estate tax

[ERD50]

kaneohe - I'll break my response into the two separate parts that your post covers:

A) Liquidity - OK, maybe a case can be made for insurance in an illiquid estate. However, there are other alternatives, and I would like to see insurance compared to the alternatives. That is the only reasonable way to make any financial decision. Also, my comments were made with respect to Martha's statement that life insurance can be used to minimize estate taxes. Liquidity is separate from that statement.

B) Moving the insurance out of the estate for tax reasons - Since we can't predict the date of death, we really can only evaluate this on averages. And it seems to me (see my example again), that this statement only holds true if Life Ins, on average, is a superior investment product. I could suggest you start a Poll and ask "Should I buy an Insurance Policy as an Investment?" and see what kind of responses you would get.

As I said earlier, look at this in generic terms:

It makes sense to get the asset with the most appreciation potential out of the estate, to avoid those high estate tax rates.

If that statement is true, then it holds that for a Life Ins policy to meet that requirement, one would have to claim that it had the highest appreciation potential. If that is true, we should all be investing in Insurance Policies, and making lots of insurance sales people very, very happy.

Where is the fault in my logic? Or, why aren't forum members investing primarily in Life Insurance?

-ERD50

PS - I'll avoid commenting on my overall views of the Estate Tax (AKA Death Tax), and stick to the mechanics in this thread. Martha has her hands full in the Soap Box.

 

[Martha]

OK, I understand the conditions. But the only way I can get the math to work is if one assumes that (on average) a life insurance policy is a better investment than the alternatives.

It makes sense to get the asset with the most appreciation potential out of the estate, to avoid those high estate tax rates. But is that a Life Insurance policy? If so, it seems we should all be buying policies as investments, estate tax issues or not. But there sure isn't much support on this forum for life insurance as an investment.

Compare the two options, when there is an existing policy in place:

1) Gift the insurance policy to the heirs.

2) Hold the insurance policy in the estate and gift an equal amount of cash to the heirs to invest.



Example for #1: An Estate has a $120K cash value policy as p/o their total NW. They give away shares of it to their ten heirs. This is within the 12K/person/year limit, so no tax consequence. Each heir is $12K richer, the estate is $120K smaller.

Example for #2: Same Estate, but give away $12K cash to each of their ten heirs. Like above, no tax consequence, each heir is $12K richer, the estate is $120K smaller.


So how can insurance (on average) benefit the heirs/estate w/o also being a superior investment vehicle on it's own? Your example, of a $50K cash value policy growing to $250K is only valid if other investment options would grow to less than that $250K in that same time. Which seems like another way of saying that insurance *is* a good investment. But again, I don't see any support for that idea on this forum.

That is what I have never understood, and all the explanations I've seen a have been slanted (gifting insurance versus no gifting at all), not in an apples-to-apples comparison of gifting cash to invest versus gifting insurance.

-ERD50

One thing to add to your mix is that when you gift that insurance policy to a trust or to your children and years later there is a big payout, there is no income tax on that payout. Also, when done for the purpose of providing cash to pay estate taxes at least some certainty as to the amount available and when it will be available is appealing to people.

 

[ERD50]

One thing to add to your mix is that when you gift that insurance policy to a trust or to your children and years later there is a big payout, there is no income tax on that payout.

Yes, but it is generally true that insurance payouts are not taxed as income. So the question stands as to whether insurance is a good investment (including tax considerations). I have not seen any support in this forum for taking out insurance on old people as an investment plan.

So to get closer to apples-apples, we need to compare insurance to alternate investments. An investment held in the estate would be subject to estate taxes, just as an ins policy would be if held in the estate. Investments held outside the estate are subject to income tax on div, int, and cap gains; insurance payouts are not. So we seem to be full circle back to: is Life insurance a superior investment (after taxes)? And if so, why isn't it being promoted as an investment strategy here?

You seem to be moving from the 'life insurance can be used to minimize estate taxes' statement, to an analysis of income tax impact on the heirs. I agree that it is the total after-tax amount that matters, but I'm still not seeing how insurance, on average, can minimize estate taxes as you stated.

Also, when done for the purpose of providing cash to pay estate taxes at least some certainty as to the amount available and when it will be available is appealing to people.

Clearly. But that still does not address whether the approach is superior to alternatives. I suspect that many policies have been sold on this basis, without reviewing the actual liquidity options for that estate. Which is OK in a way, it is the buyer's responsibility to determine the suitability of any purchase they make. Buyer beware.

-ERD50

 

[Martha]

ERD, don't read too much into my statement that "life insurance can be used to minimize estate taxes." It can, as you can remove the payout out of a person's estate. There are other ways to minimize estate taxes and taxes in general. Give away appreciated stock is one example. This is just one option to consider.

I don't disagree that there are a number of ways to get liquidity for an estate. But one advantage of life insurance is the tax advantage. Another advantage is that you know the cash will be available when it is needed, unlike many other investments where it might not be a good time to liquidate. And if you transfer the policy to your kids with you paying the premiums, they may be less likely to cash it in early than if you gift them stock or cash in equivalent amounts over the years.

