The Strategic Role of Life Insurance in Estate Planning

Estate planning is an essential financial strategy that ensures your assets are managed and transferred according to your wishes after your passing. While estate planning often involves wills, trusts, and tax planning, life insurance is a pivotal component that can enhance the effectiveness of these efforts.

Liquidity When It's Most Needed

One of the primary benefits of incorporating life insurance into estate planning is the provision of liquidity. Upon the death of an estate holder, there are immediate expenses to be met, including funeral costs, outstanding debts, and perhaps taxes. Life insurance policies can be designed to pay out quickly upon the insured’s death, providing the necessary funds to cover these expenses without the need to hastily liquidate other assets, which might otherwise be sold at an inopportune time or at a loss, or may have other sentimental value (e.g., a house that has been in the bloodline for generations).

Providing for Heirs

Life insurance can ensure that heirs receive a significant cash inheritance without any delay. This is particularly beneficial for those who wish to provide for their loved ones immediately after their passing. Moreover, life insurance payouts are generally tax-free, which means beneficiaries receive the full amount of the intended gift without the deductions associated with other types of inheritances.

Equalizing Inheritances

In situations where the assets are difficult to divide equally, such as in businesses or real estate, life insurance can be used to equalize inheritances among multiple beneficiaries. For instance, if one child inherits a family business, a life insurance policy can provide comparable value to other children, ensuring fair and equitable distribution of the estate.

Estate Taxes and Other Costs

For larger estates, federal estate taxes can pose a significant burden. Life insurance can be a strategic tool to pay these taxes without the need to liquidate other estate assets. By setting up an irrevocable life insurance trust (ILIT), the proceeds from the life insurance policy can be excluded from the taxable estate, potentially saving a significant amount in taxes and preserving more of the estate for the beneficiaries.

Business Succession Planning

For business owners, life insurance is a key element in succession planning. It can provide the funds necessary for a partner or group of employees to buy out the deceased owner’s interest in the company, facilitating a smooth transition and ensuring the business’s continuity.

Life insurance offers a versatile and powerful tool for estate planning. Its ability to provide immediate liquidity, equalize inheritances, cover estate taxes, and facilitate business succession planning makes it indispensable in a well-rounded estate strategy. As with any financial planning, it's important to consult with legal and financial advisors to tailor life insurance coverage to your specific needs and goals, ensuring that your legacy is preserved and protected according to your wishes. Through careful planning and strategic use of life insurance, you can secure peace of mind for yourself and your heirs.

Integrating Charitable Giving into Your Estate Planning

Charitable giving is a noble way to ensure your legacy lives on, impacting future generations and supporting causes close to your heart. When structuring your estate plan, there are several philanthropic vehicles to consider, each offering unique benefits and considerations. From bequests to sophisticated trusts and donor-advised funds, understanding these options can help tailor your charitable contributions to align with both your financial and altruistic goals. Here's how you can effectively incorporate charitable giving into your estate planning.

Key Charitable Vehicles in Estate Planning

1. Bequests: One of the simplest ways to make a charitable gift is through a bequest contained within your living trust. This method allows you to specify an amount of money, a percentage of your estate, or specific assets to be given to charity. Bequests are highly flexible, easy to arrange, and can significantly reduce the estate tax burden on your heirs.

2. Charitable Trusts: These are more complex instruments that provide valuable tax breaks and can be tailored to suit different goals:

• Charitable Remainder Trusts (CRTs) allow you to receive an income stream or allow your designated beneficiaries to receive an income stream for a period, after which the remaining assets go to your chosen charity.

• Charitable Lead Trusts (CLTs) provide an income stream to the charity for a set term, and thereafter, the remaining assets revert to you or pass to your heirs, potentially reducing or eliminating gift and estate taxes.

3. Donor-Advised Funds (DAFs): DAFs act as a charitable investment account. You contribute assets which immediately qualify for a tax deduction, and then recommend grants to charities over time. This vehicle is particularly useful for those who wish to remain actively involved in philanthropy without managing a private foundation.

