax free death benefits are required based on the facts of the case.
Contact your BSMG Advisor for a discussion of the life insurance funding possibilities for your S Corp clients.  Your Advisor will work with BSMG’s tax accounting and advanced planning specialists to design the most efficient insurance funding for your S Corp business owner clients.

Russell E. Towers   JD, CLU, ChFC

Vice President – Business & Estate Planning

russ@bsmg.net

The post Distributions from S Corps Can Fund Life Insurance Premiums appeared first on BSMG.

People purchase life insurance for a variety of reasons.  The income tax protection offered by life insurance on cash value accrual, withdrawals, and death benefits are well-known features.  An often overlooked feature of life insurance is the protection many states provide for life insurance against the claims of judgment creditors.  Every state has a creditor protection statute which addresses the issue of whether death proceeds and cash values are fully or partially exempt from the claims of creditors.

In cases where this issue arises, only the client’s legal counsel can provide advice based on the specific facts of the client’s situation.  However, it is often the life insurance producer who first brings this creditor protection issue to the client and legal advisor.

TYPICAL ASSET PROTECTION TECHNIQUES

Certain assets are protected under a variety of state and federal laws:

• The Internal Revenue Code and ERISA require qualified plans and IRAs to contain an anti-alienation statement which provides that a participant’s account cannot be assigned, alienated, or attached by legal process
• Titling a home (deed) in the sole name of a spouse of a professional prevents a judgment creditor (i.e. malpractice litigation) from forcing the sale of the house.  In a limited number of states, the same result may be accomplished by filing a homestead declaration
• Gifting assets to adult children or an irrevocable trust will remove the assets from the reach of judgment creditors.  However, attention should be given to the Fraudulent Transfer Acts in each state (Statute of Frauds), which generally prevents transfer of assets after legal process has been served.  Generally, real estate and non-qualified investments owned in the sole name of the debtor are assets that are most at risk of being reached by the claims of judgment creditors.

LIFE INSURANCE AS AN EXEMPT ASSET PROTECTED FROM CREDITORS

The typical life insurance exemptions only apply to personally owned or trust owned policies.  There is no exemption when life insurance policies are owned by business entity such as corporations, LLCs, and partnerships.  This distinction is important when the question is whether to own the life insurance inside or outside the business entity.

Also, if the life insurance is subject to a collateral assignment to secure a loan, the creditor already has a security interest in the contract, and any state creditor exemption statute will be of little or no benefit.

All states have some form of creditor protection for life insurance.  Many states fully protect life insurance death benefits and cash values from being reached by judgment creditors.  However, a small number of states only offer partial creditor protection up to certain specified dollar amounts.  State statutes are subject to legislative revision making it all the more important for a client to seek advice from legal counsel for the specific creditor protection rules in the state where they reside.

LIFE INSURANCE AND BANKRUPTCY

In the bankruptcy context, life insurance may be removed and exempted from the federal bankruptcy estate by the debtor and partially protected from bankruptcy creditors.  The federal Bankruptcy Code protects the actual insurance element of life insurance policies owned by a debtor (USC Section 522(d)(7)).

However, the federal Bankruptcy Code only protects up to a specified amount ($12,250 in 2016) of the debtor’s aggregate interest in any accrued dividends, interest, or loan values (net cash values) of policies owned by the debtor (USC Section 522(d)(8))

Some states allow a bankrupt debtor to choose between the federal bankruptcy exemptions or the state exemptions available in the non-bankruptcy context.  Other states do not allow a bankrupt debtor a choice of the federal bankruptcy exemptions and only allow the state’s exemptions in the non-bankruptcy context.  Often, these state exemptions will provide more liberal protection guidelines anyway than the limited federal bankruptcy exemption ($12,250 in 2016) for policy dividends, interest, or cash values.  Again, it is important for a client to consult legal counsel to determine whether his or her state of residence allows a choice between the federal bankruptcy exemptions and the state exemptions available in the non-bankruptcy context.

LIFE INSURANCE IS A SPECIAL ASSET WHICH ENJOYS PROTECTED STATUS UNDER LAW

One again, life insurance demonstrates that it is unique property to own when compared to other forms of property ownership.  A brief summary of life insurance advantages include the following:

• Cash value grows tax deferred
• Withdrawals up to cost basis and loans against cash value are tax-free (non-MEC)
• Death benefit is tax-free
• Death benefit can be arranged to be estate tax-free
• A high pre-tax equivalent internal rate of return on the death benefit
• Guaranteed lapse protection on certain type of policies
• Significant statutory creditor and bankruptcy exemptions available in most states.

For clients with personal, business, and professional situations which require a degree of asset protection planning, permanent cash value life insurance should be seriously considered.

BSMG Advanced Sales can provide the life insurance producer with specific citations of the creditor protection statutes of all 50 states.  This information can help you to focus your client on the statutes of their state in preparation for a more in-depth discussion with their legal advisor. This discussion can explore the merits of using cash value life insurance as part of their protection, cash accumulation, and asset protection strategy.

Russell E, Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net                                                                

The post Life Insurance Provides Creditor, Bankruptcy, and Tax Protection appeared first on BSMG.

With the recovery of the equities markets after the economic downturn of 2008-2009, it is common for successful business owners, professionals, and other individuals to have more than $1,000,000 in their IRA account. Many of these IRA owners have multiple sources of income as they approach their retirement years. These sources could include continued earned income from a profession, Social Security retirement benefits, K-1 “pass-through” income from ownership of S Corp or LLC entities, rental income from real estate, and other interest, dividends, or capital gains from non-qualified financial assets.

These IRA owners understand that Required Minimum Distributions (RMDs) must be taken from their IRA starting when they turn 70 ½. The question that typically arises in their financial planning is what to do with the after-tax amounts from their RMDs? For IRA owners with multiple sources of income, these after-tax RMDs are usually allocated as some form of inheritance to their heirs. Should these after-tax amounts simply be re-invested in their non-guaranteed financial asset portfolio or is there a more tax efficient way to re-allocate these funds that could provide a larger inheritance to their family?

The concept that can provide a larger after-tax inheritance is commonly known as the “Inherited IRA Legacy Plan” where after-tax RMDs are allocated to an annual premium for a no-lapse UL or no-lapse SUL life insurance product. The actuarial leveraging and income tax free life insurance death benefit can provide a larger inheritance by life expectancy and beyond than simply re-investing the after-tax RMDs in an asset portfolio with taxable yields. This is especially true in the continuing low-interest economic environment for fixed financial assets.

A Basic Blueprint for the “Inherited IRA” Using Life Insurance

Here are the steps of the “inherited IRA” transaction to provide a leveraged tax free fund for heirs in the form of life insurance:

First, create an income stream from the IRA by taking distributions from the IRA. An IRA owner doesn’t need to wait until age 70 ½ to take distributions from an IRA. Some IRA owners may wish to wait until 70 ½ while others may find it beneficial to start distributions prior to 70 ½. Starting prior to 70 ½ may work when coupled with a life insurance program because of the usual higher premium “cost of waiting”. Also, the onset of certain medical conditions as we get older that may result in less favorable underwriting may be a good reason to consider starting IRA distributions prior to 70 ½.

The income stream from the IRA is taxable, but the after-tax dollars can be used for a premium on either personally owned life insurance or insurance owned by an irrevocable life insurance trust (ILIT). The decision on personal ownership or ILIT ownership will depend on factors such as the size of the IRA gross estate in relation to the $5.34 million (single) and $10.68 million (married) federal estate tax exemption. Also, the simple size of the death benefit may dictate ownership by an ILIT whether or not the IRA owner has an estate large enough to worry about federal estate taxes. Certainly, many IRA owners may be exposed to state death taxes because of the lower state death tax exemptions of many states that still levy state death taxes.

Who shall be named as the beneficiary of the life insurance? Shall it be the children of the IRA owner outright or an ILIT for their benefit? Or shall it be an ILIT for the benefit of the grandchildren of the IRA owner?

Who shall be named as the beneficiary of the IRA? Shall it be the children of the IRA owner outright or a trust for their benefit so the “inherited IRA” can be paid over the children’s life expectancy? Or shall it be a trust for the benefit of the grandchildren so the “inherited IRA” can be paid over the longer life expectancy of the grandchildren?
Case Study of “Inherited IRA” Using After-Tax IRA Distributions for Life Insurance versus Using After-Tax Distributions for Alternative Fixed Financial Asset

Case Study of “Inherited IRA” Using After-Tax IRA Distributions for Life Insurance versus Using After-Tax Distributions for Alternative Fixed Financial Asset

Facts of Case Study:

Client and spouse are 71 and 70 respectively and have a current gross estate of $5,000,000. The client owns an IRA worth $1,000,000 and must start taking RMDs. They have other sources of retirement income including Social Security benefits, income from rental properties, and interest, dividends, and capital gains from their non-qualified asset portfolio. They ask you, their financial professional, to make a study of what to do with the after-tax RMDs that must start to be distributed from the IRA. Their combined federal and state income tax bracket is estimated at 35%. They feel that an after-tax return on their non-qualified asset portfolio is 5% going forward.

SCENARIO #1

Place After-Tax RMDs in an Asset Allocation Portfolio at 5% After-Tax Rate of Return (ROR)

• The factor from the Uniform Distribution Table for a 71 year old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
• This after-tax amount of $24,528 will be re-allocated each year into the non-qualified asset portfolio with an assumed after-tax ROR of 5%.
• The joint life expectancy of a male 71 / female 70 from the government joint life expectancy table is about 20 years.
• An annual deposit of $24,528 into a non-guaranteed financial asset for 20 years at 5% after-tax ROR would provide a fund value of $851,594. This is the hypothetical non-guaranteed amount that would be inherited by the heirs of the client and spouse.

SCENARIO #2

Place After-Tax RMDs in a No-Lapse Survivorship Universal Life (SUL) Policy for Male Age 71 (Standard NS) and Female Age 70 (Standard NS)

• The factor from the Uniform Distribution Table for a 71 year old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
• This after-tax amount of $24,528 will be re-allocated each year into a premium for a no-lapse SUL insurance policy issued by a competitive carrier.
• An annual premium of $24,528 will purchase a guaranteed SUL death benefit of $1,172,609 right from the beginning. This is the tax free amount the heirs would receive at the death of the survivor of the client and spouse. The IRR at year 20 joint life expectancy is 7.72%. In a 35% tax bracket, the pre-tax equivalent IRR is 11.88%.
• Instead, if very good health was able to provide a Male 71 Preferred NS and a Female 70 Preferred NS medical underwriting result, the $24,528 annual premium would purchase a guaranteed SUL death benefit of $1,351,838. The IRR at year 20 joint life expectancy is 8.90%. In a 35% tax bracket, the pre-tax equivalent IRR is 13.69%.

