Volume 2, Issue 1

The last issue of our newsletter examined the various educational savings vehicles available to clients, including 529 plans, UGMA/UTMAs, Coverdell Education IRAs and life insurance. Using life insurance as an education savings vehicle prompted several questions about other uses for life insurance. Therefore, this issue of the Wealth Counselor examines some of these other common uses for life insurance, the only asset class that can ensure the completion of proper funding for a myriad of unique planning needs – regardless of the state of the federal estate tax!

Income Replacement
How will my family eat if I die?

Even if the client is not subject to estate tax, life insurance can replace lost income if the client dies unexpectedly (more policies pay out for income replacement than for liquidity to pay estate tax). For example, clients with young children should consider using life insurance to ensure that there are sufficient funds available to pay for child-rearing or college and post-graduate expenses in the event of a parent’s premature death. For these income replacement policies, the estate tax, including the possibility of estate tax repeal, has no significance.

Wealth Creation
What if I die before I build an estate for my family?

Another need for life insurance unaffected by the estate tax is the use of life insurance to create wealth. Examples of this need are families who wish to add to their wealth for future generations or to fund their philanthropic objectives.

Wealth Replacement
How can my family receive the full value of my assets?

Traditionally, life insurance has been used to replace wealth lost to the federal estate tax. However, with an increasing federal estate tax exemption (currently $2 million per individual, $4 million per married couple), fewer clients are subject to federal estate tax. Thus, fewer clients need traditional wealth replacement policies. However, many clients have significant other wealth replacement needs.

For example, many clients’ most significant assets are tax-qualified plans (such as IRAs, 401(k)s and pension plans). Because these assets are Income in Respect of a Decedent (IRD), they will be subject to ordinary income tax when distributed to beneficiaries. While we often discuss with clients maximum income tax deferral (“stretch out”), many beneficiaries will deplete these assets quickly, incurring significant income tax. Recognizing this, many clients would benefit from life insurance designed to replace this lost wealth.

In addition to traditional wealth replacement needs, wealthier clients would benefit from wealth replacement for assets transferred to a charitable remainder trust (CRT) or to a charitable lead trust (CLT), which is often used to eliminate estate tax.

Planning Unrelated to the Federal Estate Tax
I didn’t know there were so many other situations where only life insurance will assure me my goals will be reached even if I die!

Clients often use life insurance in planning that is wholly unrelated to the estate tax. There is a continuing need for life insurance as a funding vehicle in numerous situations, including:

• buy-sell planning;
• key employee coverage;
• nonqualified deferred compensation;
• death-benefit-only plans;
• liquidity to pay debts;
• liquidity for state death taxes; and
• inheritance equalization.

Income-Tax-Free Status of Death Benefits
What a difference not paying taxes can make on the amount to which my premiums can grow.

With increasing federal estate tax exemption amounts, there is now an increased emphasis on income tax planning, with a particular emphasis on assets that combine basis step-up with tax-free or tax-deferred growth. Life insurance proceeds paid upon the death of the insured, as well as proceeds attributable to investment appreciation on the cash value portion of the policy, are excluded from gross income. As a result, not only is the death benefit of a life insurance policy tremendous compared to the premiums paid if the insured dies prematurely, in a properly designed policy the death benefit remains quite handsome even if the insured lives past life expectancy.

Irrevocable Life Insurance Trusts
A little planning can provide enormous tax savings.

Even though the insurance death benefit is not subject to income tax, the life insurance proceeds will likely be included in the client’s gross estate and, therefore, be subject to federal and/or state estate tax absent a properly drafted and maintained Irrevocable Life Insurance Trust (ILIT). As a result, many clients create ILITs for the purpose of owning life insurance to avoid federal and state estate tax on the death proceeds.

Planning Flexibility
How can I deal with the uncertainty of estate taxes?
Will I need the extra cash at my death, or not?

