life insurance in the estate plan and incapacity planning session 9 depaul university cfp® program

Life Insurance in the Estate Plan and Incapacity

Planning

Session 9

DePaul University CFP® Program

Life Insurance and Estate Planning Objectives

Financial protection for survivors by replacing the insured’s lost income. Frank bought life insurance to help ensure that his survivors

wouldn't suffer financially when he died. When Frank died and his paycheck stopped, his family had enough money to maintain their lifestyle and live comfortably for years.

Replace wealth that is lost due to estate settlement expenses and taxes. Frank bought enough life insurance to cover the potential costs of

settling his estate, including taxes, fees, and other debts. Charitable giving - estate enjoys tax deduction

Using life insurance, Frank was able to leave a substantial and fully deductible gift to his favorite charity at death or before.

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Estate Planning and Risk Management

A complete financial/estate plan must consider: income protection during the client’s earning years future needs – income replacement, and protection of estate.

Life insurance Disability insurance Long-term care insurance


Life Insurance in the Estate Plan

If, at death or within 3-years of death, an individual holds incidents of ownership in a life insurance policy under which s/he is the insured, the entire face value of the policy is included in the insured’s gross estate.

Incidents of ownership include: The right to name/change beneficiaries The right to assign ownership of the policy The right to policy loans from cash value The right to surrender the coverage


Question 9-1

All of the following represent “incidents of ownership” in a life insurance policy except:

A. The right to change the beneficiary from your spouse to your child.

B. The right to assign ownership of your policy to an irrevocable life insurance trust (ILIT).

C. The right to borrow from the policy’s cash savings account.

D. The right to pay the premium.


Term Life Insurance

Term insurance pays policy’s face amount if insured dies during coverage period.

Temporary protection Typically lowest cost when insured is

young Premiums generally rise as insured

ages

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Convertible Term Life Insurance

Convertible term life insurance allows changing a term policy to a permanent policy (such as whole-life or universal life) without penalties. Most term policies issued today are renewable and convertible, allowing the insured to adjust coverage needs to changing circumstances. Many young, healthy policyholders choose a convertible term insurance policy initially because of the low cost premiums and basic coverage.

In the future, may policyholders may decide that a cash value policy is better suited to their financial plan.

Conversion typically accomplished at attained age In some policies, owner may pay a lump sum to maintain the

original issue age premium going forward.


First-to-Die (Joint Life) Insurance

First-to-die (joint life) covers >2 insureds, paying benefits at the first death. Benefits may be used for:

Survivor income Survivor spouse Surviving business owners/partners

Mortgage protection Funding business buy/sell agreements Covering consumer and other debt


Second-to-Die (Survivorship Life) Insurance

Second-to-die (survivorship) life insurance covers two lives, paying benefits at the second death

Typically used to provide funds to pay federal estate tax on death of second spouse

May be term policy or permanent coverage Cost:

Greater than on a single life, but Lower than with two individual policies

Underwriting Typically less stringent than with individual policies May present insurance opportunity for insured in

questionable health


Question 9-2

Which of the following statements about second-to die life insurance is true?A. For a couple, it is typically used to pay federal estate taxes on the estate of the first spouse to die.

B. It is seldom held in trust.

C. An individual who would be denied coverage under an individual life insurance policy may be covered under a second-to-die policy.

D. A second-to-die policy is typically more expensive than two policies on two spouses.


Whole Life Insurance

Whole life insurance provides protection at a level premium for the entire life of the insured. Policy typically endows (pays face value) at age 100Types

Straight whole life (ordinary life, continuous premium life)

Premiums paid throughout insured’s life Limited-pay whole life

Premiums limited to specific number of years Examples

20-pay life Paid-up at age 65

Higher premiums than ordinary life because later (riskier) years must be “prepaid”


Universal Life Insurance

Similar to whole life insurance but cost of insurance inside the UL policy is based on annually renewable term life insurance.

Advantages include: premium flexibility adjustable death benefits.

at the policy owner's request, subject to insurability.


