Category: Tax - PFwise.com

6 Forgotten Tax Benefits of Life Insurance - Part B

10/25/2021

We discussed 3 forgotten tax benefits of life insurance here, now the next 3 tax benefits.

4. Tax-Advantaged Access to Cash When Needed
Most potential buyers don’t understand that permanent life insurance policies have contractual features that allow the owner of the policy to withdrawal cash from the policy using tax-advantaged loans and withdrawals.

Money borrowed or taken from the cash value of a life insurance policy is generally not subject to income taxes up to the “cost basis” — the amount paid into the policy through premiums.

Also, there are no regulatory restrictions on how the cash taken from a life insurance policy must be used by the owner. This creates significant flexibility to use the cash to fund a variety of needs, be they health or personal needs, such as putting on a new roof.

5. Supplemental Source of Tax-Free Retirement Income
Policyowners can withdraw or borrow against the value of their permanent life insurance contracts for any need, like supplementing their retirement income. If this benefit is used, the policyholder needs to clearly understand that tapping a life insurance policy’s cash value decreases the remaining cash value as well as the death benefit.

6. Tax-Free Way to Leave a Legacy
Life insurance can be used to create an income tax-free legacy to beneficiaries using the income tax-free death benefit. For very large death benefits there is the possibility of triggering estate taxes, which must be planned.

Legacies can be created for family members, charities, religious organizations and educational institutions. This can allow individuals to benefit numerous entities using the leverage that the life insurance death benefit creates.

The key takeaway is this: When you read about tax advantages provided to the middle class, the benefits of life insurance are infrequently mentioned.

Life insurance offers significant tax benefits that provide families with protection, the ability to accumulate cash and leave a legacy to those they care about. We need to beat the drum louder to promote these intrinsic benefits.

6 Forgotten Tax Benefits of Life Insurance - Part A

10/24/2021

Here are the top six tax advantages of cash value life insurance.

1. No Limit on the Amount Purchased
In comparison to qualified plans, there is no limit on the amount of life insurance that can be purchased subject only to the underwriting limitations of issuing life insurance carriers.

Using cash value life insurance as a tool to save for the future and to generate supplemental retirement income are valuable benefits in a world where households need to save more as corporate pension plans disappear.

2. Tax Deferral on Earnings
Permanent life insurance policies can generate cash value over time as premiums are paid and excess cash beyond the policies’ cost is generated. All cash income earned is not taxed currently and is able to earn interest on the taxes not currently paid. As we face the prospect of increasing future income tax rates, this benefit could become even more valuable.

3. Income-Tax Free Death Benefit
One of the most forgotten tax benefits of a life insurance policy is that the death benefit is income-tax free. Beneficiaries receive the policy’s death benefit, usually in a lump sum, and don’t have to report the payout as taxable income.

They can use it as they please. The fact that the payment is received without any federal or state income taxes multiplies its value to the beneficiary.

Keep reading for the next 3 forgotten tax benefits of life insurance.

Tax Plan Upends Estate Planning Using Trusts With Life Insurance

10/19/2021

Financial-planning.com has an article that details why the proposed tax plan upends estate planning using trusts with life insurance.

‘Crisis stage’
The blow to life insurance in trusts, a bread-and-butter wealth preservation strategy of the rich for decades, is one of many proposals in the emerging tax bill that take aim at the wealthy to finance President Joe Biden’s $3.5 trillion social spending plan.

The draft bill would raise the top individual rate to 39.8% from 37% and bump up the top capital gains rate to 28.8% from 23.8%. It would tax capital gains at the top ordinary rate once income hits $1 million, crack down on large retirement accounts and end backdoor Roth conversions, a favorite strategy of high-income earners to create tax-free profits. And it would kill the use of grantor trusts, the workhorse of estate planning, whether or not they contain life insurance.

It's easy to see what the tax perk has been. Say a person dies owning a $3 million home, $7 million in retirement accounts and $4 million of life insurance not held in a trust. With the current estate tax exemption at $11.7 million, $2.3 million of that $14 million estate would incur the 40% estate tax — a bill of $920,000. Now assume instead that the insurance policy is in a grantor trust. It wouldn’t go into the person’s estate, leaving nearly $1 million more for heirs.

Such savings would no longer be possible under the proposal. In any case, the historically high level at which estate taxes kick in would fall by nearly half to under $6 million in the House plan.

Under the House bill, “the life insurance issue has moved things to crisis stage,” said Steve Parrish, who co-directs the Center for Retirement Income at The American College of Financial Services.

“Right now, webinars, emails and panicked calls are circulating among estate planning professionals.”

One particularly hairy element, he said: Advisors are “trying to draft answers to their clients that avoid professional liability if they’re wrong.”

‘A major impediment’
The legislative proposal has upset financial advisors and estate lawyers because it’s common for life insurance to be held in a widely used type of trust called a grantor trust.

