The market downturn of 2008 is still sending shock waves to investors who had counted on insurance policies to cover estate taxes.
Many are receiving unwelcome surprises. Some of these variable life insurance policies are now failing. They began to unravel during the recession because they invest in baskets of mutual funds known as separate accounts. The damage is only now starting to surface for policy holders and the outcome can be startling - and expensive.
Volatile markets can undermine a variable life insurance policy and did just that to many of them after 2008, according to John Resnick, whose Harrisburg, Pa., firm provides life insurance to high-net worth clients.
Many policy holders are only feeling the effects now because the plans’ design can create a delayed reaction. A drop in cash value, together with rising mortality fees and expenses, will drain funds designed to sustain the death benefit.
Once the cash value goes to zero, “the policy will implode without value unless a much higher premium is paid,” says Resnick. Problems get worse as the insured gets older because mortality charges go up annually.
Someone who paid, say, $2 million into a policy may suddenly learn he has lost the cash value and won’t get a death benefit. The insurance company may send a notice requiring more money, and fast – within just 30 or 60 days – to keep the policy alive. Tax attorneys and insurance consultants say this has been happening for a while, but they are now seeing more failures.
Would you like to leave money to descendants as distant from you as you are from the Pilgrims who landed at Plymouth Rock? It’s possible, if you set up a “Dynasty Trust.” The Obama administration, however, proposed restrictions on such trusts in its recently released 2012 budget.
But experts agree that this proposal is unlikely to pass this year, and perhaps ever. Dynasty trusts can be used by the wealthy to put $5 million or more in assets beyond the reach of the estate tax for hundreds of years. They are especially attractive to many now that the estate tax is the most generous it has been in decades, with a $5 million per individual exemption and a 35% top rate – terms that will expire at the end of 2012. Dynasty trusts became popular after the 1986 tax reform passed a new version of the “generation-skipping tax” Back then only three states (Wisconsin, South Dakota and Idaho) allowed them, according to a 2010 paper prepared for the by University of Michigan Law Professor Larry Waggoner for the American Law Institute (ALI). Since 1986, another 22 states plus the District of Columbia have given dynasty trusts the green light.
You may think you don’t have to worry about the federal estate tax because you’re not “rich.” In fact, some unsuspecting upper middle-class folks are exposed to the tax, which hits at a painful 35% rate.
Although current law provides a generous $5 million federal estate tax exemption for estates of individuals who die in 2011 and 2012, the exemption can be exceeded if you have lots of life insurance coverage, a valuable home, healthy retirement account balances, and some other assets.
What Is Included in Your Taxable Estate?
The value of your estate for estate tax purposes includes all the following assets (minus liabilities): proceeds from life insurance policies; your primary residence and any vacation and/or rental properties; retirement accounts, investment accounts; cars, furniture, collectibles, and all the rest of your stuff. Don’t forget to count any private business ownership interests (such as shares in a family corporation or partnership).
Here’s an example: Stephanie is a divorced single parent. Since she earns a healthy salary, she has a $4 million term life policy to provide for her three teenagers. She also has $800,000 of equity in her home, $1 million in retirement plan accounts, and $500,000 worth of assorted personal assets (cars, clothes, furniture, jewelry, and so forth). Stephanie has no significant debts beyond her home mortgage. Since she has never considered herself to be anything close to “rich” she has never done any estate-tax-avoidance planning.
The complex tax code and eleventh-hour changes don’t mean it’s too late to get good advice – but you might have to pay up.
In some ways, filing taxes has gotten a lot easier in recent years: free electronic filing, Turbo Tax, and now, even an iPhone app from the IRS. But here’s a warning before you start that download: Washington is mucking things up.
The eleventh-hour tax bill negotiated by Congress and President Obama includes some 500 changes—no fewer than 160 pages are now devoted to the estate and gift tax. Those last-minute adjustments mean anyone planning to itemize deductions, be it mortgage interest or charitable donations, must wait until mid- to late February to file this year. And these changes come on the heels of the IRS pushing back companies’ deadline for sending out so-called 1099 forms to Feb. 15 a few years ago. That means taxpayers have already had to wait a full two weeks longer to get the details they need for income like dividends, interest and sales of real estate.
The result is as predictable as, well, death and you know what: Everybody, it seems, is running late this year. Taxpayers and preparers are trying to decide whether to complete a return early and risk having to refile, or wait even longer to make sure they have all they need.“Everything is being shoved closer and closer to April 15,” says John Ams, executive vice president of the National Society of Accountants. (Even the IRS was tripped up—the agency won’t be able to start processing returns until mid-February, delaying refunds for those lucky enough to get them.)
For all but the simplest 1040-filers, the new wrinkles could lead to fee increases, particularly for those with preparers who charge by the hour.
In the most recent Tax Report column on the new $5 million gift-tax exemption, there wasn’t space to discuss a different, but related break that’s among the most useful in entire U.S. tax code: the annual $13,000 gift exclusion.
Here’s how it works:
Unlike the $5 million exemption, which applies to total gifts made during a person’s life, every taxpayer can take advantage of the $13,000 exclusion, every year. A taxpayer may make as many gifts as he or she desires as long as no one person gets more than $13,000 of value in any one year.
Married couples may therefore give $26,000 to each recipient; if they make a special election, the entire $26,000 can come from one partner’s property. The annual exclusion doesn’t count against the $5 million lifetime exemption, and there is no deduction for a gift. Although many states have estate or inheritance taxes, only two have gift taxes: Connecticut and Tennessee.
