You Might Need to Plan Now Even if You’re Not Really Wealthy
For wealth folks reviewing and beefing up insurance coverage and planning before income and estate tax rates may rise may be an obvious step. But, urgent planning is needed by many even moderate wealth taxpayers now! Very wealthy people are pursuing estate tax and other planning with urgency trying to beat enactment of harsh tax increase proposals. But does any of this planning apply to those who are only somewhat wealthy? You bet! Life insurance and life insurance trusts are a foundation stone of estate planning for many families. The bottom line is anyone who has, or might even buy in the future, a large life insurance policy, should carefully consider immediate planning steps before new estate tax rules become effective.
Example: Tina Taxpayer is a single working mom with five young children. She is young, not particularly wealthy, and in great health. Tina purchases a $5 million 20-year term life insurance policy to make certain each of her five children are well provided for if she dies before they reach adulthood. Under current law, if Tina dies no estate tax will be due unless her other non-insurance assets exceed $6.7 million (since the exemption, the amount you can bequeath without tax, is $11.7 million). If the Sanders tax proposal is enacted before Tina dies, that could reduce the exemption to $3.5 million Then a substantial portion of the life insurance Tina hopes will protect her children will be consumed by federal estate taxes.
Historic Solution To Tina’s Problem
The simple answer for Tina in the above example is to create a trust to own her life insurance policy. Properly done, under current law, that could avoid all estate taxes on the proceeds. That type of trust is called an Irrevocable Life Insurance Trust, or since tax attorneys love their acronyms, and “ILIT.” But Tina is looking forward to summer vacation and taking her kids on an RV trip, does she really need to divert her attention now to create a trust for her insurance? Absolutely! The proposed tax law changes could have disastrous financial results for a working parent trying to protect their children, that is not particularly wealthy. To understand how the proposed changes can hurt more than just “the advertised” wealthiest half percent of the population. Thus, urgent planning action may be worthwhile for lots of folks, not just the uber wealthy.
How The Sanders’ Tax Proposal Could Hurt Tina?
The Sanders tax proposal has several changes that could prove costly to an unsuspecting moderate wealth taxpayer like Tina who is just trying to protect her kids. A bit of background is necessary. Having a life insurance trust purchase insurance from inception is the classic way a taxpayer like Tina can keep life insurance proceeds out of her estate. But the Sanders act provides that for any “grantor” trusts created after the enactment of the law (not next year, so you may not have the rest of the year to plan) all the assets of the trust will be included in the taxpayer’s estate. For Tina that means if she doesn’t create a trust before enactment of a Sanders’-like tax bill, she won’t be able to create a typical insurance trust. That could be really costly. Ouch!
A Bit of Technical Stuff on Insurance Trusts, Grantor and Non-Grantor Trusts
OK, no one wants to get into the weeds on technical tax mumbo jumbo, but a little bit of explanation will at least give you a general understanding of what the Sanders proposal on grantor trusts might mean. A trust that is characterized as “grantor” for income tax purposes has all of its income taxed to you as the settlor (the person who created the trust). The trust doesn’t pay tax, you do. While that might sound like a negative its actually a positive as it helps shift more wealth to your trust. But for a typical insurance trust “grantor” status is important for other reasons.
Example: Tina Taxpayer has a life insurance policy in her name (she owns it, not a trust) and she wants to move it into an irrevocable (cannot be changed) trust to get it out of her taxable estate, the tax laws provide that if she gifts the policy to a trust it will still be included in her estate if she dies within three years of the gift. However, if Tina sells the policy to an irrevocable trust, the insurance proceeds will be outside her taxable estate even if she dies within three years. That can be a big advantage. So, what does grantor trust status have to do with all this? Everything. If Tina sells a policy to her grantor trust, the trust and Tina are treated for income tax purposes as one and the same taxpayer (the trust is disregarded). That means no income tax consequence to the sale.
Planning Tip #1: It may be a valuable planning step for you to sell existing life insurance policies to a new grantor insurance trust to remove those policies from your estate before the exemption is reduced. Talk to your insurance consultant, CPA, and estate planner.