The uncertainty surrounding the federal estate tax and the exemption equivalent amount may suggest the use of the most flexible types of cash value policies, such as universal life policies. These policies permit the policy owner to vary the amount of premium payment, the level of death benefit, and the amount of cash value (in exchange for this flexibility, the client may give up the guarantees that the premium will provide a guaranteed death benefit for the life of the policy). No other single asset provides the same degree of planning flexibility. However, it is incumbent on the planning professional to ensure that the product selected fits the needs of the particular client.

Conclusion

Life insurance is the only asset class (other than cash) that a client can remove from his or her gross estate, yet it still provides liquidity (e.g., for federal or state death tax or capital gain tax) or wealth replacement (e.g., to make beneficiaries “whole” for large IRD items like IRAs, 401(k)s, and pension plans) without itself incurring income tax. All other assets removed from the client’s gross estate for estate tax purposes must be sold and the gain realized to net the required amount.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

Volume 1, Issue 3

The last issue of our newsletter examined the many benefits of 529 Plans, including the income tax and gift and estate tax benefits of these popular educational savings vehicles. There are, however, several other educational savings vehicles that clients should consider; this issue examines some of these other vehicles – and the advantages and disadvantages of each.

Why is saving for education so important?According to the College Board, the average cost of a four-year college or university is increasing at two to three times the rate of inflation. For the 2006-2007 school year, costs average $5,836 per year for an in-state four-year college and $22,218 per year at a private four-year college. Therefore it is no surprise that advisors who understand the options bring significant value to their clients.

UGMA/UTMA Accounts

The simplest form of education savings vehicles, and perhaps the most common, is an account created under the Uniform Gift to Minors Act (UGMA) or, its successor, the Uniform Transfer to Minors Act (UTMA) in the child’s state. While simple and inexpensive, there are considerable disadvantages to UGMA and UTMA accounts.

Most clients’ biggest concern with these accounts is that a gift made to an UGMA or UTMA account vests absolutely in the beneficiary. In other words, neither the custodian nor the donor can change the beneficiary after establishment of the account, and, significantly, the custodian must deliver the balance of the account outright to the beneficiary when he or she reaches the age of majority (18 or 21, as defined by state law). For a beneficiary receiving government benefits, this required outright distribution may cause the beneficiary to lose his or her government assistance upon attainment of majority. Until the beneficiary reaches majority, the custodian has a fiduciary duty to spend the income or principal for the benefit of the minor.

Effective May 17, 2006, the “kiddie tax” may also come into play for beneficiaries who are younger than 18 (it previously applied only to beneficiaries younger than 14). With the kiddie tax, if the parents claim as a dependent a child under age 18, all of that child’s unearned income above $1,700 per year (for 2006), including UGMA or UTMA income, will be taxed at the parent’s income tax rate, whether or not the parent is the custodian. For children 18 years and older, the income on assets in a UGMA or UTMA account is generally taxed at the child’s rate, typically much lower than the parents’ rate.

While a transfer to a minor under UGMA or UTMA constitutes a completed gift for federal gift tax purposes at the time of the transfer, if the donor names himself or herself as custodian of the account and that person dies before the child reaches majority, the UGMA or UTMA account assets will be includible in the donor/custodian’s gross estate for estate tax purposes.

Coverdell Education Savings Accounts (ESAs)

Education Savings Accounts, formerly Education IRAs, were of little significance until passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA increased the maximum annual contribution limit from $500 to $2,000 per beneficiary, while also increasing the AGI limits for maximum contributions to these accounts. Significantly, as a result of EGTRRA, a donor can make contributions to an ESA and a College Savings Plan for the same child in the same year. Moreover, while 529 Plans are limited to paying for higher education, ESAs can be used to fund primary and secondary school.

Life Insurance

The inside cash buildup of permanent life insurance policies such as whole life, universal life, and variable life offer another opportunity to accumulate funds that can be used for educational expenses. This strategy usually makes sense when the client has an already existing need for life insurance (such as protecting a family’s income in case of death). A very simplified explanation of this technique is for the client to pay into the life insurance policy more than is needed to support the policy through the life of the client. These extra funds accumulate inside the life insurance policy on an income tax free basis and can be accessed by the client when his or her children reach college age (or if there is an emergency or other need).