Two Universal Life Insurance Policy Designs

Most universal life insurance offered today reflects one of the two benefit designs below:

Level death benefit (aka Option A) Death benefit constant unless cash value

exceeds certain amounts Over certain cash value amounts, death benefit

increased

Increasing death benefit (aka Option B) Death benefit increases to correspond with

increasing cash value


Increasing Death Benefit Universal Life Insurance Example

Mike is covered for $200,000 under an increasing death benefit (Option B) universal life insurance policy. Its cash value has grown to $50,000.

Death benefit grows by $50,000 to $250,000 total

Thus, $250,000 will be included in Mike’s gross estate if he holds incidents of ownership in the policy within 3 years of his death.


Suicide Clause

If the insured commits suicide within the suicide period, only the aggregate premiums are paid to beneficiaryIf insured holds incidents of ownership, only the premium refund amount (not the death benefit) is included in the gross estateSuicide period typically 2 years

Following suicide period, the death benefit is payable even if insured commits suicide


Question 9-3

Due to the recession, Bruno committed suicide 18 months after his $1MM life insurance policy was issued. He had paid $30,000 in premiums. Approximately what amount will be included in Bruno’s gross estate?

A.$1,000,000

B.$970,000

C.$30,000

D.$-0-


Accidental Death Benefit(Double Indemnity)

The accidental death benefit rider pays double (if double indemnity) or triple, (if triple indemnity) if the insured’s death accidental

Assuming the insured holds incedents of ownership, the rider will double (or triple) the amount to be included in the gross estate


Simultaneous Death

The Uniform Simultaneous Death Act specifies that, if two or more people die within 120 hours of one another, and no will or other document provides for this situation explicitly, each is considered to have predeceased the other.The USDA, as adopted by various States, varies from jurisdiction to jurisdictionThe statute creates a rebuttable presumption


Simultaneous Death(continued)

Linda is insured under a life insurance policy. Her husband, Alex, is its beneficiary. They are both killed in a plane crash, dying at or near the same time. If the policyholder named a secondary beneficiary in the policy, that person will receive the life insurance benefit. If no secondary beneficiary has been named, then it is assumed that she outlived Alex, and the benefit is inherited through Linda’s estate.


General Rules for Life Insurance Inclusion in Gross Estate

Life insurance will be included in an individual’s gross estate for federal estate tax purposes if:The decedent held incidents of ownership at death, orThe insured transferred ownership of the policy within the three year period preceding deathThe policy’s death benefit is payable to the insured’s estate

Or the primary beneficiary predeceases the insured and no contingent beneficiary exists, making the estate the default beneficiary


Policy Ownership by the Insured

If it is reasonably certain that the insured’s estate will not be taxable, the client owning the policy on his/her own life is not problematic.

However, if federal estate tax is likely the client should consider alternative owners including: The spouse

Policy’s interpolated terminal reserve is included in the spouse’s estate if he/she predeceases the insured

Another family member Typically adult children

Irrevocable Life Insurance Trust (ILIT) Generally the most appropriate choice


Estate Taxation of Life Insurance on Another’s Life

For federal estate tax, the interpolated terminal reserve (approximate replacement value) is includible in the estate of an individual owning a life insurance policy under which another individual is insured.


Owning a Policy on an Insured Spouse

If one spouse dies owning a life insurance policy on the other, the amount included in the gross estate of the decedent/owner (NOT the insured) will be:

For a term life policy, the unused premium For a cash value policy, the interpolated

terminal reserve and the unused premium Similar to replacement value Insurance company provides figures


Question 9-5

Laura dies owning a $1 million (face value) whole life policy on her husband, Scott. It has an interpolated terminal reserve of $160,000 and an unused premium of $11,000. Approximately what amount, if any, is included in Laura’s gross estate?

A. $-0- because the insured is still living.

B. $1million

C. $171,000

D. $160,000


Income Taxation of Death Benefits

Under general rule, insurance death benefits are received income tax free by the beneficiaryException for life insurance “transferred for value”

Death benefit less premiums paid (basis) is taxable to the beneficiary

Exception for corporate-owned life insurance Gain from death benefit may be subject to

alternative minimum tax (AMT)


Exceptions to Transfer for Value Rule

Even where the policy is acquired for consideration, the death benefit remains income tax free under these exceptions to the rule:Policy is transferred to the insuredPolicy is transferred to a partner of the insured

May occur with buy/sell agreementsPolicy is transferred to corporation in which insured is shareholder or officer


The Irrevocable Life Insurance Trust (ILIT)

Estate taxes on insurance proceeds may be avoided by creating a properly executed irrevocable life insurance trust ILIT.May include policies on one life or second-to die policiesWith a married couple, the second-to-die policy is popular due to the marital deduction

taxes only due at the second death less costly than two separate policies.