Summary of Benefits for “Inherited IRA” Plan with Life Insurance

The benefits of channeling after-tax IRA distributions into guaranteed no-lapse life insurance are significant. When compared to the taxable yields of alternative fixed financial assets (Money markets, bank CDs, bond funds, U.S. government securities), in the continuing low interest environment, the net results are truly outstanding.

1. The net inheritance to the heirs of the IRA- SUL life insurance plan shown above is hypothetically improved by about $321,000 at joint life expectancy (20 years) with “standard” medical underwriting when compared to alternative financial assets. The net inheritance to the heirs of the IRA-SUL life insurance plan is hypothetically improved by about $500,000 at joint life expectancy (20 years) with”preferred” medical underwriting when compared to alternative fixed financial assets.
2. the SUL life insurance provides a guaranteed no-lapse benefit versus a non-guaranteed accumulation value of the alternative fixed financial asset. The non-guaranteed “cross-over” point where the non-guaranteed financial asset hypothetically exceeds the guaranteed “standard underwriting” SUL insurance death benefit does not occur until year 25 when the younger insured, if still alive, is age 95. The non-guaranteed “cross-over” point where the non-guaranteed financial asset hypothetically exceeds the guaranteed “preferred underwriting” SUL insurance death benefit does not occur until year 27 when the younger insured, if still alive, is age 97.
3. The SUL life insurance could be owned by an ILIT so that the death benefit is estate tax free for state death tax purposes. The $5,000,000 taxable estate in our case study above would generate almost $400,000 of state death taxes in state which still uses the tax table from IRC Section 2011. Part of the SUL death benefit could be used to offset these state death taxes with the rest of the death benefit managed by the trustee for the benefit of trust beneficiaries.
4. The remaining IRA value at the death of the client is paid outright to children or to a separate trust for the benefit of children or grandchildren as an “inherited IRA”. The RMDs using the Single Life Table can be “stretched” over the remaining life expectancy of the children or grandchildren depending on the dispositive provisions of the trust document. Using this “inherited IRA” stretch method, the income taxes to the heirs are spread out and paid annually over many years into the future rather than paid in a lump sum and taxed all in one tax year.

Contact your BSMG Advisor if you have a client that has significant IRA values they never expect to use during their lifetime. Your BSMG Advisor can work with BSMG Advanced Sales to craft a plan to enhance the legacy of your client’s IRA using guaranteed no-lapse life insurance.

The post Creating an Inherited IRA Legacy Plan with Life Insurance Funded by After-Tax Distributions appeared first on BSMG.

Restricted Executive Bonus plans funded with life insurance offer a hybrid arrangement that bridges the gap between a deferred compensation plan and a regular executive bonus plan.  These plans are a great benefit for a company to offer to non-owner key executives to retain and reward them for their valuable services.

A)    An employer may like the benefit control afforded by a Deferred Comp plan with a company owned life insurance policy to informally fund the agreement and a vesting schedule in the deferred comp agreement.  But, the employer may object to the non-deductibility of deferred amounts and premium payments for tax accounting purpose.  Also, the employer may object to the booking of the deferred comp liability on the company balance sheet for GAAP and FASB purposes.

B)    Conversely, a regular Executive Bonus plan provides a current deduction to the company (IRC Section 162) and current taxation to the executive.  However, the corporation has no control over the bonus once it has been paid to the executive in the form of a premium for personally owned insurance policy.  Also, the executive can leave the company for other employment at any time with no loss of the benefits (i.e. policy cash value) on bonuses already received.

C)    The Restricted Executive Bonus plan gives the corporation a current deduction PLUS control of the benefit provided in the form of forfeiture language in a restricted bonus legal agreement.  If the executive leaves the company for other employment prior to the full vesting according to the written agreement, the executive may lose some of the benefits (i.e. cash value) provided in the insurance policy

PLAN DESIGN FEATURES AND INCOME TAXATION

• A written agreement is executed where the employer agrees to pay an annual bonus subject to partial forfeiture of cumulative bonuses if the employee terminates during the vesting period (i.e. 5-10 years).  A forfeiture during the vesting period would require the executive to reimburse some amount of the cumulative bonuses back to the corporation. The corporation would have to declare any reimbursements as taxable corporate income
• The bonuses are used to pay premiums for a personally owned cash accumulation type of insurance policy. The policy could be current assumption UL, indexed UL, or whole life depending on preference of the employee and employer.  Premiums are paid from the issue age to the age of retirement only
• The company may provide an extra bonus for the taxes due so that the after-tax amount is equal to the annual premium (40% tax bracket …. $20,000 bonus ….nets $12,000 premium after taxes)
• The insurance proposal can show a tax free solve income stream from policy cash values via withdrawals to cost basis, then switching to policy loans (FIFO).  For example, the tax free policy income stream may be shown from retirement age 65 to age 85.
• The death benefit remains income tax free to the personal beneficiary of the insured executive.
• The restricted bonus plan is especially attractive in an S Corp case.  Since an S Corp is a pass-through entity to the S Corp owner for tax purposes, the non-deductible deferrals of a deferred comp plan would flow through as part of the K-1 pass-through profit to the S Corp owner personally on Schedule E of his Form 1040 U.S. Income Tax return.  In essence, the S Corp owner would be using his own personal after-tax dollars to fund the deferred comp benefit of his non-owner key executive.  The restricted bonus plan avoids this K-1 accounting problem.
• The bonuses are currently deductible to the corporation and currently taxable to the executive as earned income compensation.  Since the benefits of a restricted bonus plan are subject to a risk of forfeiture if the executive terminates employment during the vesting period, the executive can make an IRC Section 83(b) election to have the bonuses taxed currently despite the risk of forfeiture.

Contact your BSMG Life Advisor to discuss whether a Restricted Executive Bonus plan can work for your business owner client’s key executives.  BSMG has access to a wide array of cash accumulation type of life insurance products from competitive carriers.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post Restricted Executive Bonus Plans: A Simple Alternative to Deferred Comp Plans appeared first on BSMG.

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During the 1990s and early 2000s, billions of dollars of survivorship life insurance was sold.  This type of insurance provided a low present value cost and a very competitive internal rate of return (IRR) on death benefit out to joint life expectancy.  The primary need for this insurance was to offset federal estate taxes so the estate owners could leave a larger inheritance to their heirs.

An Irrevocable Life Insurance Trust (ILIT) is usually the owner and beneficiary of these policies which provides an income tax free and estate tax free death benefit.  The premiums were usually funded by annual gift exclusion and/or lifetime exemption gifts of cash to the ILIT.  The survivorship ILIT was and still is an exceptional legal, tax, and financial arrangement.  Whole life, universal life, and variable life survivorship policies were all sold in very large volumes by almost all major life insurance carriers in the United States to wealthy estate owners in their 50’s, 60’s and 70’s.  These policies tended to accumulate a significant amount of cash value under the policy designs available in the 1990s and early 2000s.

As you can imagine a significant number of these contracts have experienced the death of one of the lives that were insured.  Of course, no death benefit has yet been paid on these policies because the death benefit will not be paid until the second death.  This scenario provides an opportunity to review the existing policy.  Certain planning options may even decrease or eliminate the premium outlay for the survivor depending on the specific facts of the case.

One planning concept is known as “Survivor Survivorship” which involves an IRC Section 1035 exchange to a no-lapse single life Universal Life (UL) contract owned by the very same ILIT that currently owns the existing survivorship policy.  The surviving insured, often a widow, is now 15-20 years older than when the policy was originally purchased.  So, medical underwriting of a new single life no-lapse UL policy for an insured now in their 60’s, 70’s or 80’s will usually be one of the major hurdles to successfully complete the 1035 exchange to a new carrier.

IRS Permits Tax Free Exchanges from Survivorship Life to Single Life

The IRS has actually endorsed tax-free Section 1035 exchange treatment of a survivorship policy, following the death of one of the insureds, for a single life policy that insures the survivor alone.  In PLR 9248013, the IRS noted that at the time of the exchange, both policies were insuring the same single life and the new policy would better suit the policy owner’s needs since it was less costly.  The IRS reached the same conclusion in PLR 9330040 where a survivorship policy was exchanged after the death of one insured for a policy insuring only the survivor.

Contrast the facts above to a situation where a policy owner may wish to exchange a single life policy for a new survivorship policy.  In PLR 9542037, the IRS concluded that this type of exchange does NOT qualify for tax-free treatment under Section 1035.  The IRS said that a single life to survivorship exchange does NOT “relate to the same insured” and any gain amount in the single life policy would be taxable income to the policy owner.

So, the bottom line for successful Section 1035 exchange is this:  Single life policies can only be exchanged for another single life policy.  Survivorship policies where one insured has died can be exchanged for a single life policy.  And survivorship policies with both insureds still alive can only be exchanged for another survivorship policy.

Indexing of the Estate Tax Exemption and Tax Reform in 2017

Effective for tax year 2017, the estate tax exemption is indexed up to $5,490,000 for single individuals and $10,980,000 for married couples.  This may cause estate owners who purchased their survivorship policies in the 1990s and early 2000s when the estate tax exemption ranged from only $600,000 up to $1,000,000 to question whether or not they need insurance at all.

In addition, part of President-elect Trump’s tax reform proposals for 2017 are to totally eliminate federal estate taxes.  Whether this proposal becomes a reality remains to be seen as the U.S. House and U.S. Senate craft their own tax reform bills.

Since federal estate taxes may or may not currently exist for certain estate owners because of the high estate tax exemption or potential repeal under the Trump proposals, a life insurance professional should focus on whether a Section 1035 “Survivor Survivorship” exchange produces a good financial result from an IRR at life expectancy point of view.

The after-tax IRR at life expectancy on a typical single life no-lapse UL contract can range up to 5% assuming preferred medical underwriting.  In a 35% combined income tax bracket, the pre-tax equivalent IRR can range up to 7.7%.  This IRR is very competitive when compared to alternative non-guaranteed and taxable financial alternatives like money markets, CD’s, bond mutual funds, and U.S. government securities in this continuing low interest environment.  A good case can be made that no-lapse UL insurance should be part of the asset allocation of a  portfolio regardless of whether a client may be exposed to federal estate taxes or not.

Contact your BSMG life insurance advisor to discuss whether a “Survivor Survivorship” exchange should be explored for your widow or widower client who originally purchased a survivorship policy years ago.

Russell E. Towers   JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net                                                                                 

The post “Survivor Survivorship” Section 1035 Exchanges appeared first on BSMG.