“This problem with insurance is really buried in the legislation,” said Warren Racusin, the head of the trusts and estates group at law firm Lowenstein Sandler in New York.

A grantor trust is a type of trust over which the owner, meaning the grantor, retains control and pays income tax on its gains. It comes in many flavors, including intentionally defective grantor trusts, or IDGTs, and grantor retained annuity trusts, or GRATs — all alphabet soup names well known to estate planners for the rich. Advisors say that most irrevocable life insurance trusts, or ILITs, are set up as grantor trusts, so they’d be hit by the curb, too.

The proposal says, in obscure language, that any assets contributed to grantor trusts come 2022 would become part of the grantor’s estate for estate tax purposes. The issue is that under the plan, a policyholder who pays her annual premiums for a policy that’s held in a trust would be “contributing assets,” thus making the trust subject to the 40% estate levy.

While the proposal would “grandfather” existing grantor trusts, that’s small comfort for those with life insurance. According to Mari Galvin, the chair of the trusts and estates group at law firm Cassin & Cassin in New York, it’s not clear from the proposal whether all of a trust could be shunted into the owner’s taxable estate if premiums are paid after this year, or just the portion related to the premium payments starting next year. “Time will tell,” Galvin said.

In any case, the grandpa safety net could be mighty small. Trusts that already exist and whose policies are fully paid would “most likely” remain grandfathered, according to Andrew Bass, the chief wealth officer of Telemus Capital, an independent advisor with brokerage services in Southfield, Michigan, that manages nearly $2.2 billion for high net worth investors. But only, Bass added, if the terms of the trust prohibit it from using its own income to pay premiums. The problem, he said, is that “most trusts were written with language that allowed trust income to be used for payment of premiums, thus forcing a loss of grandfathered status.”

In any case, wealthy individuals who want to create a future trust for their life insurance couldn’t make their spouse a beneficiary without subjecting the trust to estate tax. That’s because such a trust is automatically a grantor trust and thus would have to pay estate tax under the proposal.

“That is a major impediment, as insurance is typically needed by a surviving spouse,” Bass said.

The solution becomes the problem
The proposal has the potential to upend retirement planning.
“Life insurance is used by the well-heeled to both conserve and create an estate,” Parrish said. But if a policy’s death benefit gets hit with a 40% tax at death, “the insurance becomes the problem rather than the solution.”

The idea of pre-paying premiums revolves around using outside funds, not money inside the trust, as the latter would get caught by the proposed curb.

“We are advising clients to pre-fund their premiums now” by contributing cash or other assets before the new law passes so that no additional outlays are required to pay future premiums, said David Handler, a partner in the trusts and estates group at law firm Kirkland & Ellis in Chicago.

That’s easier said than done. Ponying up early premiums for a large “permanent” policy that lasts for life can cost millions of dollars. Where to find those dollars between now and New Year’s Eve? Individuals might have cash on hand, or they might contribute securities to the trust which can be sold over time to pay the premiums, Racusin said.

Handler said that others "might borrow from banks.” But Parrish said many investors would be left out in the cold, because “in many cases, these policies are financed through loans, so it’s impractical to pre-pay the premiums.”

Flying blind
The proposed curb would hit not just the very rich. People of more middling wealth, for whom a life insurance policy is often their trust’s single largest asset, would also feel pain.

For example, a person might have a net worth under the estate tax threshold but also a large life insurance policy to care for their family if they die prematurely and their income grinds to a halt, Handler said. Which means that when the insurance death benefit is paid, the decedent’s total assets can exceed the estate tax exemption.

Wealth advisors and estate planners say they're flying by the seat of their tax pants.

Advisors, Parrish said, “are feeling damned if they do” (pre-paying or taking other moves) and “damned if they don’t" (adopting a wait-and-see approach to whether the proposal becomes law).

Bass said one solution might involve “decanting” a grantor trust, like a fine wine. That strategy involves “pouring” a trust’s assets into a new trust. Or a trust could pay the insurance premiums through so-called split dollar arrangements, which are common with wealthy executives.

Or it could be set up so that beneficiaries other than a spouse would have to approve any distributions out of the trust to the spouse, “but that could cause family rifts and may have gift tax implications for the kids,” Handler said.

Racusin likened the tax contortions to navigating wealth planning with blinders on. “It’s kind of like an architect telling a builder, ‘hey, I need you to build this house right now, but I don’t have the plan, but you need to start building it right away.’”

Why Splitting Contributions Between Traditional and Roth IRA is Not Tax Diversification

10/7/2021

Mathematically, the Roth-versus-traditional IRA decision will actually be the same, regardless of growth rates and time horizon, as long as both accounts remain intact and tax rates don’t change.