Flexible premium universal life and variable universal life policies typically include the option to take partial withdrawals from, or loans against, the cash value of the policy (some policies even have a “wash” loan feature that makes loans even more attractive). When the time comes, the client will either withdraw or borrow the necessary college funding from the accumulated cash value of the life policy.

Withdrawals from a cash value life insurance policy (other than a modified endowment contract) are not subject to income tax until the cumulative withdrawals exceed the cost basis, or the aggregate premium payments on the policy. Loans from such policies are likewise not taxable at the time of the loan nor are they taxable if they are repaid from the death benefits when the policy “matures.”

Careful planning is needed to determine the premium structure, the best method to access the cash buildup in the life insurance policy, and to make sure the viability of the policy is not endangered. Usually making withdrawals to basis first and then borrowing from the cash value is the preferred method to access the cash value of a policy having any loans repaid at death from the income tax free proceeds of the life policy.

An added benefit of this technique is that if the client dies prematurely the death benefit from the life policy becomes available to pay for college or other family expenses.

As with most sophisticated planning, there may be traps for the unwary. For example, there can be very negative tax effects if the plan is not designed properly or the policy doesn’t perform as expected and there isn’t an adequate cushion so that the life policy lapses before death. And of course there are estate tax considerations to be taken into account. That said, in the hands of an experienced life insurance professional, this technique can be quite beneficial and allow for several potential needs to be met with one planning device.

Demand Trusts

Demand rights convert what would otherwise be a gift of a future interest to a gift of a present interest, thereby qualifying the gift for the $12,000 gift tax annual exclusion. To qualify, the trustee must adhere to the strict procedure requirements for Crummey trusts: the trustee must immediately notify the minor beneficiary through the child’s legal guardian that the donor has made a gift to the trust. The beneficiary then has a specified period of time (typically 30 days) to demand a distribution from the trust in the amount of the gift. If the specified number of days lapses, the gift will stay inside the trust and continue to be governed by the trust terms.

This demand right allows the trust maker to make contributions of up to $12,000 per year, free of gift tax and possibly generation-skipping transfer (GST) tax.

Demand trusts remove the trust assets from the trust maker’s estate, even if the trust maker acts as trustee, as long as the trust instrument limits the trustee’s discretion to make distributions to “ascertainable standards”; i.e., the education, health, maintenance and support of the beneficiary (and provided the trust instrument does not give the trust maker too much control over the trust). If a demand right beneficiary dies during the time that a demand right is outstanding, the amount of the outstanding demand right is includible in the beneficiary’s gross estate for estate tax purposes.

Direct Payments to an Educational Institution Another educational funding option is for the donor to make transfers directly to an educational institution. Under the Internal Revenue Code, these transfers are not subject to gift, estate, or GST tax. Therefore, prepaid tuition payments by a donor can achieve a significant estate tax reduction. Direct payments are not deductible as a charitable contribution for income tax purposes, however, because they are made for a particular student.

Since only direct payments to the educational institution qualify, it is highly recommended that the donor make contributions to the school while the child is presently enrolled. If the donor wishes to make advance payments for numerous years’ tuition, the donor (and the parent(s) if the donor is the student’s grandparent) should enter into a written agreement with the educational institution providing that (1) the donor and/or parent will pay any future tuition increases; (2) the prepayments are non-refundable; and (3) the prepayment does not afford the child any additional rights or privileges over any other student.

Impact on Financial Aid

For some clients, the impact on needs-based financial aid may play a role in the selection process, because assets placed in the student’s name may reduce (or even eliminate) the amount of otherwise available financial aid. The needs based financial aid rules state that 5% of the parent’s assets (special rules determine this amount for financial aid purposes) and 35% of the child’s assets are available for education. Therefore, shifting assets from the parent to the student through the use of UGMA/UTMAs, ESAs, and 529 plan distributions may reduce the student’s needs based financial aid. Alternatively, life insurance should not impact needs based aid, whereas a demand trust will depend upon the child’s access through the trust terms.

