Anyone may give $14,000 annually to any number of recipients in 2014. “Split-gifts” of $28,000 may be made annually by a married couple to any number of recipients. These annual exclusion gifts are made gift tax-free, usually to children and grandchildren. Of course, each person also has a $5,340,000 lifetime exemption in 2014 for the purpose of making large gifts (adjusted taxable gifts).
An annual exclusion gift program also has some advantages from an estate tax point of view:
» Annual exclusion gifts can reduce the gross estate.
Annual exclusion gifts are totally removed from the gross estate for federal estate tax purposes. So, more goes to your heirs instead of to the Internal Revenue Service. The longer the gifting program is in place, the greater the value that passes to your heirs free of estate taxes. With a 40 percent federal estate tax rate on gross estates in excess of the federal estate tax exemption of $5,340,000, the cumulative estate tax savings can be substantial.
» Future appreciation is not included in the gross estate.
Gifts can be made outright to heirs or can be made to an irrevocable trust for the benefit of those heirs. Not only are the annual exclusion gifts removed from the gross estate, the future capital growth and income from those assets also avoids estate tax. Assets gifted to an irrevocable trust may be invested by the trustee in stocks, bonds, mutual funds, annuities or real estate. For even more tax-free leverage, an estate owner may consider purchasing a life insurance policy owned by an irrevocable life insurance trust (ILIT).
» Irrevocable life insurance trust.
An ILIT is a powerful way to leverage gifts made to heirs that will provide liquidity at the insured estate owner’s death. Death proceeds will be actuarially leveraged, income tax-free and estate tax-free. This is a strong financial and tax combination.
Here is an example of the supercharged tax-free leveraging an ILIT can provide:
Assume a married couple, each age 65 and preferred nonsmokers, have a significant estate that will be exposed to federal estate taxes because its value is in excess of their combined estate tax exemptions ($10,680,000 for a married couple). The federal marginal estate tax rate on the excess is 40 percent. Their estate is assumed to grow at a 5 percent rate of return. They have two adult children.
A $56,000 annual premium split-gift annual exclusion program with an ILIT will purchase $4,511,000 of no-lapse survivorship universal life (SUL) from a competitive carrier. Look at the results below in year 25 (age 90), which is the joint life expectancy of two 65-year-olds from the government table (Treas. Reg. 1.72-9, Table VI).
Situation A – Estate Taxable Option: Clients retain the $56,000 per year in their gross estate, which grows at a nonguaranteed after-tax rate of return of 5 percent for 25 years. The fund will hypothetically grow to $2,806,000 in 25 years. However, a 40 percent estate tax rate will deplete this fund to only $1,684,000 after estate taxes are paid.
Situation B – Estate Tax-Free Investment Option: Clients gift their $56,000 split-gift annual exclusion per year to an irrevocable trust for the benefit of their two children. The trustee invests these funds into stocks, bonds and mutual funds that generate a nonguaranteed after-tax rate of return of 5 percent for 25 years. The estate-tax free fund in the trust will hypothetically grow to $2,806,000 in 25 years.
Situation C – Estate Tax-Free Insurance Option: Clients gift their $56,000 split-gift annual exclusion per year to an ILIT for the benefit of their two children. The trustee purchases a no-lapse survivorship universal life policy (SUL) from a competitive carrier with a guaranteed death benefit of $4,511,000 throughout the 25-year period of time.
The after-tax comparison after 25 years (age 90 joint life expectancy) speaks for itself:
Estate Taxable Option: Hypothetical nonguaranteed net after-tax to heirs - $1,684,000
Estate-Tax-Free Option: Hypothetical nonguaranteed net after-tax to heirs - $2,806,000
Estate-Tax-Free Insurance Option: Guaranteed net after-tax to heirs - $4,511,000
In the example above, the after-tax internal rate of return (IRR) on the estate tax-free no-lapse SUL insurance option is 8.13 percent at age 90 joint life expectancy. In a 33 percent income tax bracket, this is equivalent to a pretax rate of return of 12.13 percent.
A good financial asset to provide the source of funds for the annual exclusion premium gifts described above is the after-tax distribution from an individual retirement account (IRA). This is especially true if there are other sources of retirement income available and the IRA will not be needed to provide retirement income. Although required minimum distributions (RMDs) from an IRA must be made beginning at age 70½, distributions can be made prior to age 70½ if financially justified. The creation of the no-lapse SUL policy described previously, in which the death benefit is free of income tax and estate tax when owned by an ILIT, should certainly be considered to be a financially justified transaction.
For instance, assume that the wealthy 65-year-old couple described in the example above had a $2 million IRA as part of their gross estate. Assume there were other assets that could provide retirement income, such as rental real estate, pass-through K-1 income from an S corporation or limited liability corporation that they owned, and combined Social Security retirement benefits. They will need to start taking RMDs from the $2 million IRA anyway, beginning when they reach age 70½. Why not start taking distributions from the IRA now, while they are younger and still healthy, instead of waiting until 70½ when insurance premiums will be higher and their health might deteriorate for medical underwriting purposes? In a 33 percent income tax bracket, an $83,582 taxable withdrawal from the IRA each year would net $56,000 after taxes. This $56,000 would then be gifted to the ILIT each year as a premium for the $4,511,000 no-lapse SUL policy described in the example above.
As you can see, the financial advantage of owning tax-free life insurance in an ILIT, when compared with other taxable and nonguaranteed fixed financial product alternatives, is truly outstanding in this continuing low-interest-rate environment. Ask yourself a simple question. Should no-lapse guaranteed life insurance be part of your client’s asset portfolio mix that will be transferred to the heirs upon death? I think the answer is abundantly clear when you do the simple analysis outlined above.