4. Private Foundations: For those with substantial assets, starting a private foundation can be an effective but complex way to control charitable giving. Foundations can fund various charities, offer family members roles in its administration, and create a lasting institutional legacy. However, they require significant management and adhere to strict regulations.

5. Endowments: Setting up an endowment can provide a charity with a permanent source of income, as the principal is kept intact while investment income is used for charitable purposes. This option is appealing if you want to ensure long-term financial support for a charity.

Strategic Considerations for Charitable Giving

Tax Implications: Each vehicle has specific tax benefits and implications. For example, bequests can reduce the size of your taxable estate, while contributions to CRTs and CLTs may reduce both income and gift taxes. Understanding these nuances is crucial in maximizing the tax efficiency of your charitable efforts.

Timing of Impact: Some options, like direct bequests or contributions to DAFs, can provide immediate benefits to charities. Others, such as endowments or CLTs, are structured to give over a long period. Consider when you want your chosen charity to benefit from your gift.

Control and Legacy: Decide how much ongoing control or involvement you wish to have. DAFs and private foundations allow for continued involvement in donation decisions, whereas bequests and endowments are generally one-time arrangements.

Family Involvement: If involving family in philanthropy is important, consider vehicles that support this goal. DAFs and private foundations can engage multiple generations in charitable activities.

Charitable giving within estate planning is not just a way to reduce taxes—it's a strategy to make a meaningful difference in the world while honoring your values. Whether it’s supporting a local community, contributing to global causes, or advancing scientific research, the right charitable vehicles can integrate your philanthropic objectives seamlessly into your overall estate plan. As always, consulting with legal and financial professionals can provide guidance tailored to your personal circumstances, ensuring your charitable contributions are both impactful and aligned with your estate planning goals.

Avoid the Estate Planning Banana Peel – Don’t Add Your Kids on Title to your Home

Many aspects of estate planning in California center around avoiding the need for probate court. Adding a death beneficiary to an asset or adding a co-owner on title to an asset are two ways to avoid the need for probate court when you die. Well, that sounds pretty easy. Why don’t we all just do that and call it a day?

Put simply, adding co-owners and death beneficiaries to assets only addresses one situation: that 1) you have died; 2) that the beneficiary/co-owner is alive upon your death; 3) the beneficiary/co-owner has capacity and is over 18 years old upon your death; and 4) the beneficiary/co-owner does not have creditors nipping at their heels.

There are so many other scenarios that can occur. All it takes is for any one of the four factors above to be false for your simple plan to become complicated and problematic. Besides that, there are tax implications for adding people onto title of your assets.

Let’s illustrate with a common example. A widowed parent owns their own home, and has two children. The parent figures that it would simplify everything if they add their two children onto the title of the home. That way, upon the parent’s death, the children receive the home, in equal shares, without having to go through the probate process.

What gets overlooked in the above hypothetical are the following considerations.

Death v. Incapacity

The only way to avoid probate in the above example is if the parent dies. If the parent is alive but incapacitated (think: dimentia), the children have no authority to act on the parent’s behalf by simply being co-owner of the home. They now co-own a property with someone who cannot handle their own affairs. They would have needed the parent to sign other legal documents, such as a durable power of attorney.

Similarly, if either or both children are incapacitated upon the parent’s death, probate may be necessary to receive ownership of the home unless the incapacitated child signed a durable power of attorney themself. Or, if the children are not yet adults, they cannot own the property outright without legal guardians involved.

Creditors

When the parent adds the children as co-owners to any asset, including their home, the parent is entangled with that child’s financial life, including that child’s creditors. If the child is going through a divorce, or someone is suing them for money, or the child owes taxes or other debts, or if the child files for bankruptcy, then the parent’s home is now subject to the claims of the child’s creditors. The parent may have to figure out how to get their own house back!

Additionally, if the child faces those same creditors after the parent’s death, there is no barrier between receiving full ownership of the house and satisfying those creditors’ claims. Ultimately, the child may end up losing the home to their creditors, which is certainly not what the parent intended.