Conclusion

There are numerous education savings options. Most often, the “right” choice for the client will depend upon his or her unique goals and objectives. It is therefore incumbent upon all wealth planning professionals to help the client determine those objectives and advise accordingly.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

Volume 1, Issue 2

Whether your client is a parent with future educational obligations for young ones, or perhaps a loving aunt, uncle, grandparent, or stepparent, now more than ever 529 plans are an attractive tool for the escalating costs of education, as well as for income and estate planning purposes. This is because one of the hidden gems of the new Pension Protection Act of 2006 (signed into law on August 17, 2006) is a provision that makes permanent the income tax-free growth of Section 529 plans used for qualified higher education expenses. Prior to this new law, these provisions would have expired December 31, 2010.

Most wealth planning professionals (and clients for that matter) understand the value of investing in 529 plans. 529 plans are by far the most popular college savings vehicle, but they’ve just become even more popular. According to a recent survey, 54% of parents with young children who do not currently own a 529 account are more likely to open one now, due to the new law, and 36% who already own a 529 plan say they are now more likely to increase the amount they contribute to existing plans. And another recent survey confirmed that older clients may want to learn more about college savings.

Income Tax Benefits

While many clients understand the educational savings benefits, many do not understand the benefits of investing in 529 plans for income tax purposes. Just like with an IRA, the power of tax-deferred growth makes 529 plans worthwhile even if not used for educational expenses. The ability to frontload up to five years of annual exclusion gifts, or $60,000 per beneficiary ($120,000 per beneficiary for married couples), without paying gift tax creates the ability to grow a significant amount of money tax free. In addition, many states offer residents a state income tax deduction for an investment in their state’s 529 plan. Planning Tip: Clients should consider an investment in a 529 plan even if it is not anticipated that the funds will be used for educational purposes. The income tax benefits alone of 529 plans make these very worthwhile investments.

Estate Planning Tax Benefits

529 plans are unique in that you can invest in a 529 plan, retain absolute control over the assets, and yet remove those assets from your estate for estate tax purposes. This type of control typically means that the asset would be subject to estate tax at a 46% rate (in 2006) at death, but not with a 529 plan. Thus, clients can invest up to $60,000 per beneficiary ($120,000 per beneficiary for married couples) without paying gift tax and, if the client lives for at least five years, all of these assets will not be subject to estate tax. More importantly for many clients, a 529 plan allows them to use the 529 plan assets in a financial emergency.

Educational Trusts

Many 529 plans permit a trust to be the owner and beneficiary of accounts set up under that state’s plan. A 529 plan combined with an Educational Trust may provide more flexibility to ensure that the 529 meets the client’s objectives by, for example, moving assets between siblings or providing a smooth transition should the client become incapacitated or die.

This combination of 529 plans and specially designed trusts can also provide divorce and creditor protections, even for those states’ 529 plans that do not provide their own asset protection; for example, to ensure that the 529 plan’s assets do not end up in the hands of a former son-in-law or daughter-in-law. And the client still retains the ability to use the funds in a financial emergency.

Conclusion

Now more than ever, clients should consider 529 plans for educational savings, income tax benefits and estate tax benefits; and when combined with a carefully-crafted Educational Trust, they will provide added flexibility to control this asset and to ensure that it meets the client’s planning objectives.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

Volume 1, Issue 1

The new Pension Protection Act of 2006 (signed into law on August 17, 2006) creates significant planning opportunities for advisors and their clients who understand it. This newsletter focuses on two key provisions: (1) non-spousal rollovers from a qualified plan to an inherited IRA and (2) charitable contributions of IRAs during lifetime.

Non-Spousal Rollovers from Qualified Plans

In the past, only a surviving spouse could roll over a qualified plan (for example, a 401(k)) to an IRA after the plan owner’s death. Once rolled over, it is as if the surviving spouse created the IRAÑhe or she can defer required minimum distributions from the IRA until reaching age 70 1/2 and can withdraw these required minimum distributions over his or her lifetime.