If future tax rates do change, though, the Roth IRA will result in more wealth when tax rates rise in the future, while the traditional IRA will benefit when tax rates are lower in the future. Though in practice, because the tax burden for a Roth IRA is paid upfront – when the (after-tax) contribution is made – there is no future uncertainty with respect to its future tax rate; instead, changes in tax rates primarily impact the future value of a traditional IRA, in particular, making it better or worse off depending on whether or how tax rates change.

To cope with this uncertainty, one popular approach is to ‘tax-diversify’ between the two types of accounts, splitting contributions between traditional and Roth IRAs so that there is at least ‘some’ benefit regardless of which direction tax rates go (as higher tax rates benefit the portion of dollars in the Roth, and lower tax rates would benefit the traditional IRA dollars instead).

However, the reality is that splitting dollars between traditional and Roth retirement accounts isn’t just a form of diversification; because the outcomes are correlated to each other, the net result is that tax diversification doesn’t actually diversify the risk, it simply neutralizes the opportunity altogether. Or viewed another way, splitting between traditional and Roth IRAs is more akin to just bailing out of stocks altogether and owning zero-return cash.

If you want to see a more thorough discussion of this topic, here is an excellent article.

Backdoor Roth Alternatives

10/5/2021

Roth 401(k)
People who have the option can contribute to a Roth 401(k) in order to accumulate assets in a Roth account. The proposed legislation does not limit these contributions, and the money can be rolled over to a Roth IRA when you leave your employer.

In many cases, a Solo 401(k) can offer a Roth option as well. This would work in the same fashion as a 401(k) offered via an employer as far as the employee contribution component.

Health Savings Account (HSA)
HSAs are a great vehicle for people who have access to a high-deductible health insurance plan. Health savings accounts allow for pretax contributions and withdrawals to cover eligible medical expenses are tax-free.

HSAs can act as another retirement account in that the money contributed to the HSA can be carried over from year to year if not used. This makes an HSA a great way to save for medical costs in retirement, essentially making it a tax-free retirement savings account. Many HSAs allow the money to be invested. If the money is not used for medical expenses in retirement, it can be withdrawn just like a traditional IRA with taxes due on the money.

Contribution limits for an HSA are:

Individuals can contribute $3,600 for 2021 and $3,650 for 2022.
Families can contribute $7,200 for 2021 and $7,300 for 2022.
Those over age 55 can contribute an extra $1,000.

Life Insurance
A whole life insurance policy, along with some other types of cash value life insurance, is another way to build tax-free income in retirement. This is more complex than a backdoor Roth to be sure, but if this is a fit for you this can be an alternative.

Essentially, you would purchase the life insurance policy. Part of the premium funds the growth in cash value. They can withdraw the portion related to the premiums tax-free and take a policy loan against the rest of the cash value that will have accrued from dividends. The additional withdrawals will serve to reduce or eliminate the death benefit. Upon their death, the death benefit passes to your heirs tax-free.

There are a number of cautions and caveats to this approach, including ensuring you don't withdraw too much so as to create a modified endowment contract situation. Additionally, the cost of the premiums and your need for the death benefit should also be considered.

What To Do If Congress Stops Backdoor Roth Conversion?

10/4/2021

The House Ways and Means Committee recently passed $2.1 trillion in tax hikes that will help fund President Joe Biden’s American Families Plan. Among their proposals are the elimination of backdoor Roth and mega backdoor Roth IRA conversions. Both of these provisions could affect people who earn too much to contribute to a Roth IRA and those who want to ramp up their Roth account balances.

The proposed legislation would end the ability to convert after-tax contributions in both 401(k) plans and traditional IRAs to a Roth after Dec. 31, 2021, effectively killing both of these options.

People who have been making after-tax contributions to their 401(k) plan to fund a mega backdoor Roth conversion need to make some decisions this year.

If their plan allows for the conversion of this money to a Roth 401(k) account within the plan, this needs to be done prior to Dec. 31, 2021, if the legislation passes as is. Note that any earnings on these after-tax contributions will be taxable upon conversion. If the plan allows for in-service withdrawals in order to roll this after-tax money to an IRA and convert to a Roth, you will want to consider doing this by the end of the year.

If none of these options are available to you, the after-tax contributions would be stuck in the plan until you leave the company. Unless this happens prior to Dec. 31, 2021, you will lose the opportunity to convert this money to a Roth if the proposed legislation passes.

For people who may want to make an after-tax contribution to a traditional IRA and do a backdoor Roth conversion, this also needs to be done by Dec. 31 of this year if this legislation passes.

End of 2021 Tax Planning Strategies

10/3/2021

The final quarter of the year is often an active period for financial advisors helping their clients make tax planning decisions for the current year and the year ahead. This year, however, the possibility of significant changes in clients’ tax situations brought on by the proposed reconciliation bill currently being negotiated in Congress means there could be especially high value in proactive end-of-year tax planning. This article from fa-mag.com mentions a few strategies and is worth reading: Tax Moves Advisors Should Make Before Year End.