The use of an indemnity LTC rider is crucial to keep the life insurance death benefit estate tax free. That’s because any rider benefits will be paid only to the ILIT as policy owner, and NOT used to pay extended care costs directly to the extended care provider. Since LTC benefit claims are paid only to the ILIT, this indemnity style LTC rider does NOT create an incident of ownership in the UL policy. Any incidents of ownership in a life insurance policy causes the life insurance death proceeds to be included in the gross estate of the insured estate owner.

This important indemnity style LTC rider contrasts with the so-called reimbursement style LTC riders. Reimbursement type of LTC riders pay extended care benefit payments directly to the provider on behalf of the insured. Most advanced planning commentators take the position that this reimbursement type of LTC rider on a UL policy owned by an ILIT is considered an incident of ownership for estate tax purposes that causes the life insurance death proceeds to be included in the gross estate of the insured.

Note: The tax reform proposals of President Trump include the repeal of federal estate taxes. ILITs may still be useful planning tools even if federal estate taxes are eliminated.

Client Profile:

Successful business owners, professionals, and wealthy individuals who have gross estates large enough to be exposed to:

• Federal estate taxes (assuming some form of federal taxes exist at death)
• State death taxes (assuming state taxes are levied in state of residence)
• Income in respect of decedent (IRD) income taxes on their QRP/IRA assets.

Key Phrases to Use with Your Client:

• Income and estate tax-free death benefit to offset estate and income taxes due at your death.
• Special indemnity Long Term Care rider that provides tax free restoration of personal funds used to pay extended care expenses.
• A guaranteed no-lapse Universal Life policy with an extremely competitive Internal Rate of Return (IRR) out to life expectancy and beyond.
• Low present value cost provides protection against death and extended care expenses in the same product package.

Planning Options Available When Indemnity LTC Rider Benefits are Paid to an ILIT

Assuming that a no-lapse UL policy with an indemnity LTC rider is owned by an ILIT, here are some planning options available to the insured and family to either offset or pay for any extended care medical costs:

Option #1: Carrier makes income tax free LTC claim payments to the ILIT. ILIT keeps cash in the ILIT to be invested in a side fund.

• ILIT keeps LTC claim payments in the trust and invests in stock, bonds, mutual funds etc.
• This trust owned portfolio of financial assets is estate tax free.
  • Offsets extended care LTC costs paid out of pocket by the estate owner.
• The estate owner pays any LTC care costs out of pocket from other personal assets.
  • These LTC medical service payments reduce the gross estate for estate tax purposes by the amount of these out of pocket payments.
• At death, the life insurance proceeds paid to the ILIT from the base UL policy are income and estate tax free.

Option #2: Carrier makes income tax free LTC claim payments to the ILIT. ILIT loans cash to insured estate owner.

• ILIT makes a private loan to the estate owner.
  • An interest only note payable at the current AFR rate is executed between the trust and the estate owner.
• The estate owner uses the cash received from the loan to pay extended care LTC expenses.
• The estate owner makes annual interest payments on the note to the ILIT from other personal resources.
• At death, the estate of the deceased pays off the loan principal on the note to the ILIT from other estate assets and takes an estate tax deduction for debts paid from the estate on Line 2 of the Form 706 U.S. Estate Tax return [IRC Section 2053(a)].
• At death, the life insurance proceeds paid to the ILIT from the UL base policy are income and estate tax free.

Option #3: Carrier makes income tax free LTC claim payments to the ILIT. ILIT distributes cash to ILIT beneficiary (adult child).

• ILIT trustee uses discretionary authority granted in a well-drafted trust document to make distributions of trust principal to any one or more of the trust beneficiaries (adult children of insured estate owner)
• This cash distribution is a tax free distribution of trust principal to the adult child.
  • The character of the income (tax free LTC benefits) retains its character when distributed to trust beneficiaries.
• The adult child voluntarily (under no obligation) makes an unlimited gift tax exclusion gift of this cash on behalf of the parent to pay the LTC medical expenses of the parent under IRC Section 2503(e).
• At death, the life insurance proceeds paid to the ILIT from the UL base policy are income and estate tax free.

The indemnity type of LTC rider may either be a qualified LTC rider under IRC Sec 7702B, or an accelerated death benefit rider for chronic illness under IRC Section 101(g). Both types of indemnity riders pay income tax free benefit claim payments to the policy owner when triggered. Any tax free benefits paid under both types of riders reduces the life insurance death benefit dollar for dollar.

What type of protection product will match your client’s needs?

1. A stand-alone annual premium traditional LTC product
2. A linked-benefit single premium life insurance-LTC product
3. An annual premium no-lapse UL life policy with a reimbursement type of LTC rider
   or
4. An annual premium no-lapse UL policy with an indemnity type of LTC rider.

Contact Joe Savastano for your client’s needs.

Russell E. Towers   JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post Universal Life Policy With Indemnity LTC Rider Owned By An ILIT appeared first on BSMG.

The recovery of the equities markets after the economic downturn of 2008-2009 has led to more successful business owners, professionals and other individuals with more than $1,000,000 in their IRA account. Many of these IRA owners have multiple sources of income as they approach their retirement years.

These sources could include:

• Continued earned income from a profession
• Social Security retirement benefits
• K-1 “pass-through” income from ownership of S Corp or LLC entities
• Rental income from real estate and other interest
• Dividends or capital gains from non-qualified financial assets

These IRA owners understand that Required Minimum Distributions (RMDs) must be taken from their IRA starting when they turn 70 ½. The question that typically arises in their financial planning is “what should I do with the after-tax amounts from my RMDs?” For IRA owners with multiple sources of income, the answer to this question is generally to allocate the funds as some form of inheritance to their heirs. Should these after-tax dollars be re-invested in their non-guaranteed financial asset portfolio? Or is there a more tax efficient way to re-allocate these funds that would provide a larger inheritance for their family?

This concept is commonly known as the Inherited IRA Legacy Plan. Under this plan the after-tax RMDs are allocated for the annual premium on a no-lapse UL or no-lapse SUL life insurance product. The income tax free life insurance death benefit can provide a larger inheritance than simply re-investing the after-tax RMDs in an asset portfolio with taxable yields. This is especially true in the low-interest economic environment for fixed financial assets.

A Basic Blueprint for the Inherited IRA Legacy Plan Using Life Insurance

Here are the steps, of the inherited IRA transaction, to provide a leveraged tax free fund for heirs in the form of life insurance:

• Step 1: Create an income stream from the IRA by taking distributions.Keep in mind, an IRA owner doesn’t need to wait until age 70 ½ to take out distributions. Starting prior to 70 ½ may work when coupled with a life insurance program because of the potential higher premium cost of waiting due to the onset of certain medical conditions and/or age.
• Step 2: Determine ownership structure of life insurance.The income stream from the IRA is taxable, but the after-tax dollars can be used for a premium on either personally owned life insurance or insurance owned by an irrevocable life insurance trust (ILIT). The decision on personal ownership or ILIT ownership will depend on factors such as the value of the IRA and the size of the gross estate in relation to the $5.49 million (single) and $10.98 million (married) federal estate tax exemption in 2017. Also, the size of the death benefit may dictate ownership by an ILIT depending on whether the IRA owner has an estate large enough to incur federal estate taxes. IRA owners may be exposed to state death taxes as well, because of the lower tax exemptions of many states that still levy such taxes.
• Step 3: Determine who shall be named as the beneficiary of the life insurance.Is it the children of the IRA owner outright or an ILIT for their benefit? Or is it an ILIT for the benefit of the grandchildren of the IRA owner?
• Step 4: Who shall be named as the beneficiary of the IRA?Is it the children of the IRA owner outright or a trust for their benefit so the inherited IRA can be paid over the children’s life expectancy? Or is it a trust for the benefit of the grandchildren so the inherited IRA can be paid over the longer life expectancy of the grandchildren?Note 1: President Trump’s tax reform proposals include elimination of the federal estate tax. Stay tuned for future developments as the U.S. Congress crafts its tax reform bills.Note 2: The U.S. Senate Finance Committee has developed a tax position on inherited IRAs that would limit post-death distributions to only 5 years by eliminating life expectancy payouts. At this time, it is unclear whether this change will be part of a larger tax reform package being developed by the U.S. Congress.

Case Study of Inherited IRA Legacy Plan Using After-Tax IRA Distributions for Life Insurance vs. Using After-Tax Distributions for Alternative Fixed Financial Asset

The scenario: What to do with the after-tax RMDs

Facts of Case Study

Client Age: 71
Spouse Age: 70
Current gross estate: $5,000,000.
IRA Balance: $1,000,000 and must start taking RMDs
Other sources of retirement income: Social Security benefits, income from rental properties and interest, dividends, and capital gains from their non-qualified asset portfolio.
Combined federal and state income tax bracket: 35%.
Estimate after-tax return on their non-qualified asset portfolio: 5%

Option #1: Place After-Tax RMDs in an Asset Allocation Portfolio at 5% After-Tax Rate of Return (ROR) – Result, after 20 years, $852,000.

• The factor from the Uniform Distribution Table for a 71 year old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528. (Check out BSMG’s RMD Calculator)
• This after-tax amount of $24,528 will be re-allocated each year into the non-qualified asset portfolio with an assumed after-tax ROR of 5%.
• The joint life expectancy (check out the Life Expectancy Calculator) of a male 71 / female 70 from the government joint life expectancy table is about 20 years.
• An annual deposit of $24,528 into a non-guaranteed financial asset for 20 years at 5% after-tax ROR would provide a fund value of $852,000.*
  *This is the hypothetical non-guaranteed amount that would be inherited by the heirs of the client and spouse

Option #2: Place After-Tax RMDs in a No-Lapse Survivorship Universal Life (SUL) Policy – Result after 20 years, $1,172,000.

• This after-tax amount (shown above) of $24,528 will be re-allocated each year into a premium for a no-lapse SUL insurance policy issued by a competitive carrier, with a death benefit of $1,172,000 right from the beginning. This is the tax free amount the heirs would receive at the death of the survivor of the client and spouse. **
• The IRR at year 20 joint life expectancy is 7.72%. In a 35% tax bracket, the pre-tax equivalent IRR is 11.88%.
• Instead, if very good health was able to provide a Male 71 Preferred NS and a Female 70 Preferred NS medical underwriting result, the $24,528 annual premium would purchase a guaranteed SUL death benefit of $1,352,000. The IRR at year 20 joint life expectancy is 8.90%. In a 35% tax bracket, the pre-tax equivalent IRR is 13.69%.
  **Rates based on both clients obtaining Standard NS underwriting class

Summary of Benefits for Inherited IRA Plan with Life Insurance

The benefits of channeling after-tax IRA distributions into guaranteed no-lapse life insurance are significant. When compared to the taxable yields of alternative fixed financial assets (Money markets, bank CDs, bond funds, U.S. government securities), in the continuing low interest environment, the net results are truly outstanding.

