Benefits of Life Insurance in Estate Planning

I’ve had a lot of conversations recently with clients about life insurance in their estate plans.  As an estate planner, I like life insurance.  It provides many benefits in estate planning that are worth considering.  So, I wanted to address some benefits of life insurance.

I’m not doing to talk about whether you should get it per se (other advisors are better suited for that and we can recommend excellent ones), and I’m not going to talk about the financial pros and cons, but instead will focus on the role of life insurance in an estate plan and administration.  For more on how insurance works and the pros and cons, you may want to read Bankrate’s recent article entitled “Life insurance for parents” which exams how life insurance can help your family.

Liquidity:Sometimes clients will ask for very detailed estate plans involving several bequests.  The estate plan is truly their legacy, and they want to express their love and appreciation to many people by giving them a gift in their estate planning.  I think that’s wonderful, but it does present a problem if the estate is illiquid.

For example, a client may have a very healthy estate of $3,500,000 and want to leave $100,000 a piece to 7 different relatives.  That’s fine in theory, but where do you get $700,000 in cash?  That client might have a house, a vacation/beach home, retirement and minimal bank accounts.  The 401(k) might have to (or tax wise should) go to his spouse.  If the house is worth $750,000, the beach home $250,000 and the retirement $2,000,000, you don’t have enough cash left over to give $700,000 to the family, unless you start selling.  With life insurance, you have the cash available.

Estate Tax Planning.This is a bit more complicated, but for clients concerned about estate tax, life insurance is a very useful tool.

The first reason why is similar to the liquidity point.  If you know you are going to pay the estate tax, which is a 40% tax rate on the value of the estate which exceeds your exemption, you may have a rather large check to write.  So, having cash at death provides your beneficiaries with a way to pay the tax without having to liquidate assets at death.

Second, it has a low lifetime value, and most of the value comes post death.  So, if you want to leave more money to your beneficiaries while keeping a smaller amount of assets during your lifetime, you may consider using life insurance in an irrevocable trust.  Here is a useful article talking about how life insurance trusts work.

https://galligan-law.com/the-irrevocable-life-insurance-trust-why-should-you-have-one/

Providing for Beneficiaries with Disabilities: Life insurance is a great income replacement tool, which the Bankrate’s article addresses.  In this particular estate planning context, it is an extremely useful tool for planning for beneficiaries with disabilities.  For example, many couples who have a child with disabilities will provide for that child for as long as they are able.  Their lifetime support provides benefits, both tangible and intangible, for their child that government benefits can’t address.  However, that support may go away when you pass.

Now, that situation is often best addressed by leaving assets to that child in a supplement needs trust, but more importantly, the assets you leave have to be liquid as you know they will be used liberally for the care of your loved one.  So, creating a trust to hold the insurance, such as an inexpensive second-to-die policy, allows the cash to be held in a tax and benefits-efficient manner for your loved one.

Simplicity.Life insurance, in its simplest form, is a contract for a company to give cash to a person you named when you die.  That money is income tax free and doesn’t have complicated rules about how to distribute the proceeds.  For comparison, retirement assets like IRA’s and other qualified retirement funds have complicated rules about to whom they pay out, how long those beneficiaries have to take the money and very specific steps to follow to obtain them.  Retirement assets are wonderful of course because tax deferral allows retirement assets to grow tremendously and provide for your retirement, but are taxed to beneficiaries and don’t flow through your estate plan as easily as life insurance proceeds.

Creditor Protection:  This is not true everywhere, but in Texas life insurance has creditor protection.  So, there are situations where an estate or a beneficiary has creditors, but life insurance can be shielded.  You don’t want to rely on that alone for asset protection planning, but is a helpful feature that cash in a bank account lacks.

If you have life insurance and want to discuss its role in your estate plan, please reach out to your estate planning attorney to learn how it can help you.

Reference: Bankrate (July 26, 2022) “Life insurance for parents”

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What Is “Income in Respect of Decedent?”

Estate administrators file a decedent’s taxes, and often that means income in respect of a decedent, which is post-death income.

While in a consultation recently, an executor brought up a discussion with a prior attorney.  The executor was told that the estate was “too small” to worry about taxes.  Although that was true for one tax, i.e. the Federal estate tax, there are actually multiple death taxes for executors to consider in an estate administration, most of which apply in more cases than the estate tax and are often overlooked by executors.

For example, every executor, trustee or administrator should consider “income in respect of a decedent” or “IRD”.  This kind of income has its own tax rules and they may be complex, says Yahoo! Finance in a recent article simply titled “Income in Respect of a Decedent (IRD).”

Incidentally, if you were looking for information on the estate tax, here are the basics.  https://galligan-law.com/what-exactly-is-the-estate-tax/

Income in respect of a decedent is any income received after a person has died, but not included in their final tax return. When the executor begins working on a decedent’s personal finances, things could become challenging, especially if the person owned a business, had many bank and investment accounts, or if they were unorganized.

What kinds of funds are considered IRDs?