Creating Capital Gains and Property Tax Problems (Click here for a brief discussion of taxes)

When the parent adds their children to title, the parent is making a lifetime gift of that portion of the home. This in itself could trigger a gift tax issue. Gift tax issues aside, typically when the parent dies, all of the capital gains built into the home are eliminated upon the parent’s death. But only the capital gains associated with the portion of the home that the parent owned at death. The portion of the home that the children now own do not receive what is called a “step up in basis”, and the capital gains for the children’s portion are not eliminated. If the parent kept all 100% interest in the home, then all of the capital gains would have been eliminated. After putting their children on title during their life, the parent is now creating a capital gains problem for the children when they sell the home.

Adding multiple children to title can also create adverse property tax implications. Even though Prop 19 has severely limited the application of the parent-child exclusion, there is still an opportunity for the parent to transfer the home to one or more children with some relief from increased property taxes. However, when more than one child is added as co-owner, the home could get reassessed when one child decides to buy another out in the future since that is not a parent-child transaction.

Co-ownership and death beneficiary designations lack any nuance. It only asks whether an owner is dead, and if the answer is yes, ownership of the asset automatically transfers to the other co-owners or to the beneficiaries in whatever condition or circumstance they find themselves. No discretion is involved to determine whether it’s a “good” situation to transfer ownership of the home to the co-owner or beneficiary. Additionally, It makes you vulnerable to your co-owners’ creditors, and could create unforeseen tax issues for your loved ones. The only surefire way to transfer ownership of your assets, with nuance and full discretion, is to create a comprehensive estate plan.

Are Holiday Gifts Taxable?

The short answer: Yup! But, spoiler: you probably won’t end up paying any gift taxes on holiday gifts.

A holiday gift is a donative transfer of an asset from one person (donor) to another (donee). A “donative transfer” simply means that the donee didn’t have to do or pay anything for it. It’s a true gift! It’s also a gift that you’re giving during life (intervivos) - as opposed to a gift that you make after you die (i.e. through a will or trust).

There is a tax that could be imposed, but that requires a little more explanation. Just like the government taxes things from your income (income taxes), to certain goods sold (sales tax), to real estate that you own (property taxes), it also taxes the transfer of items. So the gift tax is a transfer tax.

The gift tax is only imposed by the federal government (think: IRS); California doesn’t tax gifts. And it’s only imposed on the donor (the person giving the gift). If you receive a gift, and you live in California, you’re not on the hook for transfer taxes. If you give a gift, and you live in California, you still won’t owe any gift tax to the State of California and probably won’t owe any gift taxes to the federal government.

Here’s why: The federal government has this nifty rule called the “annual exclusion.” What that means is that each resident of the USA can make a gift up to $15,000, per year, to any other person, and not owe any taxes on that gift. In fact, the IRS doesn’t even want to know about it! You don’t have to report it. Married couples can combine that exclusion amount to $30,000 to one person, per year, and still fall within the same rule. So put another way, you’d have to be awfully generous this holiday season to have to deal with gift taxes.

Well, what if you are that generous?

If you make a gift in excess of $15,000 but less than what is called the exemption amount (currently $11.58 million per taxpayer for 2020; $11.7 million for 2021), you won’t owe any gift taxes. However, you do need to report it to the IRS. Once reported, the IRS will deduct the amount of the gift over $15,000 from your total exemption amount that you’re entitled to when you die. For example, if you give a $75,000 gift to your favorite niece this year, you would report a $60,000 gift ($75,000 - $15,000 exclusion amount) and the IRS would walk over to your file and deduct $60,000 from your $11.58 million unified credit. Only $11.52 million left to give before you pay transfer taxes! (The exemption amount involves estate taxes, which we can explain and discuss with you as part of your estate planning process.) 

Until then, may you have a safe, healthy, and generous holiday season!

What is... an ILIT?