Some Caveats and Additional Considerations on Selling Insurance: So, as with most tax planning, there are always layers of issues, possible tax traps, etc. So, here are a few. Congressman Van Hollen introduced a tax bill that could tax transfers by gift or to trusts after January 1, 2021 (yes, you read that right, retroactively to the beginning of this year). So a gift of an insurance policy to a trust in June 2021 could trigger an income tax even though the Van Hollen proposal has not been enacted. Some tax experts suggest that a sale should not be included within the ambit of the Van Hollen proposal, so it won’t be taxed. Others suggest a sale might trigger tax. That folks is the tax equivalent of the Almond Joy jingle “Sometimes you feel like a nut; sometimes you don’t.” Unfortunately, there is so much uncertainty about the various tax proposals, not to mention the biggest uncertainty of what might be enacted, planning is tough. Risks and complexity aside, doing nothing might prove the costliest path.
This is all really important if the estate tax exemption might be reduced from $11.7 million to $3.5 million. Lots of folks that, like Tina above, just wanted to protect their kids with life insurance, will be thrown into an estate tax. The solution as explained above might be to get your life insurance policies into an irrevocable trust before the effective date of any new law
Why is Timing Such an Issue?
Hopefully, you’ve followed the stepping stones above, so we can take one more step to help you understand why many taxpayers, including Tina (and perhaps including you as well!), might benefit from acting immediately to create a trust. The Sanders tax bill provides that a grantor trust that exists prior to the date of enactment may not be subject to the harsh new rule that all the proceeds will be included in your taxable estate. But if you wait until after enactment to create your trust, then all the proceeds will be included in your estate. So, if you have enough life insurance to warrant having an irrevocable life insurance trust based on what might be much lower exemption amounts, you perhaps should set up a grantor insurance trust now to avoid that harsh impact of the Sanders proposal. And, as illustrated with Tina above, this is not only for the super-wealthy. This is a planning step that many even more moderate wealth taxpayers, should evaluate with their advisers.
Planning Tip #2: It may be worthwhile for anyone that has or might get a large life insurance policy to set up a grantor trust now and put some money into it (see below) as quickly as possible to beat the enactment of a Sanders’-like tax bill.
Paying for your Trust Insurance and the Sanders’ Proposal
So, let’s build on the foundation above with another potentially important estate planning implication. You now understand why you might want to create a grantor irrevocable trust (not the typical living trusts) to hold insurance to have it in place before the law changes. But there’s another related piece to this step. The Sanders’ bill not only provides that all the assets in a grantor trust created after enactment are included in your estate, but if you make gifts to an old grantor trust that is exempt from the new inclusion rule, then a portion of that trust will have to be included in your estate.
Example: Tina Taxpayer set up a typical traditional life insurance trust many years ago owning a $5 million term policy. Tina has paid $10,000/year in gifts to the trust which the trustee then used to pay premiums on her life insurance. Assume that the Sanders’ tax proposal is enacted into law this year. For the next 10 years Tina continues to gift $10,000/year to her trust and the trust pays premiums. Then Tina dies. She paid $10,000 for 10 years in gifts to her insurance trust before the law changed, or $100,000. She paid $10,000 for 10 years in gifts to her insurance trust after the law changed, or $100,000. So ½ of the total premiums were paid by gifts Tina made to the trust after the Sanders proposal was enacted. That might mean that ½ the $5 million of insurance proceeds may be included in her estate and subject to estate tax with the proposed lower exemption and higher tax rates.
Planning Tip #3: It may be beneficial for you to make gifts to your insurance trust now, before the law changes. If not, your heirs could lose out big time if a portion of your grandfathered insurance trust gets pulled back into your estate. You might consult with your financial adviser and insurance consultant and make a gift of enough cash to the trust so that the gifted amount, and income it will earn, will cover 10-20 years of premiums, if you can afford to do so. If not you might do as much as feasible. For many taxpayers, perhaps you, this might be a great way to use up some of your exemption
Some Caveats and Additional Considerations about Gifts: Yep, more details and traps. Under the Van Hollen proposal a gift of appreciated assets to an irrevocable grantor trust that is not included in your estate triggers income tax on that unrealized appreciation. If you think that the Van Hollen proposal with its retroactive effective date might be enacted (get out your Ouija Board), then don’t gift appreciated stock, gift cash. If you don’t have as much cash as you want and you are concerned about triggering gain on appreciated securities, you might borrow money (e.g. margin your stocks) and if Van Hollen is not enacted, or enacted without a retroactive effective date, you can swap those stock in for the cash and pay off the loan.
Conclusion
If you own life insurance, or may, even if you’re not super wealthy, review your insurance and related planning, the benefits of transferring insurance to a grantor trust, and pre-funding that trust now. These steps could have a really beneficial impact.
The next article will examine lots of other interesting nuances on how the current tax proposals might rock your insurance planning world.