Funding the Estate Tax


FINANCIAL OUTCOME©


VOLUME 1 NUMBER 1
IDEAS FOR CREATING AND PRESERVING WEALTH

Reprinted by permission of the Financial Outcome©


The High Cost of Dying

by Barry Boscoe, CFP

What if you woke up one day and suddenly realized

you were forced to give three hundred thousand dollars

of your money to Uncle Sam?  It sounds ludicrous,

but it happens all the time.

It happens when people don’t plan for the future; it happens when they don’t prepare for the high cost of dying.  Unless proper preparations are made for the future, over half of a person’s entire life’s work can easily be lost to Uncle Sam in estate taxes.  This is the money the government will be spending, instead of being passed on to your future generations.

Unfortunately, planning for the future is like hitting a moving target.  The truth is, the importance of proper planning cannot be overemphasized.  To help explain, let’s examine a typical case.

Suppose you are in your mid-fifties, have worked hard your entire life, and managed to live well.  You’ve lived well enough to accumulate an estate worth two million dollars at the time of the death of you and your spouse.  Of that amount, eight hundred thousand dollars will be taxed, at a rate of approximately 40 percent.  This means that over three hundred thousand dollars will be taken out of the estate in taxes.  At today’s prices, that could mean having to sell a house to pay for the estate taxes.  And, if your estate is worth over five million dollars, after your lifetime exemption, it will be taxed at upwards of 55 percent.  And, that’s not all.

If we assume inflation averages 5 percent over the next fifteen years, your two million dollar estate will then be worth four million dollars.  The estate will have a marginal tax bracket of approximately 50 percent.  And a princely sum of approximately $1.4 million will be taxed out of your life’s earnings.  That’s 1.4 million dollars that could benefit your family, but is instead being handed over to the government.

Paying exorbitant estate taxes may seem inevitable, but its pain is not.  Protecting the assets of an estate from high taxes is one of the most important facets of a coordinated financial plan; protection of assets means security for the people it is intended to serve.

Once again, planning for the future is like trying to hit a moving target.  But while it’s impossible to predict what will occur, with the proper aim, and by leading the target, the target can be hit.

HOW TO PAY ESTATE TAXES?

Usually taxes are paid out of the assets of the state.  Cash or cash equivalents may be used to pay the taxes.  In other cases, refinancing or borrowing is the method used.  Obviously, these methods are not only undesirable because they remove assets from the estate, but they are uneconomical as well.

If assets are used to pay taxes, a person runs the risk of killing the goose that is laying the golden egg, because future income and appreciation will vanish.  When borrowing or refinancing, the terms can be so unfavorable that the estate’s property cannot maintain the monthly payments.

Finally, being forced to sell off assets of the estate is the most undesirable of all of the methods of paying estate taxes.  Estate taxes must be paid within nine months of the date of death, often necessitating a quick sale, sometimes during a slumping real estate market.  These two factors can cause a deep discount or reduced value on sale.

This paints a dismal picture of the estate tax dilemma, to be sure.  Fortunately, there are other alternatives.

SAVING ESTATE TAXES WITH INSURANCE

Using insurance to pay estate taxes is far superior to any of the other alternatives, because of the ultimate leverage.  A person would be prudent to consider this method when planning their financial future.

The one drawback to insurance is the fact that it must be paid for in the present, reducing the cash flow of the estate.  Most parents feel that the cost does not reduce their standard of living, while realizing that, with insurance, most of what they worked so hard for will be saved for their children.

Here is a typical example of the advantages of paying estate taxes with insurance:

Craig and Mary Smith are a married couple, both age 56.  In  planning for their financial outcome with their financial advisor and attorney, they discover their children will be paying 1.5 million dollars in estate taxes at their death.  They find they are able to invest $27,000 for only 15 years towards the payment off the estate taxes.  With insurance, the Smiths will be protected from day one; they feel secure in the knowledge that they can reach their targeted goal within 15 years.  If they were to invest that money in something other than insurance, they would need to earn 13.2 percent annually on a pre-tax basis for the next 35 years to hit the target of 1.5 million dollars.

Craig and Mary decided to use insurance to pay their estate taxes.  They purchased a whole life policy rather than term insurance, because the most important aspect of their policy is one of permanency.

SAVING ESTATE TAXES USING AN INSURANCE TRUST

It is important for the Smiths to protect the full amount of the policy from estate taxes.  They are advised by their attorney that the best way is to make their children, or an irrevocable life insurance trust, the owners of the policy.  Taxes cannot be levied on insurance owned by a  third party, and so the insurance itself cannot be taxed.  This must be done at the time the policy is initially taken out.  If the policy is transferred after the purchase, the IRS may tax the proceeds payable within three years of the transfer.

The Smiths decided to use an insurance trust because it provides the flexibility they need in planning their future.  It allows for generation-skipping tax planning, in addition to the taxes saved by having the insurance owned by the trust.

Because their children’s life insurance trust operates under the same provisions as the Smith’s living or revocable trust, the balance can be rolled over to the children’s insurance trust to ease future administration.

The Smiths will pay for the insurance by gifting the insurance premiums to their children using their annual exclusion of $10,000, or by using their lifetime exemption of $600,000.  They find it is cheaper, from a tax standpoint, to make a gift rather than to give away their assets at the time of death.

CONCLUSION

Paying estate taxes can be an incredible burden on the children the estate serves.  But through proper planning, and an understanding of all of the alternatives, much of the burden can be lifted.  As part of a coordinated financial plan, the advantages of using insurance or an insurance trust are many.  When planning your financial outcome, it is prudent to consider the use of these techniques to ease the major pain of estate taxes.  Otherwise, we may target ourselves.

Barry Boscoe, CFP, is affiliated with Brighton Advisory Group in Encino.