This is part of an on-going series of blog posts titled the "What Is..." series, where we attempt to explain, in simple terms, common estate planning terms and concepts. To read other posts in this series, click here.

An ILIT (eye-lit) is an irrevocable life insurance trust. It’s a trust that cannot be changed (irrevocable) that is created to be both the owner and the beneficiary of a life insurance policy. Why would you do this? It’s a way of having life insurance proceeds excluded from a taxable estate. 

Remember that estate taxes are calculated by adding up the value of everything you own at your death, and if it’s over the estate tax exemption, your estate owes 40% of the excess over the exemption amount. Well, “everything you own at death” includes the proceeds of any life insurance policies you owned during life. Essentially, an ILIT allows you to gift the money “out” of your estate during your life, but still have control over the proceeds after you die.

If you’re thinking “what about gift taxes?” you’re on track: The trustee of the ILIT sends a letter to the ILIT’s beneficiaries (called a “Crummey” letter) every time you transfer money into the ILIT to pay for the insurance premiums. It advises the ILIT’s beneficiaries that they can ask for their share of the money within a specified period of time. 

Typically, no one actually asks for their share because the benefits of leaving it in the trust to pay life insurance premiums would result in more money, later. If there’s no money to pay the premium, then the policy will lapse and there won’t be anything for the beneficiary later. By issuing this letter, the money you transfer to the trustee of the ILIT becomes a “present interest” gift. In other words, that letter transforms your transfer of premium money into the trust into a lifetime gift that can be eligible for the gift tax annual exclusion. The annual exclusion allows you to make gifts up to $15,000 per year per person and not result in any gift taxes owed.

There are certain rules: 

1. You can’t be the trustee of the ILIT

2. Because it’s irrevocable, you fund it and you walk away. The trustee is in control of it. 

3. When the insured person dies, the trustee invests the insurance proceeds and administers the trust for the beneficiaries of the trust. 

The ILIT trustee possesses all incidents of ownership in the policy, so the ILIT can provide the insured’s estate with liquidity, while shielding the insurance proceeds or assets bought with the proceeds from estate tax when the insured dies. 

Flipped the other way: if you own the policy and retain control, you can withdraw cash or change beneficiaries as much as you want during your lifetime. This makes it YOUR asset. This also means that the IRS would include the proceeds of your policy in your estate’s value when you die. 

For example: the current exemption amount for an individual is $11.58 million . If you have $10 million in assets, and a $2 million life insurance policy that you control and maintain, then you have $12 million of taxable assets — over the current exemption amount. If, however, the $2 million insurance policy is in an ILIT, then it’s not part of your taxable assets, and you can (assuming it’s done correctly) stay below the exemption amount, and in this case avoid owing estate taxes.

An ILIT can either be funded with an existing life insurance policy, or the ILIT can purchase the policy on your behalf. If you opt to transfer an existing life insurance policy into an ILIT and you die within 3 years of that transfer, the IRS will still include the proceeds in your estate for tax purposes. If you have the ILIT purchase the life insurance policy, you can avoid this, but you must fund the trust with sufficient money over the years to pay the premiums. 

If you and/or your spouse are the chief breadwinner(s) of the household, and that income is abruptly diminished while your children are young and there are substantial monthly expenses, oftentimes families are challenged to make ends meet. For some clients, especially those with young children and who also have a substantial mortgage to pay, life insurance can be a useful tool to “inject” cash into an estate at an unexpected time of need to help pay for your child’s living expenses so that your children’s home would not need to be sold to defray costs.

Make sense? If not, contact us!

US Treasury Confirms No Clawback

The Tax Cuts and Jobs Act (“Trump Tax Law”) of 2017 increased the federal estate tax exemption from $5 million dollars per taxpayer to $10 million. That amount is effectively doubled for married couples. The exemption amount is indexed for inflation, meaning that it goes up incrementally every year. It is the exemption amount in the year that someone dies that is used to calculate estate taxes owed. For this year (2020), the exemption amount, with inflation, is $11.58 million per person, or $23.16 million for a married couple. In simple terms, if someone dies this year owning less than $11.58 million (whether things, homes, cash, etc.), then no federal estate taxes are owed. 