ILIT May Be Funded or Unfunded

An ILIT may be funded Other income producing assets are transferred

to the trust to generate money for the premium Income is taxed under grantor trust rules Transfer of assets triggers gift tax consequences

Or, an ILIT may be unfunded The grantor makes gifts so trustee can pay the

premiums Annual gift tax exposure Usually avoided using Crummey powers


Paying the Premiums

Although though the ILIT owns the policy, the grantor can still (and typically must) pay the premiums. The grantor can annual make gifts of cash to the trust, and the trustee can use this money to pay policy premiums.

Even with Crummey powers, gifts in excess of $13,000/beneficiary power holder are taxable gifts.


Giving Up Control

If your trust purchases and owns the policy(s), the grantor typically has no right to change the beneficiary or borrow from/against the policy.

The grantor names the beneficiaries of the trust and the trust/policy owner is the beneficiary of the proceeds.

Because the ILIT is irrevocable, the grantor would typically not serve as trustee, eliminating any potential incedents of ownership.


Transferring Current Policies

A grantor can transfer ownership of a policy he owns to an ILIT in order to shield the proceeds from estate taxes.This is a taxable transfer.Grantor’s death within three years of transfer forces gross estate inclusion of proceeds.If the proceeds increase the value of the estate to more than $5.12 million tax will be due.


Beneficiaries Can Still Enjoy Proceeds

When the ILIT receives the death benefits from its policy(s) at the insured grantor’s death, thay are income and estate tax free. The trustee may: Distribute funds beneficiaries Use funds to provide estate liquidity

Purchase assets from estate Usually no gain due to basis step-up Often trustee of ILIT is also executor of estate


ILIT Example

Robert and his wife Sally accumulated a small real estate empire throughout California, including a Lake Forest home ($4,000,000), a vacation home in Lake Tahoe ($2,120,000) and three rental properties in Hawaii (together worth $5,500,000). Robert’s liquid assets were mostly spent by the end of his life, amounting to $150,000. Sally has died and Robert has not remarried. $6 million of the estate will be subject to the federal estate tax at a rate of 35% and Robert’s and Sally’s children, Peter and Ruth, will not have sufficient cash to cover the bill unless they sell off some of the properties.


ILIT Example (continued)

Robert establishes a qualifying ILIT, funding it with an insurance policy, and naming his children, Peter and Ruth, as remainder beneficiaries of the trust. Robert makes gifts to the trust covered by his $13,000 annual gift tax exclusion times the two beneficiaries, who each hold a Crummey power. The gifts are used to pay the policy premiums. When Robert dies, the proceeds of the life insurance policy are received by the trustee estate tax-free. The trustee then purchases one or more parcels from the estate. There is no (or little gain), the estate has cash and the children are beneficiaries of the trust which hold the transferred property.


Question 9-6

Most irrevocable life insurance trusts:

A. Name the grantor as trustee

B. Are designed to keep life insurance proceeds out of the insured owner’s gross estate.

C. Testamentary

D. Asset free until death.


Gifting One’s Policy

Under the three rule, even gifts of life insurance to a spouse must be included in the donor’s gross estate if they are made within 3 years of death.

Example: Sharon dies within two years of transferring ownership of a life insurance policy (under which she is the insured) to her husband, Jerry.The FACE VALUE of the policy must be included in Sharon’s gross estate.

Offset by marital deduction if Jerry is the beneficiary Same result where policy is gifted but insurance

company was not notified of the change in ownership.