  • Uncollected salary, wages, bonuses, commissions and vacation or sick pay.
  • Stock options exercised
  • Taxable distributions from retirement accounts
  • Distributions from deferred compensation
  • Bank account interest (very common one)
  • Dividends and capital gains from investments
  • Accounts receivable paid to a small business owned by the decedent (cash basis only)

As a side note, this should serve as a reminder of how important it is to create and update a detailed list of financial accounts, investments and income streams for executors to review in order to prevent possible losses and to correctly identify sources of income.

How is IRD taxed? IRD is income that would have been included in the decedent’s tax returns, if they were still living but wasn’t included in the final tax return. Where the IRD is reported depends upon who receives the income. If it is paid to the estate, it needs to be included on the fiduciary return. However, if IRD is paid directly to a beneficiary, then the beneficiary needs to include it in their own tax return.

If estate taxes are paid on the IRD, tax law does allow for an income tax deduction for estate taxes paid on the income. If the executor or beneficiaries missed the IRD, an estate planning attorney will be able to help amend tax returns to claim it.

Retirement accounts are also impacted by IRD. Required Minimum Distributions (RMDs) must be taken from IRA, 401(k) and similar accounts as owners age. The RMDs for the year a person passes are also included in their estate. The combination of estate taxes and income taxes on taxable retirement accounts can reduce the size of the estate, and therefore, inheritances. Tax law allows for the deduction of estate taxes related to amounts reported as IRD to reduce the impact of this “double taxation.”

The key here is to work diligently with your tax preparer in an estate or trust administration to identify, report and pay for IRD.  Happily, estates have several costs which might be deductible to the IRD paid by the estate, such as funeral or administrative costs, meaning it is very possible no tax will be due even where there is substantial IRD.

In all events, if you are administering an estate you want to ensure IRD is addressed, and paid for if necessary.  One of the most important aspects of estate administration is providing a sense of finality, knowing that the legal and financial steps are finished so you can focus on your family in a difficult time.  Addressing the IRD ensures you don’t receive a letter from the IRS years later about unreported income.

Reference: Yahoo! Finance (Oct. 6, 2021) “Income in Respect of a Decedent (IRD)”

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Benefits of 529 Plans

529 Plans have benefits beyond tax-deferred earnings which make them attractive options for educational funding.

I’ve been discussing 529 plans, how they work and their benefits far more frequently with clients than I used to.  You might think that tax-deferred savings is the main benefit, along with tax-free withdrawals for qualifying higher education expenses in 529 plans. However, there are also state tax incentives, such as tax deductions, credits, grants, or exemption from financial aid consideration from in-state schools in certain states.  Forbes’ recent article entitled “7 Benefits You Didn’t Know About 529 College Savings Plans (But Should)” says there are many more advantages to the college savings programs than simple tax benefits.

1) Registered Apprenticeship Programs Qualify. You can make qualified withdrawals from a 529 plan for registered apprenticeship programs. These programs cover a wide range of areas with an average annual salary for those that complete their apprenticeship of $70,000.

2) International Schools Usually Qualify. More than 400 schools outside of the US are considered to be qualified higher education institutions. You can, therefore, make tax-free withdrawals from 529 plans for qualifying expenses at those colleges.

3) Gap Year and College Credit Classes for High School. Some gap year programs have partnered with higher education institutions to qualify for funding from 529 accounts. This includes some international and domestic gap year, outdoor education, study-abroad, wilderness survival, sustainable living trades and art programs. Primary school students over 14 can also use 529 plans for college credit classes, where available.

4) Get Your Money Back if Not Going to College. If your beneficiary meets certain criteria, it’s possible to avoid a 10% penalty and changing the plan from tax-free to tax-deferred. For this to happen, the beneficiary must:

  • Receive a tax-free scholarship or grant
  • Attend a US military academy
  • Die or become disabled; or
  • Get assistance through a qualifying employer-assisted college savings program.

Note that 529 plans are technically revocable. Therefore, you can rescind the gift and pull the assets back into the estate of the account owner. However, there are tax consequences, including tax on earnings plus a 10% penalty tax.

5) Private K–12 Tuition Is Qualified. 529 withdrawals can be used for up to $10,000 of tuition expenses at private K–12 schools. However, other expenses, such as computers, supplies, travel and other costs are not qualified.

6) Pay Off Your Student Loans. If you graduate with some money leftover in a 529 account, it can be used for up to $10,000 in certain student loan repayments.

7) Estate Planning. Contributions to a 529 plan are completed gifts to the beneficiary. These can be “superfunded” for up to $75,000 per beneficiary in a single year, effectively using five years’ worth of annual gift tax exemption up front. For retirees with significant RMDs (required minimum distributions) from qualified accounts, such as 401(k)s and traditional IRAs, the 529 plan offers high contribution limits across multiple beneficiaries, while retaining control of the assets during the lifetime of the account owner. Assets also pass by contract upon death, avoiding probate and estate tax.

7.5) Medicaid Benefit.  I’m going to cheat and add one more.  In Texas, transfers to 529 plans for CERTAIN beneficiaries are exempt as transactions for longterm Medicaid.  As with all Medicaid planning, you would want to do this at the advice of an attorney, but for situations where it fits, it is a very powerful spend down tool, especially where grandchildren are school age.

Reference: Forbes (July 15, 2021) “7 Benefits You Didn’t Know About 529 College Savings Plans (But Should)”

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