• The net inheritance to the heirs could be improved by about $320,000 to $500,000 at joint life expectancy by purchasing the SUL policy when compared to alternative fixed financial assets.
• The SUL life insurance provides a guaranteed no-lapse benefit vs. a non-guaranteed accumulation value of the alternative fixed financial asset. The non-guaranteed cross-over point where the financial asset hypothetically exceeds the guaranteed standard underwriting SUL insurance death benefit does not occur until year 25 when the younger insured, if still alive, is age 95. The non-guaranteed cross-over point where the financial asset hypothetically exceeds the guaranteed preferred underwriting SUL insurance death benefit does not occur until year 27 when the younger insured is age 97.
• The SUL life insurance could be owned by an ILIT so that the death benefit is estate tax free for state death tax purposes. The $5,000,000 taxable estate in our case study above would generate upwards of about $391,000 of state death taxes in a state which still uses the tax table from IRC Section 2011. Part of the SUL death benefit could be used to offset these state death taxes with the rest of the death benefit managed by the trustee for the benefit of trust beneficiaries.
• The remaining IRA value at the death of the client is paid outright to children or to a separate trust for the benefit of children or grandchildren as an inherited IRA. The RMDs using the Single Life Table can be stretched over the remaining life expectancy of the heirs depending on the dispositive provisions of the trust document. Using this inherited IRA stretch method, the income taxes to the heirs are spread out and paid annually over many years into the future rather than paid in a lump sum and taxed all in one tax year.

Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post IRA Legacy Plans Funded by After-Tax IRA Distributions appeared first on BSMG.

With the recovery of the equities markets after the economic downturn of 2008-2009, it is common for successful business owners, professionals, and other individuals to have more than $1,000,000 in their IRA account. Many of these IRA owners have multiple sources of income as they approach their retirement years. These sources could include continued earned income from a profession, Social Security retirement benefits, K-1 “pass-through” income from ownership of S Corp or LLC entities, rental income from real estate, and other interest, dividends, or capital gains from non-qualified financial assets.

These IRA owners understand that Required Minimum Distributions (RMDs) must be taken from their IRA starting when they turn 70 ½. The question that typically arises in their financial planning is what to do with the after-tax amounts from their RMDs? For IRA owners with multiple sources of income, these after-tax RMDs are usually allocated as some form of inheritance to their heirs. Should these after-tax amounts simply be re-invested in their non-guaranteed financial asset portfolio or is there a more tax efficient way to re-allocate these funds that could provide a larger inheritance to their family?

The concept that can provide a  larger after-tax inheritance is commonly known as the “Inherited IRA Legacy Plan” where after-tax RMDs are allocated to an annual premium for a no-lapse UL or no-lapse SUL life insurance product. The actuarial leveraging and income tax free life insurance death benefit can provide a larger inheritance by life expectancy and beyond than simply re-investing the after-tax RMDs in an asset portfolio with taxable yields. This is especially true in the continuing low-interest economic environment for fixed financial assets.

A Basic Blueprint for the “Inherited IRA Legacy Plan” Using Life Insurance

Here are the steps of the “Inherited IRA Legacy Plan” transaction to provide a leveraged tax free fund for heirs in the form of life insurance:

First, create an income stream from the IRA by taking distributions from the IRA. An IRA owner doesn’t need to wait until age 70 ½ to take distributions from an IRA. Some IRA owners may wish to wait until 70 ½ while others may find it beneficial to start distributions prior to 70 ½. Starting prior to 70 ½ may work when coupled with a life insurance program because of the usual higher premium “cost of waiting”. Also, the onset of certain medical conditions as we get older that may result in less favorable underwriting may be a good reason to consider starting IRA distributions prior to 70 ½.

The income stream from the IRA is taxable, but the after-tax dollars can be used for a premium on either personally owned life insurance or insurance owned by an irrevocable life insurance trust (ILIT). The decision on personal ownership or ILIT ownership will depend on factors such as the size of the IRA gross estate in relation to the $5.34 million (single) and $10.68 million (married) federal estate tax exemption. Also, the simple size of the death benefit may dictate ownership by an ILIT whether or not the IRA owner has an estate large enough to worry about federal estate taxes. Certainly, many IRA owners may be exposed to state death taxes because of the lower state death tax exemptions of many states that still levy state death taxes.

Who shall be named as the beneficiary of the life insurance? Shall it be the children of the IRA owner outright or an ILIT for their benefit? Or shall it be an ILIT for the benefit of the grandchildren of the IRA owner?

Who shall be named as the beneficiary of the IRA? Shall it be the children of the IRA owner outright or a trust for their benefit so the “inherited IRA” can be paid over the children’s life expectancy? Or shall it be a trust for the benefit of the grandchildren so the “IRA Legacy Plan” can be paid over the longer life expectancy of the grandchildren?

Case Study of Inherited IRA Legacy Plan Using After-Tax IRA Distributions for Life Insurance versus… 

Using After-Tax Distributions for Alternative Fixed Financial Asset

Facts of Case Study:

Client and spouse are 71 and 70 respectively and have a current gross estate of $5,000,000. The client owns an IRA worth $1,000,000 and must start taking RMDs. They have other sources of retirement income including Social Security benefits, income from rental properties, and interest, dividends, and capital gains from their non-qualified asset portfolio. They ask you, their financial professional, to make a study of what to do with the after-tax RMDs that must start to be distributed from the IRA. Their combined federal and state income tax bracket is estimated at 35%. They feel that an after-tax return on their non-qualified asset portfolio is 5% going forward.

SCENARIO #1

Place After-Tax RMDs in an Asset Allocation Portfolio at 5% After-Tax Rate of Return (ROR)

• The factor from the Uniform Distribution Table for a 71 year old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
• This after-tax amount of $24,528 will be re-allocated each year into the non-qualified asset portfolio with an assumed after-tax ROR of 5%.
• The joint life expectancy of a male 71 / female 70 from the government joint life expectancy table is about 20 years.
• An annual deposit of $24,528 into a non-guaranteed financial asset for 20 years at 5% after-tax ROR would provide a fund value of $851,594. This is the hypothetical non-guaranteed amount that would be inherited by the heirs of the client and spouse.

SCENARIO #2

Place After-Tax RMDs in a No-Lapse Survivorship Universal Life (SUL) Policy for Male Age 71 (Standard NS) and Female Age 70 (Standard NS)

• The factor from the Uniform Distribution Table for a 71 year old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
• This after-tax amount of $24,528 will be re-allocated each year into a premium for a no-lapse SUL insurance policy issued by a competitive carrier.
• An annual premium of $24,528 will purchase a guaranteed SUL death benefit of $1,172,609 right from the beginning. This is the tax free amount the heirs would receive at the death of the survivor of the client and spouse. The IRR at year 20 joint life expectancy is 7.72%. In a 35% tax bracket, the pre-tax equivalent IRR is 11.88%.
• Instead, if very good health was able to provide a Male 71 Preferred NS and a Female 70 Preferred NS medical underwriting result, the $24,528 annual premium would purchase a guaranteed SUL death benefit of $1,351,838. The IRR at year 20 joint life expectancy is 8.90%. In a 35% tax bracket, the pre-tax equivalent IRR is 13.69%.

Summary of Benefits for “Inherited IRA Legacy Plan” with Life Insurance

The benefits of channeling after-tax IRA distributions into guaranteed no-lapse life insurance are significant. When compared to the taxable yields of alternative fixed financial assets (Money markets, bank CDs, bond funds, U.S. government securities), in the continuing low interest environment, the net results are truly outstanding.

1. ….the net inheritance to the heirs of the IRA- SUL life insurance plan shown above is hypothetically improved by about $321,000 at joint life expectancy (20 years) with “standard” medical underwriting when compared to alternative financial assets. The net inheritance to the heirs of the IRA-SUL life insurance plan is hypothetically improved by about $500,000 at joint life expectancy (20 years) with”preferred” medical underwriting when compared to alternative fixed financial assets.
2. ….the SUL life insurance provides a guaranteed no-lapse benefit versus a non-guaranteed accumulation value of the alternative fixed financial asset. The non-guaranteed “cross-over” point where the non-guaranteed financial asset hypothetically exceeds the guaranteed “standard underwriting” SUL insurance death benefit does not occur until year 25 when the younger insured, if still alive, is age 95. The non-guaranteed “cross-over” point where the non-guaranteed financial asset hypothetically exceeds the guaranteed “preferred underwriting” SUL insurance death benefit does not occur until year 27 when the younger insured, if still alive, is age 97.
3. the SUL life insurance could be owned by an ILIT so that the death benefit is estate tax free for state death tax purposes. The $5,000,000 taxable estate in our case study above would generate almost $400,000 of state death taxes in state which still uses the tax table from IRC Section 2011. Part of the SUL death benefit could be used to offset these state death taxes with the rest of the death benefit managed by the trustee for the benefit of trust beneficiaries.
4. The remaining IRA value at the death of the client is paid outright to children or to a separate trust for the benefit of children or grandchildren as an “inherited IRA”. The RMDs using the Single Life Table can be “stretched” over the remaining life expectancy of the children or grandchildren depending on the dispositive provisions of the trust document. Using this “inherited IRA” stretch method, the income taxes to the heirs are spread out and paid annually over many years into the future rather than paid in a lump sum and taxed all in one tax year.

Contact your BSMG Advisor if you have a client that has significant IRA values they never expect to use during their lifetime. Your BSMG Advisor can work with BSMG Advanced Sales to craft a plan to enhance the client’s IRA legacy plan using guaranteed no-lapse life insurance. 

Russell E. Towers, JD, CLU, ChFC
Vice President, Business & Estate Planning
russ@bsmg.net

The post Creating An Inherited IRA Legacy Plan with Life Insurance appeared first on BSMG.

Often times we find ourselves dealing with clients who have accumulated significant non-qualified annuity account values. Tax deferred Section 1035 exchanges, over many years, may have caused business owners, professionals or wealthy individuals to have large six figure or even seven figure account balances. In these accounts, the original cost basis continues to carry over through a series of Section 1035 exchanges.

Non-qualified annuities have become valuable financial assets that can be managed and preserved over a long period of time.  The annuities may be fixed, indexed, or variable contracts.  This preservation and management can be accomplished for spouses and non-spouses even long after the owner of a non-qualified annuity has died if certain distribution rules are followed.