For example, because the bill would increase the top ordinary income tax rate from 37% to 39.6% for individuals earning over $400,000 starting in 2022, a client who is expecting a year-end bonus could benefit from accelerating that income to this year (e.g., by asking for it to be paid in December 2021 instead of January 2022).

Additionally, the fact that most capital gains realized after September 13, 2021, would be subject to a higher top capital gains tax rate of 25% under the bill means it will be even more important to consider the tax consequences of performing year-end rebalancing in HNW clients’ taxable accounts… especially given the potential for large unrealized gains in those accounts after a year of strong market growth.

Furthermore, with the proposed bill reducing the estate tax exemption amount by 50% effective on the day of enactment, couples with taxable estates over $11.7 million may have only a small window to gift away excess assets to avoid having them be subject to estate tax (especially given that a number of popular estate planning strategies, from GRATs to IDGTs, would also be shut down if/when the legislation is enacted).

Smart Charitable Giving in 2021

9/25/2021

Part of legislation that became effective in 2020 carved out a new break for taxpayers who donate to charity and claim the standard deduction, as most do, instead of itemizing their deductions. For the 2021 tax year, here are the changes:

Married couples filing jointly for 2021 can deduct as much as $600 of charitable donations if they don’t itemize, while the limit is $300 for singles. For 2020, the maximum deduction was $300 per return for joint filers and singles.

On federal income-tax returns for 2020, this deduction was an “above-the-line” deduction, meaning it was entered above the line for adjusted gross income, or AGI. That reduced AGI, a number that can affect many other tax items. Congress wrote the law slightly differently for 2021, making it below the line—not reducing AGI, but still reducing taxable income. A draft of IRS Form 1040 for 2021 shows it on line 12-b.

A few reminders on points that haven’t changed:

This provision applies to “cash” donations, such as cash, check and credit cards. Make sure you have the required documentation.
Contributions of “noncash” items, such as clothing or securities, don’t count.
Gifts must go to “qualified” charities; donor-advised funds aren’t considered qualified for this provision.

Meanwhile, a popular provision known as a qualified charitable distribution, or QCD, remains alive and well. With a QCD, investors 70½ or older typically can transfer as much $100,000 a year directly from an IRA to charity without owing taxes on that transfer. This move, which must be done directly from the IRA to a qualified charity, counts toward the taxpayer’s required minimum distribution for that year. Donations to donor-advised funds don’t count. Transfers of more than the exclusion amount are included in income, the IRS says. See IRS Publication 590-B for more details.

4 Signs You Are Ready for Roth IRA Conversion

9/23/2021

The sweeping tax overhaul enacted in 2017 lowered tax rates starting with the 2018 tax year. These lower rates are scheduled to end with the 2025 tax year.
The Setting Every Community Up for Retirement Enhancement (Secure) Act eliminated the ability to stretch an inherited IRA for most non-spousal beneficiaries and requires that these beneficiaries fully withdraw the money in the IRA within 10 years. This applies to inherited Roth IRAs as well, but there is no tax to the beneficiaries in most cases with an inherited Roth IRA.
There are many unknowns as to what impact President Joe Biden’s tax proposals might have on rates, making Roth IRAs a viable option for many investors.

Here are 4 signs that the time may be right for Roth IRA conversion:

1. You earned less than usual this year.
A key issue to consider is your tax bracket for the year. If you are still working and fall into a lower-than-normal tax bracket, that can present an opportunity to do the Roth IRA conversion at a lower tax rate then you would incur during a more normal earning year.

2. You have retired but want to delay Social Security.
One time period where you might be in a lower tax bracket is your first few years of retirement. Your income is likely lower due to not receiving a salary or self-employment income. If you’ve decided to delay taking Social Security to maximize its benefit, this could provide a window of several years in which you are in a low tax bracket.

It is important to know that if you have reached the age where RMDs have commenced that the RMD money cannot be diverted to a Roth IRA conversion and that RMDs must be taken before any conversions are done.

3. You want to donate to charity.
Along the lines of managing your tax bracket, if you plan to give appreciated assets to charity, the tax deduction from these donations can be used to offset the tax hit of the Roth IRA conversion. It’s important that you are able to take an itemized deduction for the contribution, however.

4. You have cash on hand.
While it probably goes without saying, it’s critical that you ensure you have the cash available outside of your IRAs to pay the taxes. Having to take money from your traditional IRA to cover the taxes due will reduce the net amount that is ultimately converted to a Roth.

Additionally, the money to pay the taxes would end up as a distribution from the traditional IRA in this case. That money would be subject to taxes and to a 10% early withdrawal penalty if you are under age 59 ½. This type of situation would greatly diminish the benefits of a Roth IRA conversion and should be avoided in virtually all cases.

