Do you have more wealth than you will need during your lifetime? Do you have a taxable estate? If so, you should be working on strategies to transfer your wealth to your beneficiaries as efficiently as possible.
Most people who are wealthy have tax and legal advisors who guide them in how to maximize wealth transfer to the next generation. One of the most Frequently used strategies is that of lifetime gifts to transfer wealth. The end of the year is usually the most active when it comes to carrying out gifting strategies. One reason for this is because it is a time of year that stresses family and giving. Another big reason is that December 31st is the deadline to qualify for the $13,000 gift tax exclusion. If you make a gift after the December 31st deadline your gift will not qualify for the 2010 gifting exclusion.
If you don’t use the $13,000 gift tax exclusion for 2010 you lose it, it cannot be used in another year. For wealth transfer planning strategies 2010 is a year unlike any other. Outside of any changes to the law as it is now these unique transfer tax rules are set to expire on January 1, 2011. For clients whose estates are worth more than $10,000,000 and have both the financial capability and the inclination to make large transfers, some of these rules are advantageous. Making Taxable Gifts and Making Generation Skipping Transfers are two end of year opportunities in particular.
Taxable Gifts in 2010
Currently the maximum tax rate on taxable gifts for 2010 is 35%. This 35% tax rate on gifts is 10% less than the gift tax rates of 2009 and 2011. Therefore, if you are interested in making additional lifetime transfers of your wealth to family members and you have already used your $1,000,000 gift tax exemption, you have a very good reason to make large gifts this year. With the 10% drop in gift taxes you are looking at big savings. Let’s look at an example. If you were to make a taxable gift of $1,000,000 in 2010 the 35% gift tax rate would result in a federal tax bill of $350,000. If you make that same gift in 2011 you would owe $450,000 if gift taxes. That’s an increase of $100,000.
General Skipping Transfers in 2010
In 2010 there also exists a tremendous opportunity to make significant gifts to grandchildren and younger generations. Based on current law the GST tax has been waived for 2010. For some time, the GST tax has been very complex and costly. In 2010 GST gifts and non-GST gifts are being taxed in the same way. Therefore, there may exist an opportunity in what remains of 2010 to minimize the effect of transfer taxes on gifts that would normally have been taxed under the GST tax rules. Keep in mind that all of this may change if Congress changes this rule retroactively.
Gifting With Life Insurance
Here are some of advantages of gifting with life insurance: (1) Growth/Leverage – Premiums paid for life insurance death benefit protection can provide significant leverage in the early years and may provide a competitive rate of return through life expectancy. (2) Income Tax-Free Payment – Policy death benefits (including the amount in excess of premiums paid) are generally income tax free under IRC Section 101. (3) Predictable Value – The policy may be structured to pay a known death benefit amount when the insured dies. (4) Value Not Directly Linked to Market Performance – The policy may be structured so that the death benefit may not directly depend on financial market performance. (5) Liquidity – The death benefits are paid in cash; generally no income taxes, transfer costs, commissions or management fees are subtracted from the death benefit. (6) May Avoid Estate & Generation Skipping Taxes – Ownership of the policy may be structured so that the death benefits will not be subject to federal estate or generation skipping taxes as part of the insured’s taxable estate. (7) Avoids Probate – Death benefits may be structured to be paid directly to the beneficiaries without the costs and delays that often impact assets distributed through the probate court system.
Gifts of Cash To Pay Premiums
In addition to these potential advantages, there are some additional factors that can make life insurance a valuable wealth transfer tool for the wealthy:
1. Wealthy people usually don’t personally own the life insurance policies that insure their lives. To avoid estate and generation skipping taxes, their policies are often owned by younger family members or by trusts for their benefit. In these cases, they don’t need to give away the policy. Instead, they only need to provide the funds the policy owner needs to pay the premiums.
2. Unlike most assets, life insurance policies are rarely paid for in one lump sum. Policy premiums are usually paid in a series of annual installments. Gifts of cash to pay premiums can be structured so they are gift tax free under tax exemptions established by Congress and the IRS (e.g. $13,000 in 2009 per donee for annual exclusion gifts; non-present interest gifts may total up to $1,000,000 over a donor’s lifetime). With careful planning, cash can be transferred to pay premiums without triggering gift taxes.
3. Gifts of cash for premiums can do “double duty” in reducing the insured’s federal estate taxes. First, gifts of premiums reduce the size of the taxable estate. Second, when the insured doesn’t own the policy, the death benefits may be excluded from the taxable estate. As a result, more money may stay in the family.
4. Because life insurance death benefits are paid in cash, they can be used in different ways for different objectives. For example, the death benefits can be used to pay estate settlement costs, debts, and taxes as well as provide for business stability. Life insurance death benefits often have the flexibility to complement other wealth transfer objectives.
Is Life Insurance Financially Efficient?
For some people these potential advantages are important, but not enough. They want proof that life insurance will provide good value for the premiums paid in. They want to see a numerical analysis that evaluates a particular policy’s financial efficiency. One method for evaluating a life insurance policy’s financial efficiency is called an internal rate of return (IRR) analysis. A complete IRR analysis usually considers the fact that death benefits are generally paid out income tax free. Based on the insured’s marginal income tax bracket, the IRR is the after-tax interest rate at which the policy premiums would have to grow in order to equal the projected policy death benefit. Because it is difficult to predict the year in which an insured will die, IRRs are usually calculated for a series of years including the year of the insured’s life expectancy. Another way to evaluate a policy’s financial efficiency is to compare its projected performance to the projected performance of a different asset (e.g. a stock or mutual fund) purchased with the same dollars that are used to pay the policy premiums. A financial model can be created to make the comparison. Such a model would be based on a number of assumptions. As long as the assumptions are reasonable, the results may be useful in deciding if life insurance is financially efficient in a particular wealth transfer plan.
The wealthy can choose from among many financial products and strategies. They use life insurance when its potential advantages and financial performance increase their ability to pass on more of their net worth and accomplish their other wealth transfer objectives. It can be a valuable and efficient transfer tool.
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