Business Buy-Sell Agreements

Death or disability of a business owner or partner may jeopardize continuation of that business. Often the optimal plan is for the surviving partner(s) or shareholder(s) to buy the business interest of a deceased or disabled partner.Contractual agreement sets terms for both buyer(s) and seller(s)Purchase can be funded by

Life insurance (common) Other assets


Two Types of Buy-Sell Agreements

Buy-sell agreements are typically designed as either:Cross purchase arrangements

Individual owners purchase life insurance on one another

Cumbersome with many owners/partnersEntity (stock redemption) arrangements

Entity owns life insurance on major shareholders (or partners)

Typically, closely held corporation One policy per insured shareholder/partner


Advantages to Buy-Sell Agreements

Properly designed buy-sell agreements typically provide the following advantages:

Higher probability that business will continue Ready market for business interests Liquidity for

Disabled owner’s expenses Deceased owner’s estate tax and expenses

Establishes value for decedent’s estate If reasonable


Cross Purchase Buy-Sell Example

Hugh, Sue, and Stu own Taco Swell, a chain of fast food restaurants recently appraised to be worth $3,000,000. Under a cross purchase arrangement, they would own life insurance as follows:

Owner Insured Insured

Hugh $500K on Sue $500K on Stu

Sue $500K on Hugh $500K on Stu

Stu $500K on Hugh $500K on Sue


Stock Redemption (Entity Purchase) Buy-Sell Agreements

Under a stock redemption (entity purchase) agreement, the business (typically a corporation) agrees to purchase a deceased (or disabled) owners’ interest(s) in the business.

The business owns and is beneficiary of the life insurance policies funding the agreement

May be best arrangement when > 3 owners


Tax and Other Implications to Stock Redemption (Entity Purchase) Buy-Sell Agreements

Premiums are not deductible to business Death benefits not taxable to business as beneficiary

However, benefits may be exposed to corporate alternative minimum tax (AMT)

Remaining owners receive increased business value No step up in basis to remaining owners Life insurance can be attached by business creditors Transfer for value exposure if policies sold to parties

other than the insured


Death-Activated Buy-Sell Agreement Example

Red signed a buy-sell agreement before his death. His interest in the business was appraised at $1,000,000. His basis in the business is $100,000.

When Red dies (assuming agreement remains in force), business (or partners) buy Red’s interest from his estate for $1,000,000

Red’s estate enjoys full step up in basis Avoids $900,000 capital gain

$1,000,000 in Red’s gross estate Possible estate tax exposure


Transfer for Value Exposures with Buy-Sell Agreements

If the business closes, eliminating the need for insurance policies on others, individuals can purchase the life insurance policies.If owners purchase (or exchange) policies, thus owning insurance on lives of others, transfer for value occurs

Death benefits then taxable at ordinary ratesIf owners purchase policies on their own lives exception from transfer for value rules applies

Death benefits remain nontaxable (income tax)


Question 9-7

Jack and Mack, both married, own Jack and Mack’s Landscaping. They enter into a cross purchase buy/sell agreement funded with life insurance. How should their policies be owned?

A. Jack owns on Mack’s life and vice versa.

B. Jack and Mack’s Landscaping owns the policies on its two owners.

C. Jack and Mack’s spouses own the policies respectively.

D. The policies are not considered “owned” for purposes of the buy/sell agreement.


Key Person (Key Employee) Life Insurance

A business may own life insurance on the life of one or more key employeesBusiness has insurable interest due to:

Possible lost income on key person’s death Possible increased expenses due to key

person’s death


Estate Tax Implications of Key Person Life Insurance

In a key person life insurance arrangement, the owner of the policy is the employer, who names itself beneficiary of the policy’s proceeds.

Thus no amounts attributable to the policy covering the insured employee is includible in that employee’s gross estate.

Proceeds will increase stockvalue.


Incapacity

Incapacity describes the inability to engage in legal matters (contracts, generally) due to lack of intellectual or physical ability.An incapacitated person may be legally incompetent.Minors lack capacity to contract

This means that a contract is voidable by the minor – not by the other party


Powers of Attorney

Incapacity planning may be addressed through powers of attorney for property or for health care.A power of attorney is a written document under which an individual, known as the principal, empowers another adult, known as attorney-in-fact, holder of the power, or agent, to act on that principal’s behalf.


Durable versus Nondurable Powers of Attorney

A nondurable power of attorney becomes invalid upon the incapacity of the principal. Thus ineffective for incapacity planning

A durable power of attorney survives the principal’s incapacity Principal must be competent when DPOA is

executed Power holder called “attorney-in-fact” or

“agent”


Powers Terminate on Death

Whether durable or nondurable, powers of attorney become invalid upon the death of the principal.