The estate tax (gifts at the time of death) exemption is linked to our gift tax system (gifts during life). The amount of lifetime gifts you give is added to the total amount of property you own when you die. For example, if George makes $5 million of gifts during his life, and then dies owning $7 million worth of property, then he would be on the hook for $12 million of gifts. That would use  his entire $11.58 million dollar exemption, and his estate would owe some estate taxes. I know, it’s a pretty good problem to have.

The Trump Tax Law provision elevating the estate tax exemption is set to sunset (expire) on January 1, 2026. If Congress does nothing between now and then, the exemption level will revert back to the $5 million amount, indexed for inflation. Essentially, the exemption will be cut in half if Congress does nothing.

So what happens if someone makes lifetime gifts in 2025, and then the exemption amount reverts back to the lower amount in 2026, and then the person dies thereafter? (To use the example above, George gives $5 million in 2025 and then dies in 2027 when the exemption amount is “only” $5 million, indexed for inflation.)

On November 26, 2019, the Treasury Department and the IRS issued final regulations adopting the regulations that were proposed in November of 2018, effectively ensuring that if a decedent uses the increased exclusion amount for gifts made while the Trump Tax Law is in effect and dies after the sunset of the Trump Tax Law, the decedent won’t be treated as having made taxable gifts in excess of his or her exclusion amount.

In plain English, this means that there won’t be a clawback if George uses the exclusion amount in effect now, even if the exclusion amount is lower when George dies.  For George, the IRS will use the greater of the exclusion amount used during the transfer or on the date of death. So George will not be penalized later even though the exemption amount dropped.

The final regulations also reinforce the notion of a “use it or lose it” benefit and direct that a taxpayer who uses the exemption is deemed to use the base $5 million (indexed) exemption first and then the additional amount of exemption available through 2025.  For individuals dying after 2025, if no gifts were made between 2018 and 2025 in excess of the basic federal exclusion amount in effect at the time of death, the additional exclusion amount is no longer available. In other words, unless George uses the increased exemption amounts before 2026, he will not receive that benefit later.

Either way, the exemption amounts cover a vast majority of American estates. However, for very high net worth families, we anticipate very large transfers of wealth to occur between now and 2026 so that the benefit of the heightened exemption amounts are not lost.

Married: You Either Are or You Aren't.

Have you heard that story about the couple who lived together for seven years, and then they accidentally became married? Or what about the one where your friends were in a “common law” marriage?

Well… they’re both bogus concepts. At least in California. We don’t even know where the “seven year” part came from.

In California, you’re either married with a state license and certificate from the county clerk (and a few other requirements) or you’re not married. Period. There’s no intermediary status. There’s no “common law” marriage. You can’t accidentally find yourself in a marriage. The law doesn’t care how long it took your significant other to propose, or the size of the ring… or whether there was a ring at all! There are a dozen or so states that recognize “common law” marriage, but we’re not one of them.

So how does the law view your live-in significant other? You know, the person you’ve been living with romantically for years?

To put it simply: short of marriage, the law views your significant other as a roommate. It doesn’t matter how long you’ve lived together, whether you have children together, or whether you share ownership of property. You need that marriage license in order to be considered lawfully married.

Married couples enjoy benefits that unmarried people do not. Married couples are legally considered family (for example: when visiting one another in a hospital, or for inheritance purposes, or for health care benefits). Unmarried couples cannot own community property. That’s only for married couples, too. Also, tax treatment for married couples is dramatically different than for an unmarried couple.

You may have heard of “Registered Domestic Partners”. Or just “domestic partners”. But that has its own set of requirements, and is governed by state law. It doesn’t happen accidentally or automatically. And it’s only recognized in a few states (including California), but not by the federal government, like marriage is.

