Tim and Christine have a problem. They’re well paid, they stand to inherit modest, if not sizeable estates, their investments have done extraordinarily well, and they’re looking forward to a long and enjoyable retirement. Sound like problems you’d like to have?
Tim and Christine, of course, are a hypothetical couple. And while their present circumstances sound pretty darn good, their not-too-distant future isn’t quite as rosy as they might think. In that not-too-distant future, if they access their investments to fund their retirement, help pay their children’s college expenses, or perhaps make a major purchase such as a second home, they could owe considerable income and capital gains taxes on the money they withdraw, or on assets they liquidate. In addition, upon their deaths, their heirs could be hit with a sizeable estate tax bill on assets that remain in their estate.
So what can Tim, Christine, and the millions of other hard-working Americans who find themselves in a similar situation do to reduce or eliminate these potential taxes, and creates a source of tax advantaged funds for educational funding, personal retirement planning or other lifetime needs?
The answer may be a simple but effective financial tool called a Survivorship Stand-By Life Insurance Trust, or "SST". With an SST, individuals with Tim and Chris- tine’s situation and objectives can obtain both tax advantaged lifetime access to resources, tax advantaged liquidity to pay estate taxes upon second death, and the flexibility to alter the terms of their plan – all using a single financial product and plan.
Don’t just solve half of the problem
Couples who need liquidity to pay estate taxes upon the death of the second to die often use an Irrevocable Life Insurance Trust (ILIT) funded with a second-to-die life insurance policy. They establish the ILIT during their lifetime; they make gifts to the ILIT which, in turn, applies those gifts to purchase and pay the premiums on a second-to-die life insurance policy. Upon second death, the proceeds from the second- to-die life insurance policy are paid to the trust, and can be used as a source of estate liquidity, allowing the estate to remain essentially intact.
The problem with this arrangement, however, is that only half of the couple’s objectives are solved – the need for estate-liquidity. It doesn’t allow them access to, and use of, their policy’s cash values – because in order to keep the death proceeds out of their taxable estate, they cannot have any beneficial interest in the policy or the trust. In addition, they cannot alter or revoke the terms of the ILIT if their objective subsequently changes – so flexibility is compromised. The SST strategy, however, combines the estate tax benefits of an ILIT with the "living" benefits of being able to personally own and access the values of–the second-to-die life insurance policy. Moreover, the plan can be modified to suit changed circumstances or objectives.
Here’s how it works:
The spouse with the shorter life expectancy (due, for example, to age, health history or gender) would apply for, and own, a second-to-die policy co-insuring both spouses. The SST would be both the contingent owner of the policy and the policy benificiary, and would ownership following the policy owner spouse’s (first to die’s) death. If an existing second-to-die policy were already in force, ownership could be transferred solely to the spouse with the shorter life expectancy. The transfer would be free from gift tax consequences due to the unlimited marital deduction.
During the policy owner’s lifetime, the couple could access their policy’s cash values via tax free loans and withdrawals to help fund their retirement goals and other lifetime objectives. (Please note: Policy loans will reduce the pol- icy’s face amount and cash value. Cash values can be accessed through withdrawals without income tax consequences provided the withdrawals do not exceed the policy’s cost basis– usually the total premiums paid. In order for these income tax results to apply, the policy cannot policy cannot be surrendered, lapsed or terminated during the insured’s lifetime) The policy owner-spouse’s” premium payments would not be subject to gift taxes, and the “non-owner spouse” could make gifts to the owner-spouse in order to help pay the premiums–again, free from gift tax consequences due to the unlim- ited marital deduction. The SST is commonly set up as a Testamentary Trust, which means it would be created under the terms of the owner- spouse’s will at his or her death. Alternatively, an existing ILIT can receive the policy owner’s death.
Upon the death of the owner-spouse (first death), policy ownership passes to the SST, as contingent owner and beneficiary. Although the policy cash value is included int he policy owner’s taxable estate, it can be shielded from estate tax with the remaining estate tax exemption. The non-owner spouse (second to die) would remain insured the the policy. However, because the non-owner spouse is neither the owner of the policy, nor a beneficiary of the SST, neither the policy’s cash value nor its death proceeds would be included in his or her taxable estate upon second death. The end result: the couple would retain access to the policy’s cash values via loans and withdrawals while the policy owner is living, and the policy proceeds will ultimately be excluded from both taxable estates.
Problem solved? Not quite. What happens if the policy owner-spouse doesn’t die first?
by Patrick R. Davidson, MBA | Business Consultant and Wealth Coach, Provident Financial Services
This article has been prepared based on Patrick Davidson’s current understanding of tax laws. Please note that a trust is a legal arrangement that may result in the inability to change the trust in the future, requires relinquishing control over the trust assets, must be properly administered, and has other significant consequences. Before implementing any plans based on your specific circumstances and objectives, you should consult with your personal legal, tax and financial advisors.