In most cases, non-qualified annuities can remain tax deferred all the way until the death of the owner. Income taxes on the gain amount in excess of cost basis will eventually need to be paid by the beneficiary of the annuity after the annuity owner has died. This is known as income in respect of decedent (IRD). If planned well, this taxable IRD gain amount can be spread over many years after the death of the annuity owner in the form of an inherited non-qualified annuity.

Here is a detailed summary of the inherited distribution options available to spouses, non-spouses and trusts for inherited non-qualified annuities under IRC Section 72(s):

Spouse Designated Beneficiary

1. 5 year rule. Account value must be totally distributed within 5 years of death (IRC Section 72(s)(1))
2. Life expectancy rule: Annuitized life expectancy distributions must start no later than 1 year after the death of the holder-owner (IRC Section 72(s)(2)).
3. Spouse can continue the existing contract as his/her own and name a new beneficiary. The surviving spouse can continue tax deferral of gain in excess of cost basis all the way until death if desired (IRC Section 72(s)(3)).

Non-Spouse Designated Beneficiary

1. 5 year rule. Account value must be totally distributed within 5 years of death (IRC Section 72(s)(1)).
2. Life expectancy rule: Annuitized life expectancy distributions must start no later than 1 year after the death of the holder-owner (IRC Section 72(s)(2)).
3. PLR 200313016 also allows a life expectancy payout for inherited non-qualified annuities based on the Single Life Table of Treas. Reg. 1.401(a)(9)-9. This required annual inherited distribution must start no later than 1 year after the death of the holder-owner. Presumably, this would allow a deferred annuity type of product with an irrevocable income rider withdrawal option to be utilized. IRS ruled in PLR 200313016 that this method would satisfy the life expectancy requirement of IRC Section 72(s)(2).

Trust or Estate as Beneficiary

1. 5 year rule. Account value must be totally distributed within 5 years of death (IRC Section 72(s)(1)).
2. Life expectancy rule. It is not clear if the Life Expectancy rule can be used where a trust or estate is the beneficiary of a non-qualified annuity. No Treasury Regulations or IRS rulings exist for non-qualified annuities where a trust or estate is the beneficiary. A trust or estate is not considered to be an individual designated beneficiary under IRC Section 72(s)(4)). Legally, a trust or estate may be named as beneficiary, but it is not clear whether the life expectancy rule can be used.

Technical Tax Rules for Inherited Non-Qualified Annuities

There are certain technical rules that apply to the post-death distribution methods described above.  Here is a short list of the most important rules for inherited non-qualified annuities:

Technical Notes

1. Generally, the death of the holder (owner) of a non-qualified annuity terminates the contract and required distributions from the contract must commence under the rules of IRC Section 72(s). One of the distribution options described above may be chosen with the existing annuity carrier. An exception is the option for a spouse beneficiary to continue the contract as his/her own under IRC Section 72(s)(3). The new spousal continuation contract is still eligible for a tax free Section 1035 exchange to a non-qualified annuity with another carrier.
2. For income tax purposes, the distribution option chosen will be governed by either the LIFO distribution rules of IRC Section 72(e) or the exclusion ratio rules of IRC Section 72(b).
3. Where an Irrevocable Trust is the owner of a non-qualified annuity, IRC Section 72(s)(6) states that the holder for purposes of post-death distributions of a non-qualified annuity shall be the primary annuitant. With an Irrevocable Trust as owner, it’s important to determine who will be the annuitant, either the older parent (grantor of the trust) or the younger adult child (beneficiary of the trust).
4. There is currently no authority in the Code, Treasury Regulations, or Revenue Rulings for post-death transfers of non-qualified annuity funds from one annuity carrier to another annuity carrier after the holder-owner has died. However, in PLR 201330016, IRS permitted a post-death exchange of non-qualified annuity funds as long as the transfer was made directly from the old annuity carrier to the new annuity carrier. The IRS characterized this transaction as a permitted tax-free exchange of annuity contracts within the scope of IRC Section 1035(a)(3). Each annuity carrier involved in the exchange transaction must be consulted to determine their own business practices for this post-death situation.

BSMG can provide access to multiple annuity carriers to fund non-qualified annuities both during lifetime and as an inherited non-qualified annuity for legacy purposes.  Contact your BSMG Annuity Advisor to design a legacy annuity distribution plan for your best annuity clients.

Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net        

The post Distribution Options for Inherited Non-Qualified Annuities appeared first on BSMG.

For many years, irrevocable trusts have been structured for as grantor trusts, for income tax purposes, while still maintaining tax free status for estate tax purposes. A number of favorable IRS Revenue Rulings have solidified the irrevocable grantor trust power of substitution concept under IRC Section 675(4)(C).

This concept allows a grantor to substitute assets of equal value for those already in the trust, without causing any of the asset value to be included in their gross estate for estate tax purposes.

Grantor Trust – Here’s a short history of the important IRS Rulings which permit grantor trusts and the power of substitution concept:

• Rul. 85-13 was the first ruling which stated that a grantor of an irrevocable trust would be treated as owner of the trust assets only for income tax purposes but NOT for estate tax purposes.
• In Rul. 2004-64, IRS ruled that a grantor’s payment of income taxes on investment income of assets held in an irrevocable trust was NOT a taxable gift to the trust.
• In Rul. 2007-13, IRS ruled that a transfer of a life insurance policy from one irrevocable grantor trust to another irrevocable grantor trust would NOT violate the transfer for value rule. The death proceeds retained their income tax free character under IRC Section 101.
• Rul. 2008-22 was the first ruling to outline how a grantor trust with a Section 675(4)(C) power of substitution clause could be used so that a grantor could substitute assets of equal value for assets already held by the grantor’s irrevocable trust. The ruling stated that the trust assets would NOT be included in the grantor’s gross estate as a retained life interest under IRC Section 2036 and NOT be included as a power to alter, amend or revoke under IRC Section 2038.
• Finally, Rul. 2011-28 ruled that the Section 675(4)(C) power of substitution would NOT cause life insurance owned by an grantor irrevocable life insurance trust to be included in the gross estate as an incident of ownership under IRC Section 2042.
  

Picture a wealthy client with the following estate profile:

• A gross estate well in excess of the estate tax exemption ($5.49 million single and $10.98 million married) so that the excess is subject to a 40% estate tax rate plus state death taxes in many states.
• Over the years, the estate owner has made significant gifts of capital assets in a gain position to a grantor irrevocable trust to remove future appreciation from the gross estate. The grantor irrevocable trust contained a Section 675(4)(C) power of substitution clause. These were lifetime gift tax exemption gifts (currently $5.49 million single and $10.98 married). Form 709 U.S. Gift Tax returns were filed to document the gifts and their value.
• These gifted capital assets were real estate, publicly traded securities and shares in privately owned S Corps or LLCs. Under IRC Section 1015, the adjusted cost basis of these lifetime gifts carries-over and remains the cost basis for any future sale of those capital assets by the trust. This contrasts with capital assets included in the gross estate at death which would get a stepped-up basis to date of death value.
• The estate owner kept a part of his investment portfolios liquid in the form of significant money market account or bank holdings in an uncertain economic environment.

Given this estate profile, are there any recommendations that could be made to improve the estate plan using the Section 675(4)(C) power of substitution clause of the grantor’s irrevocable trust?

The grantor and his/her trustee could consider transferring money market cash to the trust as a substitute for a portion of the capital assets. This cash would have to equal the appraised fair market value of the capital assets now held by the trust. The capital assets would be returned to the grantor estate owner and would ultimately be included in the gross estate at stepped-up basis value for capital gains purposes for the heirs of the estate owner.

The substituted cash could be used by the trustee to buy a single pay or annual pay no-lapse guaranteed UL or SUL policy owned by the trust. The leveraged death benefit of this policy would be income tax free, estate tax free and provide an excellent guaranteed Internal Rate of Return (IRR) at life expectancy.

Let’s take a look at an example of how this may be beneficial to a wealthy estate owner who has a similar estate asset profile as that described above.

Facts of Hypothetical Estate:

Estate owner and spouse are each 67 years old and have a gross estate in excess of $50 million. They made lifetime exemption gifts of capital assets to a grantor irrevocable trust over the years totaling $5,000,000 with a cost basis of only $500,000.

This $500,000 cost basis carried-over to the trust for purposes of any future sale. Form 709 U.S. Gift Tax returns were filed.

The estate owner sold other personally owned real estate and the net after tax cash received on the sale was $6,000,000 which was deposited into a money market account.

Their grantor irrevocable trust holding the gifted capital assets has a clause which permits asset substitution under IRC Section 675(4)(C).

Hypothetical Recommendation to Take Advantage of Power of Substitution Clause:

1. Grantor transfers $5,000,000 of cash from the money market account into the trust. The cost basis of this cash is $5,000,000.
2. The trustee transfers $5,000,000 of capital assets that were originally gifted to the trust back to the grantor to complete the substitution transaction under Section 675(4)(C).
3. If the grantor holds these capital assets until death, there will be a stepped-up basis to date of the death value. In a 25% combined federal and state capital gains bracket, this will potentially avoid at least $1,125,000 of capital gains taxes for the heirs of the grantor when compared to the original carry over basis of the lifetime exemption gifts ($5,000,000 minus $500,000 cost basis = $4,500,000 potential capital gain x 25% capital gains tax = $ 1,125,000).
4. The trustee uses the $5,000,000 of substituted cash to purchase a single pay no-lapse SUL policy with a face amount of $15,776,000 (male 67-preferred / female 67-preferred) from a competitive carrier. The policy is a MEC, but death benefits of MECs are still income tax free. The death benefit is also estate tax free based on the rationale of Rev. Rul. 2011-28 which held that a Section 675(4)(C) power of substitution will NOT be considered to be an incident of ownership under IRC Section 2042.
5. The guaranteed IRR on the SUL policy at joint life expectancy (23 years) is 5.12%. In a 30% tax bracket, the pre-tax equivalent is 7.31%. This is truly outstanding in this continuing low interest environment for fixed financial assets and a significant improvement over the close to 0% current yield on money market accounts.
6. As an alternative, the $5,000,000 of substituted cash could be invested by the ILIT trustee in a portfolio of investments. Some of the interest, dividends or capital gains could be used to pay an annual no-lapse premium for an SUL policy instead. Since the trust is a grantor trust for income tax purposes, the grantor will report any income on his personal Form 1040 U.S. income tax return during lifetime. This payment of income taxes on trust income will indirectly reduce the grantor’s estate for estate tax purposes. So, the full gain on the trust investments will be retained by the trust and could be used to pay the annual SUL premiums.