Alternatively, a beneficiary other than a surviving spouse (for example, a child or unmarried partner) has been forced to withdraw the qualified plan in full – and pay income tax on this amount – over the period set forth in the plan agreement, typically within one to five years of the plan owner’s death. Thus, a non-spouse beneficiary could not defer income tax by “stretching out” distributions over his or her life expectancy.

Beginning January 1, 2007, a non-spouse beneficiary can roll over a qualified plan to an “Inherited IRA” after the plan owner’s death. If the owner names a trust as beneficiary of the qualified plan, the trustee of that trust can roll over the qualified plan to an inherited IRA for the benefit of the trust beneficiary.

With an Inherited IRA, a non-spouse beneficiary can use his or her own life expectancy to determine required minimum distributions. This significantly reduces the amount that the beneficiary must withdraw each year, thereby deferring income tax and allowing the account balance to continue to grow income tax free.

A rollover to a non-spouse beneficiary must be directly from the trustee of the qualified plan to the trustee of the Inherited IRA (a trustee-to-trustee transfer). In addition, and unlike a spousal rollover, the IRA must remain in the name of the deceased owner.

Until January 1, 2007, a non-spouse beneficiary must continue to use the payout schedule dictated by the qualified plan agreement. Thus, if the plan agreement provides that all funds must be distributed within three years of the owner’s death, the beneficiary must withdraw, and therefore pay income tax on, the entire plan balance within three years, thereby eliminating potentially significant growth through income tax deferral.

Example

On October 1, 2006, Susan Participant dies having named a trust for her daughter Emily’s benefit as the death beneficiary with her 401(k) plan. Anytime after December 31, 2006, the trustee of Emily’s trust can request a trustee-to-trustee transfer of the 401(k) to an inherited IRA for Emily’s trust’s benefit, using Emily’s life expectancy to determine the required minimum distributions from the inherited IRA.

Clients Impacted by This Change

All clients with qualified plans and clients named as the beneficiary of a qualified plan will potentially benefit from this new provision.

Charitable Contribution of IRA During Lifetime

In 2006 and 2007 only, a taxpayer who is at least 70 1/2 years old can contribute to charity up to $100,000 per year from one or more Individual Retirement Accounts (IRAs).

If the contribution is made by direct transfer from the IRA custodian to a “public” charity, the taxpayer need not report the distribution as taxable income. In other words, unlike a typical IRA distribution, the distribution will not appear as taxable income on the taxpayer’s income tax return. Because the distribution does not appear as income, the taxpayer does not get an offsetting charitable income tax deduction to reduce the income created by the IRA distribution.

Significantly, charitable contributions that meet these requirements satisfy the taxpayer’s required minimum distributions for the year of distribution.

Clients Impacted by This Change

There are two critical questions: (1) Does the client have IRAs from which they can make direct contributions to charity or, alternatively, can the client roll out of a qualified plan into an IRA; and (2) Is the client currently making or contemplating charitable gifts. Consider the following classes of clients who will benefit from this provision.

1. Clients Who Claim the Standard Federal Income Tax Deduction
   For clients who do not itemize, this new law provides the equivalent of an unlimited federal charitable income tax deduction for up to $100,000 of the charitable gifts that they make from an IRA.
2. Clients Who Would Lose Phased-Out Deductions with Increased Income
   Under the new law, a direct contribution of an IRA up to $100,000 does not increase the taxpayer’s Adjustable Gross Income (AGI). Correspondingly, it does not impact other deductions.
3. Clients Who Are Subject to the 50% Limitation on AGI
   A direct contribution to charity of up to $100,000 is not subject to the typical 50% of AGI cap for cash contributions to a public charity.
4. Clients Who Live in States That Do Not Permit State Income Tax Charitable Deductions
   For clients in Indiana, Michigan, New Jersey, Ohio and Massachusetts, direct contributions from IRAs will result in the highest possible net state tax savings.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.