A couple’s decision not to marry does not detract from the love, trust, support or any of the interpersonal relationship benefits married couples can share. However, it is important for an unmarried couple to know that the law treats couples in vastly different ways based solely on marital status. A marriage certificate may literally be “just a piece of paper” but that piece of paper has important legal ramifications.

If you would like to discuss how your situation would be affected by getting married (or not), please contact us for a free consultation.

Explaining the Gift and Estate Tax

The gift and estate tax are both transfer taxes. That means that they tax the transfer of assets from one person or entity to another. The amount of the tax is based on the value of the asset being transferred. For example, if I give you my 2007 Toyota Camry, then I am transferring an automobile from me to you. The value of that transfer would be the fair market value of the Camry when I transfer it. So we'd have to figure out how to value it (most likely look in Kelley Blue Book, or something similar) and the tax would be calculated based on that value, and I would owe any taxes generated on the transfer since I am the grantor (giver) of the gift. There are exemptions from paying the tax that I'll get into below. Also, this post only refers to federal transfer taxes. California does not impose state-level transfer taxes on gifts.

Let's first distinguish between the gift tax and the estate tax. I already told you that they're both transfer taxes. The gift tax is a tax on lifetime transfers. The estate tax--also affectionately called the "death tax" (they're the same thing)--refers to a tax on gifts through death (think: gifts made from wills or trusts; inheritances). So in my example above, about giving you my car, that would implicate the gift tax and not the estate tax. I gave it to you while I was alive.

If you make a lifetime gift, the grantor of the gift would owe the taxes. The same is true for death gifts. The estate of the person who made the gift would (typically) owe any estate taxes owed. (Some states have what is called an "inheritance tax" where the recipient also owes a tax, but California does not have an inheritance tax.)

Now that we've sorted out when each tax is implicated, let's figure out when you actually owe anything.

Both the gift tax and estate tax share a unified exemption amount. What that means in plain English is that you can transfer--either through life or death--a certain value of property, and you won't owe ANY transfer taxes. And that exemption amount is a whopping $11.18 million per person! That is not a typo. The latest tax law passed by Congress increased each person's exemption amount from $5 million to $10 million. And that amount is adjusted for inflation each year. That's how we got to $11.18 million. As of January 1, 2018, anyone making a gift may transfer up to $11.18 million worth of assets and pay zero taxes. The exemption amount is determined in the year you make the gift, or the year in which you died. That pretty much means that these transfer taxes do not apply to more than 99.98% of the population. If you're one of the lucky few who have more than that value in assets, then the transfer tax rate for the amount in excess is a flat 40%.

Please note that in 2026, this amount reverts back to the $5 million amount, and it will be adjusted for inflation to be somewhere around the $6 million mark per person.

A benefit that married couples get is that spouses can effectively combine their exemption amounts. So married couples can give away upwards of $22.36 million, and owe zero transfer taxes.

Wait, does this mean that I can cut a check for $1 million to my best friend, and I'll owe zero gift taxes? Yup, that's right. Except that I would need to let the IRS know that I made that gift by filing a gift tax return (Form 709). The IRS would then go over to my file and reduce my $11.18 million exemption by $1 million. Only $10.18 left to give away until I owe any transfer taxes!

Maybe some of you have heard that you are limited to a certain amount of gifts per year. What's that all about?

You're probably thinking of what's called the annual exclusion. The annual exclusion is an amount the IRS lets you gift in one single year, per recipient, and not have to file that gift tax return. If your gift is below the annual exclusion amount, then you don't have to tell the IRS about it. That amount is currently set at $15,000 per year, per recipient. Married couples may combine their gifts, so they effectively may make gifts up to $30,000 per year, per recipient and not have to file a gift tax return notifying the IRS.

So going back to my $1 million lifetime gift example, I would only notify the IRS of $985,000 of the gift since I get to use my annual exclusion on that gift to my best friend. If I'm married, I only need to tell them about $970,000 of the gift.

As you can see, transfer taxes are probably not going to be an issue for you. Actually, let me put it another way: if transfer taxes are a concern for you, we should hang out this weekend!