For instance, a $200,000 annual premium (4% ROR on $5,000,000 trust principal) would purchase $13,188,000 of SUL no-lapse protection on the same Male 67 (Preferred) / Female 67 (Preferred) as was illustrated in the single pay scenario above. The IRR at joint life expectancy (23 years) is 8.02%. In a 30% tax bracket, the pre-tax equivalent is 11.46%.

In summary, the estate owner in the example above has avoided significant capital gains taxes for the heirs by using the substitution technique allowed for grantor trusts under IRC Section 675(4)(C). And the grantor trust has used the substituted cash to purchase a tax free guaranteed SUL for the benefit of the heirs with a great IRR at life expectancy.

Call BSMG at 800-343-7772 today to discuss a case or feel free to reach out to Russ Towers, Vice President Business & Estate Planning directly.

Russell E. Towers, JD, CLU, ChFC
Vice President, Business & Estate Planning
russ@bsmg.net

The post Leverage Your Clients Tax Benefits by Using Grantor Trust Power of Substitution appeared first on BSMG.

The ILIT or Irrevocable Life Insurance Trust has played a major role in estate planning for many years as the best financial method to provide a fund of money that’s highly leveraged, income tax free, estate tax free, gift tax free and generation-skipping transfer tax free.

However, over a period of time, the facts and circumstances of a client’s estate plan will change. The ILIT that served their needs fifteen or twenty years ago may not match their current estate planning desires.  The client may wish to add or delete trust beneficiaries, change the trustee or change certain key terms of the trust. These changes cannot be made because an irrevocable trust means exactly that … it’s IRREVOCABLE! The trust cannot be altered, amended, or revoked without adverse estate tax consequences. Possessing any of these rights or any incidents of ownership in the policy will cause the death proceeds to be included in the gross estate for estate tax purposes.

We often get the question, are there any options for transferring a policy out of an ILIT when the terms of the trust no longer meet the client’s planning objectives?

Let’s take a look at 5 planning options that may be able to rescue an old policy owned by an ILIT and still utilize it for current planning purposes.

1. The grantor can simply stop making annual gifts to the existing trust to pay premiums. The trustee could take a reduced paid-up policy or the policy could be surrendered completely if the income tax consequences are minimal. Future premium gifts can be made to a new ILIT which meets the client’s current planning objectives.
2. The ILIT can sell the policy to the insured grantor for its fair market value (generally the cash value). Then, the grantor can gift the policy ownership to a new ILIT for its gift tax value (generally the cash value). Since the policy ownership is initially transferred to the insured, this is one of the exceptions to the so-called transfer for value rule of IRC Section 101, and the policy death proceeds remain income tax free.  However, the insured must survive three years beyond the gift of the policy to the new ILIT to remove the death proceeds from the gross estate for estate tax purposes.
3. If the trust terms permit discretionary distributions of trust principal to trust beneficiaries, the policy can be transferred from the trust to the trust beneficiaries (i.e. children of the grantor). The children would become equal owners and equal beneficiaries of the policy.  Next, the children could voluntarily transfer policy ownership to the new ILIT where they are beneficiaries.  The transfer is estate tax free (insured estate owner never acquires ownership of the policy) and income tax free (a distribution of trust principal is tax free to the trust beneficiaries).
4. The existing ILIT can sell the policy to the new ILIT for its fair market value (cash value). Since the policy is never owned by the insured, there is no problem with the three year inclusion rule and the death proceeds remain estate tax free. However, the transfer of ownership to the new ILIT must still meet one of the exceptions to the transfer for value rule to keep the death proceeds income tax free. This result can be accomplished by drafting the new ILIT as a grantor trust for income tax purposes under the guidelines of Rev. Rul. 2007-13. In this case, the policy transfer is considered to be a transfer to the insured for purposes of the transfer for value rule under IRC Section 101. Or, the new ILIT can be a partner, in a partnership where the insured is also a partner.  This result is often accomplished by creating a Family Limited Partnership (FLP) and then transferring limited partner shares to the new ILIT.  Thus, the new ILIT is now a partner of the insured which meets another exception to the transfer for value rule under IRC Section 101.
5. Under certain limited circumstances, a legal merger of the old trust into the new trust can be accomplished if the beneficiaries of both trusts are the same and the beneficiaries lose no vested property rights in such a transfer. A special legal document plus written waivers by the trust beneficiaries is required to effectively create such a merger of trusts.

Contact BSMG Advanced Sales for a discussion of potential rescue techniques that may be considered based on your client’s estate planning objectives.

Russell E. Towers, JD, CLU, ChFC
Vice President, Business & Estate Planning
russ@bsmg.net

The post 5 Rescue Techniques to Remove a Life Policy from an ILIT appeared first on BSMG.

As people age into their 80s with longer life expectancies, their mental capacity is often diminished when it comes to managing their financial affairs. This declining capacity suggests an interesting issue which can impact whether continued gifting of premiums to Irrevocable Life Insurance Trusts (ILITs) can take place.

Many ILITs have been funded with no-lapse Universal Life (UL) and no-lapse Survivorship Universal Life (SUL) since the late 1990s. In a typical design, the account cash value falls to $0 by the time insureds reach their 80s. If the insured estate owner develops a reduced mental capacity such as Alzheimer’s, they may be unable to manage their financial affairs. It would be easy to miss premium payments into a no-lapse UL or SUL type of product which may cause the policy to quickly lapse for non-payment.

How can your client take the necessary steps to make sure this unfortunate scenario does not take place?

A Durable Power of Attorney document is a critical piece of a good estate plan for wealthy clients who have ILITs they are depending upon to offset federal estate taxes, state death taxes, and other final expenses. This legal document allows the power holder (attorney in fact) to execute specific legal and financial transactions on behalf of the incapacitated person. It may be crucial to a wealthy individual’s estate plan that a planned giving program be continued all the way until the death of the estate owner. This is of importance if continued premium gifts to an ILIT must be made to keep the policy in force all the way until death. The durable power holder would have to make premium gifts on behalf of the incapacitated estate owner.  Therefore, it is critical that the power holder have clear and specific authority in the durable power document to make these gift transfers.

Several Tax Court cases and IRS Rulings have held that a Durable Power of Attorney document must contain specific clauses which allow the power holder (attorney in fact) to make gifts of the incapacitated person’s property for purposes of the gift tax annual exclusion, the lifetime gift exemption, or the generation skipping exemption. If the document is silent with respect to this gifting power, then the power holder is presumed NOT to have the power to make gifts. This lack of power could cause a no-lapse UL or SUL type of policy to lapse quickly for non-payment of required annual premium.

A number of U.S. Tax Court cases basically have taken the position that, in the absence of state law to the contrary, the power holder does NOT have the authority to make gifts of the incapacitated person’s property where that authority is not expressly conferred in the document.  Most states also support this view with state statutory laws.

In addition to the power to make gifts, a good Durable Power of Attorney document can allow the power holder to perform several other important legal and financial functions:

• The estate owner must have sufficient mental capacity to execute the Durable Power document in the first place. This mental capacity is much the same as whether a person has the mental capacity to execute a will.
• The power to acquire life insurance on the lives of family members of the grantor of the Durable Power in whom the grantor has an insurable interest
• The power to retain any investments and to change and vary the form of any investments owned by the estate owner
• The power to invest in fixed and variable annuities and stocks, bonds and mutual funds as the power holder deems advisable including cash and money market accounts
• The power to sell, exchange or convey any property owned by the grantor of the Durable Power
• The power to manage, operate, mortgage and lease any real estate of the grantor
• The power to continue and to operate any business entity where the grantor owns shares in that entity
• The power to compromise and settle any legal claim due to the grantor or against the grantor
• The power to borrow money for any purpose connected with the protection, preservation and improvement of the grantor’s assets
• The power to employ agents such as attorneys, accountants, investment professionals and real estate brokers whose services may be required to administer the assets of the grantor
• The power to make gifts or gratuitous transfers to a spouse, descendants or charitable organizations. The maximum gift permitted each year to a non-charitable donee shall normally be limited to the maximum gift tax annual exclusion permitted under IRC Section 2503(b) and the unlimited educational and medical expense gifts permitted under IRC Section 2503(e). However, for estate planning purposes the power holder may make additional gifts up to an amount equal to any remaining lifetime gift exemption as permitted by IRC Section 2505(a), as amended from time to time.

• The grantor should also designate a successor power holder in case the original power holder dies, resigns or becomes incapacitated themselves.

Case example of no-lapse SUL policy owned by an ILIT:   

Mr. and Mrs. Jones created an ILIT for the benefit of their three children to be the owner and beneficiary of a $1,700,000 no-lapse guaranteed SUL policy fourteen years ago when they were each 72 years old. They also executed a Durable Power of Attorney document which permits their power holder daughter to make gifts on their behalf. They have gifted the guaranteed annual premium of $39,000 each year to the trust using their “Crummey” power gift tax annual exclusions. A cumulative total of $546,000 has already been gifted to the ILIT for premiums.  The nominal account cash value of the policy has fallen to $0. Mr. Jones died three years ago and Mrs. Jones (now age 86) has recently been placed into an extended care facility and requires her Durable Power holder daughter to manage her financial affairs.

It is critical that the power holder daughter continue to make the $39,000 annual premium gifts to the ILIT to keep the $1,700,000 no-lapse SUL policy in force. If the policy ever lapsed for non-payment of premium because the cash gifts were not made to the ILIT, the valuable income and estate tax free benefit of $1,700,000 would be lost to the heirs.

Summary

BSMG Advanced Sales can provide a specimen Durable Power of Attorney document that includes the power to make annual gift exclusion and lifetime exemption gifts. This gifting power is extremely important. It will permit the power holder (attorney in fact) to make sure that valuable policies owned by ILITs stay in force to provide an income and estate tax free death benefit.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net            

The post Durable Power of Attorney & No-Lapse Universal Life Insurance Owned by ILITs appeared first on BSMG.

IRC Section 1035 provides that exchanges into life insurance or annuity contracts with Long Term Care (LTC) riders will be income tax free because these riders are treated as  LTC contracts under IRC Section 7702B(e). These Section 1035 tax free exchange provisions positively impact so-called linked benefit life insurance-LTC products and linked benefit annuity-LTC products.

These products fall into 2 major categories which provide flexibility for case design:

• Single deposit or flex-pay life insurance products with an LTC rider.
  Life insurance death benefits are income tax free.  Lifetime LTC rider benefits paid on these contracts are also income tax free (IRC Section 7702B(e)), but will reduce the net life insurance death benefit to a minimum residual amount.