How the Very Rich Uses Private Placement Life Insurance (PPLI) to Avoid the Looming Biden Tax Increases

9/13/2021

Private Placement Life Insurance (PPLI) has long been a tax-shelter vehicle for ultra-high-net-worth clients, leveraging the tax-deferral build-up of cash value in a permanent life insurance policy but in a structure that accommodates more specific investment choices (for that particular HNW client) and without the sometimes-expensive commission structure that can overlay 'traditional' permanent life insurance.

However, a change to life insurance reserve requirements under the Consolidated Appropriations Act in late 2020 now allows insurance companies to use lower interest rate assumptions (based on a new variable rate tied to current market rates) in determining whether a life insurance policy will become a taxable Modified Endowment Contract (MEC), which has the end result of allowing substantially higher cash value contributions into permanent life insurance without triggering MEC status.

At the same time, the rise of a potentially significant increase in the taxation of both ordinary income and especially capital gains under President Biden's proposals is leading to growing interest in a wide range of 'tax shelters' for ultra-HNW clients.

The combination of the two is leading to a rapid increase in the number of HNW individuals now exploring PPLI as a tax shelter, with the new, more appealing tax-deferred cash value accumulation potential, coupled with a looming Biden tax increase. Of course, the reality is that surrendering a high-growth life insurance policy is itself still taxable, which means the value of high-growth PPLI, once implemented, can generally only be extracted partially via policy loans, or by holding the policy until death (though that option itself may still be appealing for those otherwise concerned that the Biden administration will eliminate the step-up in basis rules).

Because of the complex rules involved in establishing PPLI, it's generally recommended only for those who can contribute at least $2M (and more commonly, $5M+) to the policy.

THE MEGA BACKDOOR ROTH IRA STRATEGY AND SOLO 401(K) PLANS

9/12/2021

Do you know Solo 401(k)s for side jobs or businesses can possibly be rolled into mega backdoor Roth IRAs? This blogpost shows you this strategy - the required conditions and caveats to implement it, worth a read if your situation fits the bill.

Note: only after-tax contributions are allowed to be used in this strategy, and your side business must not be related to your regular job to take advantage of this rollover, and of course your side business must be successful so you can afford the cash flow contribution.

Tax Consequence of Leaving Life Insurance Surrender Value With the Insurer under Interest-only Option?

9/11/2021

Q. What are the tax consequences of leaving life insurance cash surrender values or endowment maturity proceeds with the insurer under the interest-only option?

A. The interest is fully taxable to the payee as it is received or credited. Under some circumstances, election of the interest option will postpone tax on the proceeds. If the option is elected before maturity or surrender without reservation of the right to withdraw the proceeds, the proceeds are not constructively received in the year of maturity or surrender.

But if the right of withdrawal is retained, the IRS apparently considers the proceeds as constructively received when they first become withdrawable. (It can be argued, however, that the proceeds are not constructively received when the policyholder has a contractual right to change to another option.) If the option is elected on or after the maturity or surrender date, the proceeds are constructively received in the year of maturity or surrender.

Is Interest Paid on an Insurance Loan Tax Deductible?

9/10/2021

Q. Can a taxpayer deduct interest paid on a loan to purchase or carry a life insurance, endowment, or annuity contract?

A. Interest paid or accrued on indebtedness incurred to purchase or continue in effect a single premium life insurance, endowment, or annuity contract purchased after March 1, 1954, is not deductible.

For this purpose, a single premium contract is defined as one on which substantially all the premiums are paid within four years from the date of purchase, or on which an amount is deposited with the insurer for payment of a substantial number of future premiums.

When a single premium annuity is used as collateral to either obtain or continue a mortgage, the IRS has found that IRC Section 264(a)(2) disallows the allocable amount of mortgage interest to the extent that the mortgage is collateralized by the annuity.

Tax Impact When Life Insurance Dividends Used to Buy Paid-up Additions?

9/9/2021

Q. What are the tax results when life insurance or endowment dividends are used to purchase paid-up insurance additions?

A. Normally, no tax liability will arise at any time when life insurance or endowment dividends are used to purchase paid-up insurance additions.

Dividends not in excess of investment in the contract are not taxable income, the annual increase in the cash values of the paid-up additions is not taxed to the policyholder, and death proceeds are tax-free.

In effect, dividends reduce the cost basis of the original amount of insurance and constitute the cost of the paid-up additions. Consequently, upon maturity, sale, or surrender during an insured’s lifetime, gross premiums, including the cost of paid-up additions, are used as the cost of the insurance in computing gain upon the entire amount of proceeds, including proceeds from the additions.

Are Dividends From a Life Insurance Policy Taxable?

9/8/2021

Q. Are dividends payable on a participating life insurance policy taxable income?

A. As a general rule, all dividends paid or credited before the maturity or surrender of a contract are tax-exempt as return of investment until an amount equal to the policyholder’s basis has been recovered. More specifically, when aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums, the excess is taxable income.