If you go the trust route so that your kids can't spend the money, it is cheaper and easier to have trustee of a life insurance irrevocable trust than to have a trustee managing assets without your imput in another irrevocable trust. People do not like to lose that kind of control. (You can't have control or your estate will get dinged for taxes). And, for the non-life insurance trust the income from the trust may end up bearing taxes at the higher trust rate or the income has to be distributed to beneficiaries who will pay the tax.

So, it is more than a question of what is the best investment.

But I am not a financial planner or an estate planner, so I am just hypothesizing.

 

[kaneohe]

ERD,

Can't argue w/ your thought that insurance is not the best investment.
How about the idea that the outcome for a single individual can deviate significantly from the average because that individual's sample size is just too small to guarantee anything close to the average. That's why a young parent might buy term insurance to protect against a worst case outcome----death at a young age----to protect the surviving family. Maybe not the best "investment" in statistical (average) terms but insurance. Same for the
insurance for protecting the estate.....maybe not the best statistically speaking but would protect against bad outcomes (early death). Esp. if it term insurance, might be relatively easy to get out of the estate since not much cash value to it.......and could mushroom a lot in value at death.

 

[ERD50]

kaneohe - just to be clear, I am a BIG fan of insurance, when purchased for the right reasons. I have health insurance on the family, house insurance, car insurance, even insurance for my umbrella.

But that is to protect against risks that I may not be able to afford. Each of those policies has been an economic loss for me, and I'm fine with that, and I hope my good fortune continues.

There *may* be a case for Life Insurance outside an estate to provide liquidity to pay the Estate tax. That would be very case dependent, and there may be better options. But your last statement seems to go back to the idea that insurance would be a good investment - I guess I don't understand what it would be protecting against?

-ERD50

 

[kaneohe]

ERD,

I guess it's protecting the estate from decreasing in value to some extent since it's not included in the value of the estate. Whether it is a good "investment" or not depends on how soon you die after you start paying for it and probably, as you point out, it is not sound on an actuarial basis, but it might be useful as you point out for liquidity so you don't have to sell equity in a down market. As with most insurance, I suppose, you want it not to pay off. With term insurance which has no value while you are alive, you also retain full use of your other assets which you wouldn't if you gave the equivalent value away.

 

[ERD50]

ERD, don't read too much into my statement that "life insurance can be used to minimize estate taxes." It can, as you can remove the payout out of a person's estate.

Well, I don't think I am trying to read anything into it, but I am trying to understand it. And the statement that "life insurance can be used to minimize estate taxes." just has never made sense to me.

You gave some other reasons that it might be useful, but I'm trying to focus on understanding this one point that you offered up.

The examples you provide are when there is already insurance in the estate. So moving it might be a step in optimizing the existing situation (I'm not sure I agree with that either, but it's a different point anyhow). To me, that's different than saying "life insurance can be used to minimize estate taxes.".

So, can you give an example where Life insurance can be purchased (in or out of the estate), and the Estate Tax is reduced? Obviously, the Estate Tax would be reduced if money was gifted from the estate to purchase the Life Insurance, but it is the gifting that reduces the Estate Tax, not what is purchased with it, right? If that is the case, then it would be (admittedly silly, but) just as accurate to say "beer can be used to minimize estate taxes". Substitute "gifting" for either "beer" or "life insurance", and that makes sense to me.

What am I missing? And I don't mean for this to come across as confrontational, I am honestly trying to understand this point. I've heard it offered so many times (by insurance salespeople and their associates), and like I said, I simply do not 'get it'.

Thanks, if you (or anyone else) can clarify.

-ERD50

 

[MasterBlaster]

Read the following down to the part about the charitable remainder trust...

< From Wikipedia>...

In one popular scheme, an irrevocable life insurance trust, the parents give their kids (within the allowed yearly gift tax limit) money to buy life insurance on the parents in an irrevocable life insurance trust. Structured in this way, life insurance is free of estate tax. However, if the parents have a very high net worth and the life insurance policy would be inadequate in size due to the limits in premiums, a charitable remainder trust may be used. This is where a large asset is flagged to be donated to a charity, sold, and invested. The investment income buys life insurance but the principal goes to the charity when the parents die. Meanwhile the children get the full amount as well in life insurance proceeds. This is a large reason for many charitable gifts, and proponents of the estate tax argue the tax should be maintained to encourage this form of charity.

 

[ERD50]

Thanks for the input MB, however...

it's kind of skirting into side issues that I'd prefer to avoid until I can get the basic question answered on how "life insurance can be used to minimize estate taxes.".

The wiki excerpt is going into charitable trust territory. I could give an answer on how that also appears to be circular logic to me (if the goal of avoiding Estate Tax is to give more money to heirs, giving it to charity does not accomplish that), but a fuller answer would be kind of long, and I might delve into Soap Box territory. So I'll leave it for now.