• Single deposit non-qualified deferred annuity products with LTC rider.
  Lifetime cash withdrawals from the deferred annuity will still be treated as Last In First Out (LIFO) income on gain in excess of cost basis. Death benefits will still be treated as taxable LIFO income in respect of decedent (IRD) on gain in excess of cost basis. However, lifetime LTC rider benefits will be income tax free (IRC Section 7702B(e)). The full deferred annuity account value will first be reduced to zero to pay LTC benefit claims before the remaining tax free LTC rider benefit claims are paid.

Here are the key Section 1035 exchange provisions that make these opportunities possible:

1. Life insurance exchanges into a life insurance contract with an LTC rider is defined as a life insurance to life insurance exchange for Section 1035 purposes (IRC Section 1035(b)(3))
   
   This means that existing life insurance contract cash values can be exchanged tax free into a linked benefit life insurance-LTC contract (single deposit or annual flex pay).  Only complete life insurance to life insurance exchanges are permitted …. i.e. the old contract must cease to exist. For flex-pay exchanges, a trail of annual premiums may be paid out of pocket by the policy owner in addition to the lump sum exchange amount from the old life insurance contract.The possibility of a 1 for 2 Section 1035 life insurance to life insurance exchange also exists. In this case, a traditional UL policy without an LTC rider could be one of the new contracts.  The other new contract could be a linked benefit life insurance-LTC contract (single deposit). Carryover cost basis on the exchange to the two new contracts will be allocated proportionally.
2. Annuity exchanges into an annuity contract with an LTC rider is defined as an annuity to annuity exchange for Section 1035 purposes (IRC Section 1035(b)(2))
   
   This means that existing deferred annuity account values can be exchanged tax free into a linked benefit deferred annuity-LTC contract (single deposit).         Also, since this type of exchange is considered to be an annuity to annuity exchange, partial exchanges from one annuity contract to another annuity contract are already permitted under the guidance of Rev. Rul. 2003-76 and Rev. Proc. 2011-38. Carryover cost basis will be allocated proportionally between the old and new contracts.

Cost basis tracking will be important for both life insurance-LTC and annuity-LTC linked benefit products.

• The Code provides rules for using cash value or account value of linked benefit products to pay the monthly charges (costs) for the LTC rider. These charges will be totally excluded from gross income and will simply reduce the cost basis of the insurance-LTC contract or annuity-LTC contract. However, the contract cost basis cannot fall below zero (IRC Section 72(e)(11)(A)(B)).

1035 Exchange Options for Standalone LTC and Guaranteed UL with LTC Rider

On another important issue regarding LTC Section 1035 exchanges, the IRS has issued additional tax guidance regarding partial exchanges involving annuities and Stand-Alone  individual LTC products.

• In Notice 2011-68, IRS allowed a series of annual partial tax free exchanges from a deferred annuity contract to fund annual premiums for a stand-alone LTC contract. This method can work well administratively when both the deferred annuity contract and the stand-alone LTC contract are issued by the same carrier.

Finally, annual premium or limited pay guaranteed universal life (GUL) insurance products with a qualified LTC rider are available for Section 1035 exchanges

• Life insurance death benefits are income tax free. Lifetime LTC benefits paid on these contracts are also income tax free (IRC Section 7702B(e)) and reduce the death benefit dollar for dollar.
• This tax free Section 1035 exchange option is available for both GUL with LTC rider and Survivorship GUL with a joint LTC rider

BSMG life insurance, annuity, and LTC advisors can provide access to a wide variety of linked-benefit LTC, standalone LTC, and GUL-LTC type of products from our competitive carriers.  Contact us today for a policy review of your client’s insurance or annuity contracts to see if a product with an LTC type of rider may provide a more flexible and more efficient combination of protection benefits.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post Linked Benefit Products Offer Great Section 1035 Exchange Options appeared first on BSMG.

Often a policy review of your client’s existing life insurance and annuity contracts will conclude that a more cost efficient contract with better guarantees and rates of return makes sense. This will cause a producer to seek a potential transfer of the existing cash values to a new contract via a tax free Section 1035 exchange.

IRC Section 1035 tax-free exchanges of life insurance and annuity contracts must be carefully handled to insure a smooth transfer of funds from the old carrier to the new carrier. Of course, new medical underwriting must take place for a life insurance exchange. The health of the insured may have changed between the time the original policy was issued and the potential Section 1035 exchange.  Here are 5 important guidelines to keep in mind.

1. Possible Exchanges Where the Contract Owner is the Same Before and After the Exchange

• Life insurance can be exchanged for life insurance
• Life insurance can be exchanged for an annuity. This includes exchanges to either a deferred annuity or a single premium immediate annuity (SPIA)
• A deferred annuity can be exchanged for another annuity. This includes exchanges to either another deferred annuity or a SPIA
• An annuity CANNOT be exchanged for life insurance.

2. Types of Contracts that Can Be Exchanged with the Same Insured or Annuitant

• Single life to single life
• Single life to single annuitant
• Survivorship life to survivorship life
• Survivorship life (one insured deceased) to single life
• Single annuitant to single annuitantThe following exchanges DO NOT relate to the same insured(s), so will NOT achieve a tax-free transfer:
• Single annuitant to joint annuitant
• Single annuitant to single annuitant

3. Exchange of Life Insurance Policies with Loans

You must be careful when exchanging policies with loans that are in a gain position. A policy is in a gain position if the total cash value is greater than the adjusted cost basis.

• If the loan is extinguished (discharged) on the exchange, the lesser of the loan or the gain in the policy will be taxable income to the policy owner. This will generate a Form 1099-R from the carrier.
• If the loan is carried over on the exchange to the new carrier, the exchange will be accomplished tax free. However, the new policy will be issued with an outstanding loan right from the start. Many carriers have loan to value limits that must be met before they will accept a Section 1035 carry over loan.

4. Multiple Contract Exchanges

Multiple policies with the same owner and the same insured can be exchanged for a new policy. And one policy can be exchanged for multiple new policies. The cost basis of the contracts will be carried over to the new carrier and adjusted cumulatively (i.e. 2 for 1; 3 for 1) or proportionally (i.e. 1 for 2; 1 for 3) as the case may be.

5. Important Administrative Issues

Finally, be careful with the paperwork to complete a Section 1035 exchange. Carriers want the ownership to match exactly between the Section 1035 exchange form of the new carrier and the actual owner(s) of record with the old carrier. Otherwise, the old carrier may not process the exchange until the “title” ownership matches exactly. This is especially important when existing policies owned by an Irrevocable Life Insurance Trust (ILIT) are being exchanged.

Also, if a different policy owner is desired for the new policy, a change of ownership form must be executed. This change of ownership could take place either before or after the exchange depending on the specific facts of each case.

Contact your BSMG Life or Annuity Advisor when considering a Section 1035 exchange from one carrier to another carrier. Your BSMG Advisor will work with BSMG Case Managers and BSMG Advanced Sales to assure that the transfer of funds is handled in an expedited manner.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post IRC Section 1035 Exchanges Require Special Attention appeared first on BSMG.

With the recovery of the equities markets after the economic downturn of 2008-2009, it is common for successful business owners, professionals, and other individuals to have more than $1,000,000 in their IRA account.

Many of these IRA owners have multiple sources of income as they approach their retirement years. These sources could include continued earned income from a profession, Social Security retirement benefits, K-1 pass-through income from ownership of S Corp or LLC entities, rental income from real estate, and other interest, dividends, or capital gains from non-qualified financial assets.

These IRA owners understand that Required Minimum Distributions (RMDs) must be taken from their IRA starting when they turn 70 ½. The question that typically arises in their financial planning is what to do with the after-tax amounts from their RMDs? For IRA owners with multiple sources of income, these after-tax RMDs are usually allocated as some form of inheritance to their heirs. Should these after-tax amounts simply be re-invested in their non-guaranteed financial asset portfolio or is there a more tax efficient way to re-allocate these funds that could provide a larger inheritance to their family?

The concept that can provide a larger after-tax inheritance is commonly known as the Inherited IRA Legacy Plan where after-tax RMDs are allocated to an annual premium for a no-lapse UL or no-lapse SUL life insurance product.

The actuarial leveraging and income tax-free life insurance death benefit can provide a larger inheritance by life expectancy and beyond than simply re-investing the after-tax RMDs in an asset portfolio with taxable yields. This is especially true in the continuing low-interest economic environment for fixed financial assets.

A Basic Blueprint for the Inherited IRA Using Life Insurance

Here are the steps of the inherited IRA transaction to provide a leveraged tax-free fund for heirs in the form of life insurance:

First, create an income stream from the IRA by taking distributions from the IRA. An IRA owner doesn’t need to wait until age 70 ½ to take distributions from an IRA. Some IRA owners may wish to wait until 70 ½ while others may find it beneficial to start distributions prior to 70 ½. Starting prior to 70 ½ may work when coupled with a life insurance program because of the usual higher premium cost of waiting. Also, the onset of certain medical conditions as we get older that may result in less favorable underwriting may be a good reason to consider starting IRA distributions prior to 70 ½.

The income stream from the IRA is taxable, but the after-tax dollars can be used for a premium on either personally owned life insurance or insurance owned by an irrevocable life insurance trust (ILIT).

The decision on personal ownership or ILIT ownership will depend on factors such as the size of the IRA gross estate in relation to the $5.49 million (single) and $10.98 million (married) federal estate tax exemption in 2017. Also, the simple size of the death benefit may dictate ownership by an ILIT whether or not the IRA owner has an estate large enough to worry about federal estate taxes. Certainly, many IRA owners may be exposed to state death taxes because of the lower state death tax exemptions of many states that still levy state death taxes.

Who shall be named as the beneficiary of the life insurance? Shall it be the children of the IRA owner outright or an ILIT for their benefit? Or shall it be an ILIT for the benefit of the grandchildren of the IRA owner?

Who shall be named as the beneficiary of the IRA? Shall it be the children of the IRA owner outright or a trust for their benefit so the inherited IRA can be paid over the children’s life expectancy? Or shall it be a trust for the benefit of the grandchildren so the inherited IRA can be paid over the longer life expectancy of the grandchildren?

Case Study of Inherited IRA Using After-Tax IRA Distributions for Life Insurance versus Using After-Tax Distributions for Alternative Fixed Financial Asset

Facts of Case Study:

Client and spouse are 71 and 70 respectively and have a current gross estate of $5,000,000. The client owns an IRA worth $1,000,000 and must start taking RMDs. They have other sources of retirement income including Social Security benefits, income from rental properties, and interest, dividends, and capital gains from their non-qualified asset portfolio. They ask you, their financial professional, to make a study of what to do with the after-tax RMDs that must start to be distributed from the IRA. Their combined federal and state income tax bracket is estimated at 35%. They feel that an after-tax return on their non-qualified asset portfolio is 5% going forward.