It is immaterial whether dividends are taken in cash, applied against current premiums, used to purchase paid-up additions, or left with the insurance company to accumulate interest.

Thus, accumulated dividends are not taxable either currently or when withdrawn (but the interest on accumulated dividends is taxable) until aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums. At that point, the excess is taxable income.

Tax Consequence of Giving Spouse a Life Insurance Policy

9/7/2021

Q. If a taxpayer gives a spouse a life insurance policy, is the taxpayer entitled to a gift tax marital deduction?

A. Yes. An outright gift of a life insurance policy to the donor’s spouse qualifies for the gift tax marital deduction on the same basis as the gift of a bond or any other similar property. The same should hold for subsequent premiums paid on the policy by the donor.

An annual exclusion may be allowed instead of the marital deduction if the recipient spouse is not a U.S. citizen.

Do I Need to Pay Net Investment Income Tax?

8/17/2021

The Net Investment Income Tax (NIIT) became effective January 1, 2013, to help fund the Affordable Care Act. This additional 3.8% federal tax can impact taxpayers who exceed the modified adjusted gross income (MAGI) thresholds of $200,000 for single filers, and $250,000 for married couples filing jointly. The 3.8% NIIT applies to the lesser of net investment income or the excess of MAGI over the threshold amount. However, taxpayers may be able to avoid the NIIT by carefully managing their MAGI levels and net investment income levels.

Planning Considerations
Consider strategies that lower MAGI and net investment income.

Tax-deferred annuities: If you do not need income now and would like for some of your assets to continue growing tax-deferred, a nonqualified annuity allows you to defer the growth. Because no income is being paid out, the deferred growth will not be subject to NIIT. However, if you start taking distributions, the growth will increase your MAGI and may be subject to NIIT.
Charitable giving: Gifts made to charities may lower your overall MAGI.
Roth IRAs: Qualified distributions from Roth IRAs are not subject to income tax, so it will not increase your MAGI. o Municipal bonds: Income from these bonds is generally not included in MAGI.
Your workplace retirement plan: Distributions from most 401(k)s, 403(b)s, and other employer retirement plans are not considered net investment income, but will increase your MAGI.

Are Your Investments Taxed Diversified?

8/16/2021

Use the following checklist to help determine how tax-diversified your investments are.

Living Benefits Payouts and Taxes - Part B

8/15/2021

In last blogpost, we showed that taxes usually not apply for living benefits payouts. Below we will show some exceptions.

Third-Party Ownership
Living benefits are normally free from income tax even when the insured is not the owner. Some exceptions to the income tax free nature of living benefits when a third party is the owner of the contract are:

business related policies. Terminal and chronic illness long term care benefits may not be exempted from income tax.
if the policy has become subject to the transfer for value rule. While critical illness benefits may fall outside the statutory transfer for value rule, they may also become taxable if the owner acquired the policy for money or in exchange for services or property after inception of the policy.
corporate owned policies. These may cause or increase the Alternative Minimum Tax (AMT) by including annual increases in cash values and death benefits in AMT tax.

MEC with a Long Term Care Rider
Generally, MEC’s follow the LIFO (last in, first out) rules for taxation so that any loans or withdrawals from a MEC result in taxable gains being distributed first before the nontaxable return of basis. However, when LTC benefits are paid out of a MEC from a LTC rider, the benefits received by the insured for long term care are not taxable because they are considered LTC rider benefits rather than withdrawals from the MEC.

In addition, one can do a tax-free 1035 exchange from a MEC contract to a MEC contract with a LTC rider and thereafter receive benefits during lifetime for long term care without experiencing taxation of the benefits.

Lapsing a Policy After Receipt of Living Benefit
The general rules on surrender determine the tax consequences of allowing a policy to lapse, even after payment of an accelerated death benefit. When 100% of the policy face amount has been accelerated as a terminal illness benefit, the base policy and all riders will terminate.

When a policy lapse occurs after a chronic illness claim or long term care claim, there is no taxable income related to prior living benefit payments as they are considered a tax-free accelerated death benefit. Similarly, prior critical illness benefit payments are not taxable on a later lapse of the policy. (NOTE: This differs from the tax treatment of the lapse of a policy with an outstanding loan in excess of basis in the policy. In that scenario, the outstanding loan balance is included as part of the amount realized, and the result is additional ordinary income to the policy owner.)

Qualified Plans
If life insurance with accelerated death benefit riders is owned by a qualified plan, the plan documents should address living benefit riders.

Long term care/chronic illness and critical illness riders may not be considered by the IRS to be permissible incidental benefits in a qualified plan.
Terminal illness riders in a qualified plan require attention. To the extent that a life insurance policy inside a qualified plan has cash value when the participant is terminally ill, the distribution of living benefit payment from the plan could be viewed as a pro rata distribution of death benefit and cash value.