At this point the executor (if one is named) takes over

Often the same individual is named to both fiduciary offices.


Question 9-8

The intent of making a power of attorney “durable” is to:

A. Make it last beyond the death of the principal.

B. Name successor attorneys-in-fact.

C. Make it valid through the principal’s incapacity.

D. Make it limited to financial matters only.


Durable Power of Attorney for Health Care (DPOAHC)

A durable power of attorney for health care (DPOAHC) empowers an attorney-in-fact to make a variety of health care decisions for a principal unable to make such decisions for him/herself.

DPOAHC may be immediately effective but will only be honored if principal is unable to communicate his or her wishes

DPOAHC generally a document separate from property/financial-related powers of attorney


Durable Power of Attorney for Property

The durable power of attorney for property can be designed to empower the attorney-in-fact immediately or only upon the incapacity of the principal (a springing power).Such powers typically enable the attorney-in-fact to:

Buy, sell or lease the principal’s assets Collect debts on the principal’s behalf Sue on the principal’s behalf Operate the principal’s business


Powers of Attorney Transfer and Tax Functions

Under a power of attorney, the attorney-in-fact may:Make gifts to members of the principal’s family to accomplish

Estate equalization with spouse Maximization of annual gift tax exclusion(s)

Create living trusts to benefit principal and principal’s familyTransfer principal’s property to a previously established living trustSign joint tax returns (with spouse) on principal’s behalfExercise special powers if appointment


General versus Limited Powers of Attorney

General powers of attorney (durable or nondurable) authorize the attorney-in-fact to act on the principal’s behalf in all legal and financial matters

Limited powers of attorney authorize the attorney-in-fact to perform only certain acts or control specified property Example: Trading authorization for a

brokerage account is a limited power of attorney addressing that account only


Springing Power of Attorney

A springing power of attorney authorizes the agent to act on the principal’s behalf only if the principal becomes incompetent/ incapacitated.

Possibly appropriate in circumstances the where principal wishes to maintain control as long as s/he is able

Can be problematic if principal fails to communicate intent to agent or POA fails to identify what constitutes incapacity


Question 9-9

What is the most likely reason why Elizabeth made her power of attorney a “springing” power?A. She wants to control her own affairs presuming she is able to do so.

B. She wants the power of attorney only to activate upon her death.

C. She wants her power of attorney to be revocable.

D. All the above.


Advance Medical Directives

Living wills and durable powers of attorney for health care direct physicians and hospitals as to the medical choices of the principal and should be part of a clients’ estate plan.Living will addresses life-ending decisions only

Example: Unplug the respiratorDurable powers of attorney for health care grant broader powers

Example: Surgical authorization for patient unable to communicate by speech or writing


Guardianships/Conservatorships

Guardians and conservators are persons appointed by the Court for a ward when the Court determines that one of the following circumstances exists:

The ward is a minor (less than 18 years old)The ward is mentally ill, as evidenced by the opinion of a qualified physician The ward is mentally retarded, as certified by a qualified physician The ward, because of excessive drinking, gambling and the like, wastes or lessens his estate, commonly called a "spendthrift."


Guardian/Conservator of the Person

A second individual may be appointed to represent an incompetent (the ward). The guardian of the person is responsible for the ward’s daily well being and addresses such matters as the ward’s:Living situationMedical careFood and clothingEtc.


Guardian/Conservator of the Estate

The guardian of the estate is responsible for the ward’s financial well being and addresses such matters including:Pay the ward's debts Represent the ward in all lawsuitsControl and manage the ward's property Invest the ward's funds Collect funds due the ward Support the ward and his family from the ward's fundsSell, lease or mortgage the ward's property, given Probate Court approval


Question 9-10

The ultimate supervisory responsibility in conjunction with a guardianship/conservatorship rests with:

A.The guardian

B.The family of the ward

C.The court

D.The trustee


Revocable Trusts for Incapacity Planning

While most transferors select themselves as trustees of their own revocable living trusts, a successor trustee should be named to succeed the grantor as trustee in the event of incapacityThe trust should set forth the criteria for determining incapacityNamed successor should have a copy of the trust document

Also, ideally, a current statement of accounts


Revocable Trusts versus Powers of Attorney

For incapacity planning, the living revocable trust has two advantages over the power of attorney:The trust continues beyond death

Facilitates orderly post mortem transfer Probate avoided for property actually titled in the

name of the trust

Trusts are universally honored Acceptance of power of attorney documents

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Medicaid

Medicaid is a federally-funded, state-run program that provides medical assistance to individuals and families with limited assets and resources. Each state sets its own guidelines regarding eligibility and services. In most states Medicaid is not available to individuals owning >$2,000 in assets.