But thanks, maybe we can hit that point later?

-ERD50

 

[Martha]

Well, leaving to charity also can minimize estate taxes.

However, it also makes sense in some circumstances for a person to set up a life insurance trust from the get go to provide cash money available immediately to pay estate taxes AND that cash will not be part of the estate. So, it minimizes estate taxes.

Say you buy a million dollar policy in a life insurance trust for $50,000 and you knock that $50,000 off your unified credit. Five years from now you die and the beneficiaries get the million dollars, with only a $50,000 impact on the taxable estate. You minimized estate taxes.

Say alternatively, you gave the beneficiaries $50,000 and said "invest wisely, you will need the cash to pay estate taxes when I die tomorrow, five years from now or 30 years from now." You die in five years and the money has tripled because they invested wisely. But that adds up to only $150,000. So, there are reasons to use a life insurance strategy. But if you live a long time life insurance might not be the best investment. Then comes the problem of losing control which occurs when you gift cash for others to invest.

I think life insurance is handy if you are passing along a family business. I think that if you have an existing policy there are circumstances where it makes sense to gift the policy.

 

[ERD50]

Martha: You minimized estate taxes.

Wait a minute. In your example, NO estate taxes were minimized in EITHER case. It appears that you assumed that none of the $50,000 passed under the annual exclusion, so it all hit the unified credit. So the Estate Tax bill in each case would be identical, would it not? And the estates would also be identical if it all slipped under the annual exclusion (say $10K to five heirs). This is where I just don't 'get' the statement that "life insurance can be used to minimize estate taxes.".

Even if you roll this forward 20 or 30 years (assuming the tax laws are the same -hah!), each of those estates had $50K less in them after this transaction, and a $50K smaller credit allowance. They will still be on even terms, same tax bill due, right?

Now, whether that insurance policy or an alternate investment provides a better financial return is an entirely separate matter (my point all along) - they are both out of that estate, and have no bearing on the amount of Estate Tax due. How can they? What am I missing?


Martha: Well, leaving to charity also can minimize estate taxes.

True, but... well, let's stick to life insurance and minimizing estate taxes. If I'm not understanding *that* basic concept, I don't want to move on to other aspects of this complex tax.

thanks -ERD50

 

[Martha]

Martha: You minimized estate taxes.

Wait a minute. In your example, NO estate taxes were minimized in EITHER case. It appears that you assumed that none of the $50,000 passed under the annual exclusion, so it all hit the unified credit. So the Estate Tax bill in each case would be identical, would it not? And the estates would also be identical if it all slipped under the annual exclusion (say $10K to five heirs). This is where I just don't 'get' the statement that "life insurance can be used to minimize estate taxes.".

What we have here is a failure to communicate. For ease of discussion, I assumed no annual gift exclusion. If the life insurance was owned by the decedent with the heirs as beneficiaries, then there would have been a great big hit to the estate. By having it outside the estate, the heirs get a pile of money tax free. That is how estate tax was minimized. And if you look at all the assets originating from the decedent, the heirs get more money with life insurance than if they had invested an equivalent amount because the giver died early.

I did acknowledge that estate tax could be minimized by gifting the same amount to the heirs who then would invest the money. I think that this is your point. But it has risks because it requires a long period of time to grow and there is more uncertainty as to whether cash will be available when needed, if cash is needed at death. The cash may be needed if you are passing on an illiquid asset. The giver might die early so he wants insurance available. The giver might not trust the heirs to save the money and invest it properly to pay estate taxes in the future. Liquidity aside, the giver might prefer life insurance to maximize what the heirs get on death, especially if the heirs are young or are the type to be tempted to spend the money. The giver could set up an irrevocable trust to invest the money, but who is going to make the investment decisions? The giver can't and you still have the early death problem.

So as a technical matter, if it makes you happy ERD, the estate tax will be the same if you gift $50,000 in cash or $50,000 in cash value of a life insurance policy. BUT, the amount available to the heirs at the time the giver dies will not necessarily be the same.

 

[ERD50]

What we have here is a failure to communicate.

So as a technical matter, if it makes you happy ERD, the estate tax will be the same if you gift $50,000 in cash or $50,000 in cash value of a life insurance policy.

OK, I think we finally got somewhere -thanks. And it's not about me being happy, I'm just trying to understand this, and I needed to understand if that statement was a true statement. I was afraid I was misunderstanding a key point.

I sure don't see it as a 'technical matter', it seems pretty darn essential to understanding this stuff, for instance...

BUT, the amount available to the heirs at the time the giver dies will not necessarily be the same.

Very true (as I understand it ), and this is exactly why a person needs to differentiate between 'minimizing estate taxes', and 'the amount available to the heirs at the time the giver dies'. They are NOT the same thing, and it sure makes it tough to learn about this if the two get intermingled.

For example, there are some very simple ways to completely eliminate estate taxes. But the heirs might not like it much .

-ERD50