Keeping Down the Tax Hit


LOS ANGELES BUSINESS JOURNAL


Vol. 15  No. 4

Reprinted by permission of the Los Angeles Business Journal™


Keeping Down the Tax Hit is Vital to Protecting Assets for Your Heirs

by Barry Boscoe, CFP

Protecting the assets of an estate from high taxes is just one aspect of a well designed financial plan, but it may be the most important.  A Financial plan that provides for the payment of estate taxes allows your estate to be passed onto future generations instead of handed over to the government in the form of estate taxes.

If you don’t make the proper preparations, possibly half of your entire life’s work may easily be lost to Uncle Sam.  It happens all the time when people don’t plan for the future and the high cost of dying.

Consider this example.  You’re in your mid-50’s, you’ve worked hard and managed what you’ve accumulated so that you now have an estate worth over $2 million.  You didn’t plan for estate taxes because it seemed like a distant reality but, unfortunately, it was not.  Out of the accumulated $2 million estate you or your spouse left $800,000 will be taxed at a rate of approximately 40 percent.  That means over $300,000 will be taken out of the estate in taxes.  In today’s economy, that could mean having to sell your house to pay those estate taxes.

Tax bracket rises

And, as your estimated worth goes up, so does your tax bracket.  If your estate is worth $5 million after your lifetime exemption, it will be fixed at upwards of 55 percent.

Let’s say your estate is currently worth $2 million.  At a rate of 5 percent inflation over the next 15 years, your estate will be worth $4 million.  That will put your estate in the marginal tax bracket of approximately 50 percent.  In that tax bracket the sum of approximately $1.4 million will be taxed out of your life’s earnings.  That’s $1.4 million that could benefit your family, but due to lack of planning, it’s now being handed over to the government.

Paying exorbitant estate taxes may seem inevitable but it’s not.  Protecting your personal and corporate assets is one of the most important facets of a coordinated financial plan; protection of assets means security for the people it’s intended to serve.

Joe Robbie, former owner of the Miami Dolphins, had many hidden assets that could have been used to pay his estate taxes at the time of his death.  Unfortunately, the appropriate planning was not done forcing his estate to sell off one of its great family assets, the Miami Dolphins, to pay the estate taxes.

Paying estate taxes

The most common approach, but least economical method to pay taxes, is to use the assets from the estate.  Assets available will consist of the following:  1) cash, 2) cash equivalents, such as stocks and bonds, 3) borrowing or refinancing, 4) real estate liquids-non.

If existing assets are used to pay taxes, a person runs the risk of killing the goose that laid 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, selling estate assets to pay taxes is the least desirable option of all.  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.  Either factor can cause a deep discount or reduce the value of the sale.  Choosing any of the above creates a further negative impact on the estate.  Do not despair.

Using insurance

A prudent option to consider would be to use life insurance to pay estate taxes.  It’s a far superior method to the other alternatives because of the ultimate leverage it offers.  The one drawback to insurance is that it has to be paid in the present, which may reduce the cash flow of the estate.  But there are many insurance options that will not reduce your standard of living and still protect what you’ve worked so hard to accumulate.  Here’s an example of the advantages of paying estate taxes with insurance.

Craig and Mary Smith are a married couple, both age 56.  In planning their financial outcome with their financial adviser and attorney, they discover their children will be paying $1.5 million in estate taxes at their death.  They find that they are able to invest $27,000 for only 15 years towards the payment of the estate taxes.

With insurance, the Smith’s will be protected from day one; they feel secure knowing that they can reach their targeted goal within 15 years.  If instead they were to invest the $27,000 in something other than insurance, they would need to earn 13.2 percent annually for the next 35 years to hit the same target of $1.5 million.  Craig and Mary decided to purchase a whole life policy rather than term insurance to take care of estate taxes because permanency was important to them.

Act when buying the policy

It is equally important for the Smiths to protect the full amount of the death benefits 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 owner 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 benefits payable within three years of the transfer.

The Smiths chose an insurance trust because it provides the flexibility they may need in the future.

Insurance trusts allow for generation-skipping tax planning, in addition to the taxes saved by having the insurance owned by the trust.

Because the children’s life insurance trust operates under the same provisions as the Smith’s living or revocable trust, the balance can be rolled over into the children’s 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 exemptions of $600,000.  It is less expensive from a tax standpoint to make a gift currently rather than to give away the assets at the time of death.

Boscoe is a Certified Financial Planner with Brighton Advisory Group in Encino.