Medicaid pays for: Health care costs, including doctor's visits Long-term care, including custodial care


Lookback Rules Impact Eligibility

The Deficit Reduction Act of 2005 increased the Medicaid look-back period to 5-years. Thus, asset transfers for less than FMV within the 5-year period before an individual applies to Medicaid for long-term care assistance will reduce benefits. Example:Within the previous 5-years, Grandpa gifted $40,000 to various family members. If the average nursing home cost in Grandpa’s state is $4,000 per month, Grandpa is denied 10 months of Medicaid nursing home assistance.

Had Grandpa gifted $400,000, he would be denied 100 months of Medicaid long-term care assistance.


Medicaid Home Equity Eligibility Rules

Any individual with home equity above $500,000 is now ineligible for Medicaid Exception where applicant’s spouse resides in the home or the home is occupied by a child under age 21, blind or disabled States may raise the threshold to up to $750,000.


Medicaid Eligibility and Annuities

If a Medicaid applicant has any interest in an annuity, the purchase of the annuity will be treated as an uncompensated transfer subject to a penalty period unless the state is named as the primary remainder beneficiary for at least the total amount of medical assistance paid for on behalf of the Medicaid applicant

Or the state is named as the contingent remainder beneficiary after the community spouse or minor or disabled child.


Medicaid and the Community Spouse

Federal law does not require that a married couple impoverish themselves before one spouse may gain eligibility for Medicaid. Instead, the spouse of a Medicaid enrollee, called a “community spouse,” is entitled to a specific portion of the combined income and assets owned by the couple. Generally, a community spouse is entitled to half of the couple’s combined resources (up to a maximum), and at least a minimum amount of the combined monthly income.


Question 9-11

Medicaid rules would be least likely to require that:A.The community spouse hold assets of no more than $2,000.

B.The recipient’s assets and income fall below stated thresholds.

C.Assets given away within five years of applying for Medicaid benefits may jeopardize such benefits.

D. The recipient must be unable to complete certain ADLs in order to receive long-term care benefits.


The Special Needs Trust

A special needs trust (SNT) is a means to leave money to a disabled family member, without interfering with public benefits such as Medicaid or Social Security Disability benefits.The most common special needs trust is a family-type trust, set up by the parents. The parents fund the money for the trust, often by will, and sometimes using life insurance payable to the trust.In most cases, the disabled child/beneficiary has a discretionary life interest. After the beneficiary’s death the remainder passes to other family members.


Maintaining Benefit Eligibility

The key to a family-type special needs trust is that the money CANNOT be used for housing, food, or clothing. Those are considered "basic needs" under SSI and Medicaid laws. If the disabled person is receiving free housing, food or clothing from a family member or a trust, government benefits will be reduced or eliminated.


Appropriate Special Needs Trust Design

The trust can be used to purchase a home, and perhaps rent it to the disabled person. The trust can pay for repairs, utilities and taxes for a home; it can purchase furnishings for the home. The SNT can pay for vacations, summer camp, or trips. It can buy bowling shoes or other sporting equipment. The SNT can pay medical costs not otherwise covered by Medicaid, such as vitamins.

It can pay for funeral and burial costs.


The Payback Trust

A court-ordered trust, also called a “Type A” or “Payback” special needs trust, is appropriate where the disabled person has inherited money, or received a personal injury settlement.

Because the disabled person “owns” the money, the trust is a grantor trust.

The disabled person must be under 65 years old and meet the medical standards of Social Security disability.

The trust must require that, at the disabled person’s death, remaining assets will first reimburse the State for assistance it provided to the disabled beneficiary


life insurance in the estate plan and incapacity planning session 9 depaul university cfp® program

Documents

life insurance policy

joint life insurance

universal life

term policy

protection of estate

coverage depaul university

policy loans

permanent policy