Insureds and plan trustees should consult with their tax advisors to evaluate the tax consequences of plan ownership of a life insurance policy with living benefit provisions.

Summary
With the increasing popularity of hybrid life insurance products with chronic, critical, terminal and long term care benefits, it is important to be aware of the issues that may arise due to tax consequences of these living benefits. Policies owned by businesses, policies in qualified plans, and any other policies not owned by the insured all require careful review so that the value of these benefits is understood and realized.

Living Benefits Payouts and Taxes - Part A

8/14/2021

Over the past two decades, life insurance products have come to include benefits payable during the life of the insured as well as at death. More recently, hybrid life insurance with long term care (LTC) or chronic illness riders has proved popular in the marketplace. This early payout is called a living benefit (also known as accelerated death benefit, or ADB).

Living benefits on a policy may be triggered when the insured experiences a qualifying chronic, critical or terminal illness. Exact requirements for living benefits depend on life expectancy and the terms of the life insurance contract. However, since the income tax free receipt of life insurance proceeds is usually described as dependent on the death of the insured, the taxation of these living benefits has raised questions.

Below we will examine some of the potential tax implications with regard to qualifying health events and policy ownership. In general:

Terminal illness or chronic illness/long term care benefits should be income tax-free if the death benefit would have been income tax-free upon the death of the insured. These benefits would be taxable to the business for business-owned policies.
Critical illness benefits should generally be income-tax free when premiums are paid by the individual insured rather than by an employer.

The table below compares some of the differences in taxation based on ownership of the life insurance policy:

In next blogpost, we will discuss some special cases that the above table may not apply.

International Marriage and the U.S. Estate Tax Mistake

8/13/2021

International marriage brings some additional complications, but one complication that many couples may not be aware of is the different treatment under the U.S. gift and estate tax laws. Simply stated, there is no unlimited marital deduction for transfers to a non-citizen spouse.

Most planners are aware that there is not a U.S. estate tax on assets transferred to a surviving U.S. citizen spouse due to the unlimited marital estate tax deduction. For this reason, many do not think that there is any particular need for estate planning for couples with less than $10.86 million in assets. However, this can be an expensive oversight and a missed opportunity for those couples where one or both spouses are not U.S. citizens. The non-citizen spouse does not receive the benefit of the estate tax marital deduction for U.S. estate taxes due on a deceased spouse’s estate. Estate taxes are due after transfers of $5.43 million from a U.S. resident or citizen, unless they establish a qualified domestic trust (QDOT). Naturally, there are many more couples with more than $5.43 million than couples with $10.86 million.

Definition of a Qualified Domestic Trust (QDOT)
A QDOT provides deferral of estate taxes during the surviving spouse’s life. The assets in the QDOT will be subject to estate taxes when distributed to meet an immediate, substantial financial hardship related to the health, maintenance, education or support of the survivor spouse or of a person whom the surviving spouse is legally obligated to support. Income from the QDOT assets may also be distributed to the survivor spouse without owing estate tax, but this distribution is subject to income tax by the spouse. Moreover, at the death of the surviving spouse, the deferral of estate tax provided by the QDOT ends. The remaining QDOT assets are subject to estate taxes at the rate and in the amount that would have otherwise been due as part of the first decedent spouse’s estate. If the assets have appreciated in value, the ultimate estate tax due may be greater than if the full amount had been subjected to estate taxes at the time of the first spouse’s death. The QDOT itself will also require a U.S. trustee—possibly an institutional trustee—necessitating annual trustee fees and legal fees to establish the trust.

Life insurance as a solution
Life insurance can be a better planning option than a QDOT. Life insurance is often paid for using tax exempt gifts. For example, spouses who are both US citizens can freely transfer assets between themselves without owing gift taxes. However, while there is no marital deduction for a gift to a non-citizen spouse, the annual exempt gift allowed is $147,000 per year, indexed for inflation. This compares to an annual gift tax exempt amount of $14,000 to a non-spouse. This annual exempt gift can be used to fund a life insurance policy owned by the spouse or held in an irrevocable life insurance trust (ILIT).

In many cases, the amount of life insurance that can be purchased with this amount will cover potential future U.S. estate taxes. The death benefit will be free of U.S. income taxes to the beneficiary as well as estate taxes in the decedent insured’s estate, so long as the decedent did not hold any incidents of ownership in the policy at death. When life insurance death benefit is available to cover the deceased spouse’s estate taxes, a QDOT may not be necessary to defer estate taxes and the assets and income of the deceased’s estate can be used without restriction. The surviving spouse does not need to turn to a QDOT trustee for money.

This article addresses the basics of estate planning for married couples with diverse citizenships and U.S. estates. Many additional factors come into play when working through considerations for a specific couple, including estate tax and income tax treaties with the country or countries of citizenship and residence for the couple, laws of succession in the involved countries, and the overall estate planning goals of the couple.