SCENARIO #1

Place After-Tax RMDs in an Asset Allocation Portfolio at 5% After-Tax Rate of Return (ROR)

• The factor from the Uniform Distribution Table for a 71-year-old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
• This after-tax amount of $24,528 will be re-allocated each year into the non-qualified asset portfolio with an assumed after-tax ROR of 5%.
• The joint life expectancy of a male 71 / female 70 from the government joint life expectancy table is about 20 years.
• An annual deposit of $24,528 into a non-guaranteed financial asset for 20 years at 5% after-tax ROR would provide a fund value of $852,000. This is the hypothetical non-guaranteed amount that would be inherited by the heirs of the client and spouse.

SCENARIO #2

Place After-Tax RMDs in a No-Lapse Survivorship Universal Life (SUL) Policy for Male Age 71 (Standard NS) and Female Age 70 (Standard NS)

• The factor from the Uniform Distribution Table for a 71-year-old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
• This after-tax amount of $24,528 will be re-allocated each year into a premium for a no-lapse SUL insurance policy issued by a competitive carrier.
• An annual premium of $24,528 will purchase a guaranteed SUL death benefit of $1,172,000 right from the beginning. This is the tax-free amount the heirs would receive at the death of the survivor of the client and spouse. The IRR at year 20 joint life expectancy is 7.72%. In a 35% tax bracket, the pre-tax equivalent IRR is 11.88%.
• Instead, if very good health was able to provide a Male 71 Preferred NS and a Female 70 Preferred NS medical underwriting result, the $24,528 annual premium would purchase a guaranteed SUL death benefit of $1,352,000. The IRR at year 20 joint life expectancy is 8.90%. In a 35% tax bracket, the pre-tax equivalent IRR is 13.69%.

Summary of Benefits for Inherited IRA Plan with Life Insurance

The benefits of channeling after-tax IRA distributions into guaranteed no-lapse life insurance are significant. When compared to the taxable yields of alternative fixed financial assets (Money markets, bank CDs, bond funds, U.S. government securities), in the continuing low-interest environment, the net results are truly outstanding.

1. The net inheritance to the heirs of the IRA- SUL life insurance plan shown above is hypothetically improved by about $320,000 at joint life expectancy (20 years) with standard medical underwriting when compared to alternative financial assets. The net inheritance to the heirs of the IRA-SUL life insurance plan is hypothetically improved by about $500,000 at joint life expectancy (20 years) with preferred medical underwriting when compared to alternative fixed financial assets.
2. The SUL life insurance provides a guaranteed no-lapse benefit versus a non-guaranteed accumulation value of the alternative fixed financial asset. The non-guaranteed cross-over point where the non-guaranteed financial asset hypothetically exceeds the guaranteed standard underwriting SUL insurance death benefit does not occur until year 25 when the younger insured, if still alive, is age 95. The non-guaranteed cross-over point where the non-guaranteed financial asset hypothetically exceeds the guaranteed preferred underwriting SUL insurance death benefit does not occur until year 27 when the younger insured, if still alive, is age 97.
3. The SUL life insurance could be owned by an ILIT so that the death benefit is estate tax-free for state death tax purposes. The $5,000,000 taxable estate in our case study above would generate about $300,000 of state death taxes in certain states which still uses the tax table from IRC Section 2011. Part of the SUL death benefit could be used to offset these state death taxes with the rest of the death benefit managed by the trustee for the benefit of trust beneficiaries.

The remaining IRA value at the death of the client is paid outright to children or to a separate trust for the benefit of children or grandchildren as an inherited IRA. The RMDs using the Single Life Table can be stretched over the remaining life expectancy of the children or grandchildren depending on the dispositive provisions of the trust document. Using this inherited IRA stretch method, the income taxes to the heirs are spread out and paid annually over many years into the future rather than paid in a lump sum and taxed all in one tax year.

Contact your BSMG Advisor if you have a client that has significant IRA values they never expect to use during their lifetime. Your BSMG Advisor can work with BSMG Advanced Sales to craft a plan to enhance the legacy of your client’s IRA using guaranteed no-lapse life insurance.

Russell E. Towers, JD, CLU, ChFC
Vice President, Business & Estate Planning
russ@bsmg.net

The post Creating an Inherited IRA Legacy Plan with Life Insurance Funded by After-Tax Distributions appeared first on BSMG.

Most assets of a married couple are considered to be “countable assets” for purposes of qualifying for Medicaid extended care benefits. This includes all assets held jointly by the couple as well as any assets held in the sole name of either spouse (including retirement plans like IRAs and non-qualified deferred annuities). Often, these combined assets must be spent down to the Community Spouse Resource Allowance (CSRA) of $120,900 in 2017 for the healthy spouse before the institutionalized spouse will be eligible to receive Medicaid benefit payments.

Also, the equity in primary residence is generally exempt for the healthy stay at home spouse. Given these modest exemptions, is there any planning concept that may be utilized to protect the assets of the couple from being depleted so that their heirs may receive an inheritance?

The answer is yes! The use of short term “period certain only” Single Premium Immediate Annuity (SPIA) remains a viable tool in assisting some of your clients to qualify for Medicaid benefits while protecting asset values for their heirs.  A SPIA that is owned by and payable to the healthy stay at home community spouse will generally NOT be considered a “countable asset” for purposes of qualifying the institutionalized spouse for Medicaid.  The SPIA is considered to be the separate income stream of the healthy stay at home spouse and not subject to being liquidated to pay extended nursing costs for the institutionalized spouse.

Let’s look at a simple case study to illustrate the concept:

Case Study
(Rules vary by state, always consult an elder planning attorney when speaking about Medicaid planning):

• Married Couple, Both Age 80
• Husband, the “Institutionalized” spouse , has been admitted to a nursing home, and wishes to apply for Medicaid benefits
• Wife is the healthy or “stay-at-home” community spouse
• The couple owns $200,000 of excess liquid assets beyond the 2017 Community Spouse Resource Allowance (CSRA) of $120,900 for a total of $320,900 of countable assets.
• There is $400,000 of net equity in the primary residence

Goals

• Make the institutionalized spouse eligible for Medicaid now
• Provide current income for the healthy spouse while providing an option to transfer excess funds via gift to the adult children
• Plan for potential future Medicaid eligibility of the healthy spouse

Normally, this couple would have to spend-down their excess assets in order to be eligible for Medicaid.  Since the enactment the Deficit Reduction act of 2005 (effective February 8, 2006), any transfers or gifts are subject to a 5 year look-back that starts on the application date for Medicaid benefits.

There is a viable strategy to avoid spending down or being subject to the look-back. The healthy spouse purchases a 5 year period certain only SPIA ($200,000 deposit) and receives about $3,200 per month (this type of annuity pays for 60 months, then stops).  The annuity is set up with an endorsement to the contract to be irrevocable, non-assignable, and non-transferable to comply with the Medicaid rules for immediate annuities.

The state must be listed as the remainder beneficiary, after the healthy spouse who is receiving the current income. The state has a claim to the remaining income payments if the healthy spouse does NOT outlive the SPIA benefit period, in this case, 60 months.

After the SPIA policy is issued, and the free-look period expires, the institutionalized spouse may apply for Medicaid benefits immediately, without being subject to the 5 year look-back. The healthy spouse can spend the income, and can gift any excess income to children or grandchildren ($14,000 annual gift exclusion allowed from spouse to each family member). By purchasing the SPIA and gifting excess income, the couple has accomplished three things:

• Obtain eligibility for Medicaid benefits for the institutionalized spouse – no 5 year look back on the purchase of the SPIA.
• Provide current income to the healthy spouse for living expenses; anything spent is not countable for the healthy spouse’s future Medicaid eligibility
• Optimize future eligibility of healthy spouse for Medicaid by gifting excess income to family members. Each annual gift will start a 5 year look-back towards the healthy spouse’s future eligibility for Medicaid (i.e. year 1 gift is safe by year 6; year 2 gift is safe by year 7 etc).

In this case, the shorter the term certain of the SPIA, the better, as the excess income, if any, needs to be gifted to family members sooner rather than later. Each gift starts its own 5 year look-back, which is an important factor to determine the healthy spouse’s future eligibility for Medicaid benefits.

Step-by-Step Summary of the “Medicaid SPIA” Process

For ease of understanding, here is a basic step-by-step summary of the Medicaid SPIA process which is designed to convert countable assets for Medicaid qualification purposes into a non-countable income stream of the healthy spouse:

Step 1: Make an asset inventory of all liquid and non-liquid assets of the client and spouse and the current value of each asset.  This includes ALL assets in the husband’s sole name, ALL assets in the wife’s sole name, and ALL jointly owned assets. This includes all types of qualified retirement plans such as IRAs, all non-qualified assets such as mutual funds, all non-qualified annuities, and all cash value of life insurance.

Step 2:  Determine the value of the primary residence. In 2017, the home equity is exempt up to either $560,000 or $840,000 depending on the state exemption limit. In addition, $120,900 of any other listed assets are considered to be exempt as the Community Spouse Resource Allowance (CSRA).

Step 3: Consider the purchase of a so-called Medicaid compliant short-term SPIA to convert all countable assets above the 2017 $120,900 CSRA into a non-countable income stream of the healthy community spouse.  The short-term SPIA (5 years) will be irrevocable and non-assignable by contract endorsement.  The state Division of Medicaid Assistance should be named as the primary beneficiary, “as its interest may appear” if the healthy spouse dies before the end of the 5 year period certain term.

Step 4: Clients apply for Medicaid benefits for the institutionalized spouse listing only the home equity and $120,900 (CSRA) of any other assets.  Disclose the short-term period certain SPIA on the application for Medicaid benefits as non-countable income of the healthy spouse.

Step 5: After the healthy spouse receives each annual SPIA payment, make irrevocable annual gifts to the adult children over 5 years of amounts not needed for current fixed expenses.  The gift in year 1 will be safe from the look-back rule by year 6; the gift in year 2 will be safe from the look-back rule in year 7 etc.

The advice of a qualified elder planning attorney is vitally important when Medicaid planning is involved, since rules vary somewhat by state.  Clients should work with both their law firm and financial advisor to make sure everyone is on the same page and the plan has sound legal standing.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post Medicaid Planning and SPIAs appeared first on BSMG.