Wealth Planning is the art of reducing, eliminating, and/or identifying the most efficient methods of paying the estate and gift tax bills.
There is a tax imposed on estates at both the state and federal level. New York State currently imposes an estate tax on all assets exceeding $6,110,000. (Click here for details.) The Federal Government imposes a tax on your right to transfer property (either by way of gifting during lifetime or at death). For the year 2022, the combined estate and gift tax exemption is $12,060,000 per person or $24,120,000 per couple. Click here for more details.
Using Life Insurance to Pay the Estate Tax
One common technique to pay estate taxes is to use the proceeds of life insurance.
IMPORTANT NOTE: In order to effectively use life insurance to pay the estate taxes, your life insurance must be held in a life insurance Trust (“ILIT”). If you hold your life insurance outright (meaning, in your individual name), the proceeds of the life insurance are “includable” in your estate. If the proceeds are “includable” in your estate, this means they have to be reported on your Estate Tax Return and would increase the amount of tax you owe, thereby defeating the purpose of using the life insurance to pay your estate taxes. If, on the other hand, your life insurance trust holds the life insurance, then the proceeds of the life insurance will not be includable in your estate.
Here is How the Process Works
Find a life insurance policy that you want to purchase. The policy can be a single life or a second to die. If you intend to make use of the marital deduction and pay nothing at the death of the first spouse, then you should consider a second to die policy. Once you have identified the policy, you create a life insurance trust. You can be the donor of this life insurance trust. However, you should not be the trustee of this trust. You cannot retain any “incidents of ownership,” meaning, you cannot in any way be considered to control the life insurance or the assets in the trust.
Instead of paying the annual premiums directly to the life insurance company, each year, you will contribute the premiums payments into the life insurance trust. Your trustee will have to send out the check to the insurance company for the premiums. But, before your trustee sends out that check, your trustee should send out a Crummy letter to each beneficiary in the trust. The purpose of the Crummy letter is to qualify the gift of the premium payments to be a present interest gift and to allow you to utilize your annual gift tax exclusion.
(Without a Crummy letter, if you contribute money to the trust, then you will be deemed to be making a gift of a future interest and the amount of the premium payments would be charged against your lifetime exemption amount. This is not the best use of your lifetime exemption, especially, when you can qualify the contribution to your trust as part of your annual exclusion.) Click here to learn more about Crummy letters.
When you die, the ILIT will collect the policy and then your trustee will use those funds, first and foremost, to pay the estate taxes. Your trustee will give the remaining funds to the beneficiaries.
Wealth Planning with Charitable Trusts
A Charitable trust is a split interest gift that allows you to leave money to your beneficiaries while also qualifying a portion of the funds for an estate tax deduction. There are two major types of Charitable Trusts – Charitable Lead Trust and Charitable Remainder Trust. Click here for samples of various Charitable Remainder Trusts from the IRS.
A Charitable Lead Trust is one where the Trust pays a Charity of your choosing for a set number of years and, upon completion of payments to the Charity, the Trust then pays the remainder over to your intended beneficiaries. Click here for samples of various Charitable Lead Trusts from the IRS.
A Charitable Remainder Trust is one where the Trust pays your intended beneficiaries for a set number of years, and, upon completion of those years, pays the balance over to a Charity.
Regardless of which type of Trust you choose, your estate will qualify for an estate tax deduction equal to the present value of the gift to the Charity. You can note this deduction on your estate tax return and, in this way, lower your estate tax bill.
You can create and fund Charitable Trusts during lifetime or at death. The advantage of funding Charitable Trusts during lifetime is that you may also qualify for an income tax deduction during lifetime, and an estate tax deduction at death.
It is recommend that you transfer appreciated assets into your Charitable Trust so that you can avoid capital gains taxes on the sale of those appreciated assets. You place an appreciated asset, such as an appreciated stock, into the Charitable Trust, sell the stock inside the trust to avoid the capital gains tax, and then receive an income stream from the trust (either an annuity or a unitrust) for life. Whatever is left at your death will go to a Charity for which you will receive an estate tax deduction. The charitable portion must be at least 10% of the original asset.
Wealth Planning with Qualified Personal Residence Trusts
Another popular tool to minimize estate tax is a Qualified Personal Residence Trust (“QPRT”). The purpose of a QPRT is to remove the value of your residence from your estate, while still offering you the opportunity to reside in the residence. You create a QPRT for a term of years. You can place your entire home, or a portion of your home into the QPRT. (For the purpose of a QPRT, a home can be either a primary residence or a second home (i.e., beach house, lake house, mountain house) but is ideally used for the second home). The placing of the home into the QPRT is considered a gift and you will need to file a gift tax return for the present value of the gift (NOTE: Even though you are transferring your entire home into the QPRT, you are not considered as having made a gift of the entire value of your home). Because the QPRT is a grantor trust, you can continue to deduct the real estate taxes and interest part of the mortgage.
The trust then holds the residence for a number of years for your exclusive benefit. You continue to live in the home. If you die before the term of years has run, then the entire value of the QPRT is includable in your estate. After the number of year has run, the home then passes in Trust to the beneficiaries of the QPRT. You can continue to live in the property and pay fair market value rent to the beneficiaries (or the trust) for the right to reside in the premises. The payment of the rent is another way to remove additional funds from your estate.
If the residence inside the QPRT is sold during the term of the QPRT, then the sales proceeds must either be reinvested into a new residence or the trust has to be converted into a GRAT (discussed below).
A QPRT also offers some level of creditor protection because the QPRT because you are transferring a portion of your property to the Trust, rather than the entire property, and thus, disincentivizing creditors from wanting to come after a fractional interest.
Planning with GRATs
A GRAT is a Grantor Retained Annuity Trust and yet another Wealth Planning technique. You place assets (usually stocks, mutual funds, or income producing property) for a term of years into this trust. The Trust then pays you a specified income stream (either a fixed dollar amount or a percentage of the initial fair market value of the assets) for a specified number of years (can be 2-20). The At the end of the term, the remaining balance passes to your beneficiaries (e.g. your children).
Because a GRAT is a grantor trust, you would be responsible for any income and capital gains taxes due, thereby further reducing your estate. Because you, and not your trust, are responsible for paying the taxes, there is more in the GRAT to pass to your beneficiaries.
If you die during the term of the GRAT, then the entire value of the GRAT is includable in your estate. This is a great reason to explore rolling GRATs with various terms.
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