Two Typical Estate Planning Strategies and a Case Study - Part B

8/12/2021

In last blogpost, we discussed 2 typical estate planning strategies, and showed a couple that faces real situations. Now we will discuss the solution for this couple.

STAYING CLEAR OF THE CLIFF
As it turns out, Robert and Becky’s state estate taxes would be significant. The New York estate tax threshold is $5.85 million in 2020 and will increase with inflation each year thereafter. For those with estates worth less than $5.85 million who die in 2020, no New York estate taxes are paid. New York also has a state estate tax “cliff” that must be considered. For estates that exceed the exemption amount by less than 5%, taxes are only owed on the amount over the threshold. Beyond the cliff, estates with a value of more than 105% of the annual exemption amount are then taxed on the entire estate value.

If we assume Robert and Becky’s existing $10 million net worth increases at a conservative rate, in 20 years the estate’s projected net worth would be an estimated $20 million.

The following table below considers two different sets of scenarios of what could happen if Robert were to die unexpectedly today, in 2020:

Scenario #1: Assumes an “all-to-spouse” will without portability of the federal exemption at the first death. Portability requires the timely filing of a federal estate tax return at the first spouse’s death (IRS Form 706).
Scenario #2: Assumes federal portability is elected at the death of the first spouse, and an amount equal to the New York exemption amount is transferred at the first death to a “B” trust.

As this hypothetical case study shows, by having the necessary planning conversations now and putting a strategy in place, Robert and Becky can eliminate their entire tax bill!

Two Typical Estate Planning Strategies and a Case Study - Part A

8/11/2021

There are two typical estate planning strategies:

Strategy #1: For smaller and simpler situations, pass all assets to the surviving spouse outright by the use of the unlimited marital deduction (“All to Spouse Will”).
Strategy #2: For more sizable estates, consider establishing a “B” trust at the death of the first spouse to pass the unused federal estate tax exemption amount of the first spouse to die to the “B” trust.

Structuring the estates either way postpones any federal estate taxes until the death of the second spouse. Both arrangements are feasible options, but the use of the “B” trust keeps the appreciation between deaths from being included in the surviving spouse’s estate. Portability of the exemption of the first spouse to die, when available, should not be overlooked at the first death. And even when it is used at the federal level, it may not be available at the state level, resulting in a different state planning need. This is illustrated in the following case study

A Case Study
Meet Robert and Becky, a hypothetical married couple residing in New York:

Robert, age 58, owns a small manufacturing company
Becky, age 55, vice president of a local bank
$10 million combined net worth
Familiar with the federal estate exemption amount and don’t believe estate taxes are a concern, as their combined estate is below $23.16 million in 2020 and would not be subject to federal estate taxes

NOT SO FAST
There are three potential problems:

The couple’s current net worth is $10 million, but what will it be at death when estate taxes would be payable?
The current federal exemption is $23.16 million in 2020 per couple, but that is scheduled to be reduced to approximately $13.18 million in 2026 and $17.06 million in 20 years assuming 2% inflation.
Robert and Becky have ignored any state estate taxes that would be owed to the State of New York, which may be significant.

Keep reading for the solution for this couple that would completely eliminate the federal and state inheritance taxes.

The Impact of State Estate and Inheritance Taxes on Estate Plans

8/10/2021

Often people may think that estate planning is only for the very wealthy. Even affluent people might think they don’t need an estate plan because of the high federal estate tax exemption. However, there are often two critical components to estate planning that people are likely overlooking:

The federal estate tax exemption is subject to change - With the passing of the Tax Cuts and Jobs Act of 2017, the federal estate tax exemption doubled to $11,580,000 in 2020. This increase is temporary, though, and the exemption is scheduled to revert to approximately $6.59 million in 2026. Are you aware of today’s increased exemption thinking about what might happen when that drastic decrease occurs? Are you also taking the potential growth of their estates into consideration?
The impact of state estate taxes and inheritance taxes - Even if a decreased federal estate tax exemption will not be a concern for you, have you considered the impact state estate taxes and inheritance taxes might have on your wealth transfer plans? It may come as a surprise to you that currently there are 17 plus DC states that impose an estate or inheritance tax.

Reasons to Consider Tax-Free Bonds

8/8/2021

An article from thestreet.com discusses several reasons why people should consider tax-free bonds:

Here is the reality - there is not a lot of value in short-term bonds today, but keeping a significant portion of the muni allocation in shorter-term bonds and in cash provides the opportunity to lengthen maturities if rates rise during the second half of the year or in early 2022.

In addition, there are opportunities to enhance yields by investing in lower-quality debt — either the lower tiers of the investment-grade universe or in non-investment grade municipal bonds. Selectivity in this segment of the bond market is critical, so investing with an actively managed fund rather than an index fund or ETF is recommended.

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