The recipient may be anyone—not just a relative—and the gift may be either cash or a non-cash item such stock or other property. It may even be possible to give a $13,000 “interest” in a piece of real estate or an item that can’t be divided, such as a painting. Such moves are complex and require expert help, however, says estate attorney Ronald Aucutt of McGuireWoods. Gifts don’t have to be made outright to a recipient either; they may be made to a trust instead.
Gifts must also be “completed.”
Now is the time, tax-wise, to give a lot of money away.
New tax rules in 2011 should make it a top priority for the wealthy to consider whether to make a gift, and when. The rules let someone give away a lot more money free of gift tax than ever before.
When Congress extended the Bush tax cuts late last year, the deal also included a big rise in the amount a person can give away tax-free over his or her lifetime. Since 2001, total gifts over $1 million had resulted in a tax. The new ceiling is $5 million. The new rules last only through 2012. What happens after that is a mystery, so many wealthy taxpayers want to make sure they give away $5 million–plus all growth and appreciation on that gift–while the giving is good. For married couples, there is $10 million at stake.
The issue of how best to help clients take advantage of the new gift-tax rules is “the hottest one out there, by far” for tax advisers, according to Robert Keebler, a certified public accountant in Green Bay, Wisc.
The very wealthy who can afford to part with $5 million — or $10 million for couples — should definitely go ahead and do so in the next two years, according to several advisers. This timeline for gift giving also makes sense for those who are affluent but not extremely rich. Where a person resides should be factored into this decision, of course, because cost of living varies.
In a recent post about the new estate tax rules, one reader commented: “Well if this accountant was this ladies tax preparer early in her career she should darn well know where every bit of paper is regarding each share.” After all, this reader said, his accountant has records going back “to the beginning of time” regarding his asset purchases.
I smiled when I read that, visualizing my 20-something self, having been 80+ year Mildred’s accountant since she was a young housewife. In fact, I never met Mildred. It was Ruth, her younger sister (who was 70-ish), who took over as Mildred’s guardian and hired me to catch up on several years of unfiled tax returns. However, it was early in my career, I became aware of the basis nightmare that many people face.
Let me give you 10 reasons why your accountant might not have your records:
1. It’s not unusual for a tax professional to start working with an elderly person for the first time after the person has been incapacitated. By that time, the client might be unable to participate in the tax preparation and planning process.
2. One spouse handled all the finances. The other spouse knew nothing about the details – and never found the records.
The 2010 Tax Relief Act establishes an exclusion from estate taxes for $5 million dollars per person, effective all of 2010 through December 31, 2012. But wait, 2010 was practically over by the time this legislation passed. Under the old rules, the estates of those who died were off the hook for estate taxes in 2010. Did that change?
Not exactly. Now there’s a choice. The Tax Relief Act gave estate executors a choice between no estate taxes – and the right to use the new estate tax law. Why would anyone want to subject an estate to taxes if they can opt out? There are actually some pretty sound reasons to consider this. Let me explain.
In 2010 with no estate taxes, larger estates also lost the right to a step-up in basis. ‘Step-up’ means the tax basis of the estate’s assets rise to whichever is lower: either cost or their fair market value (FMV) at the date of death–or optionally, 6 months after death (if the overall estate value is lower). The ‘step-up’ concept is important for two types of assets – highly-appreciated assets and assets whose cost is difficult to prove due to the passage of time, modifications of assets, and lost records.
In plain English, here’s an example. Mildred, a little old lady built up her stock portfolio over 30 or 40 years, a little bit at a time. The original records for those accounts are nowhere to be found. She was one of my clients, early in my tax practice. She was in the later stages of Alzheimer’s disease, so there was no way to ask her about the purchases. The stocks had split an unknown number of times – or perhaps experienced reverse splits. Companies had been split off, issuing new stocks. The family couldn’t possibly figure out where to start. Due to the step-up in basis, when Mildred died, we didn’t have to play detective and research all her purchase prices and trace the splits. We simply recorded the FMV on the date of death – and the heirs could sell the stocks without paying any capital gains taxes on a generation of appreciation.
Let’s go back to the original rules for 2010.
The sweeping tax bill President Obama just signed into law impacts just about everyone. But not all tax breaks were created equal.
In many cases, higher earners may be keeping more cash in their pockets. Households with income of $500,000 to $1 million will gain $3,859 compared to current tax rules.
Wealthier Americans will benefit greatly from a two-year extension of current rates on long-term capital gains and dividends, keeping both at a top rate of 15%. Without the extension, the rate on long-term gains would have risen to 20%, and the top dividend rate could have risen to as high as 39.6% for the wealthiest taxpayers in the highest tax bracket.
Wealthy Americans hoping to pass on estates to their heirs get a break through the deal, which lowers the top estate-tax rate to 35% and increases the exemption to $5 million per individual.
A moment, please, for the rich who did their heirs the courtesy of dying on time.
At least five American billionaires died in 2010: Mary Janet Cargill (agribusiness), Dan Duncan (oil), Walter Shorenstein (real estate), George Steinbrenner (shipping, Yankees), and John Kluge (television). And as each drew their last breath, perhaps they took some comfort in knowing their timing was excellent, financially speaking. The year-long suspension of the estate tax saved their families hundreds of millions at least. (It also cost the government as much.)
Now, the estate tax is coming back – although it won’t hit nearly as hard as did before this year’s full exemption. The expected passage of the new tax bill would extend the exemption for assets up to $5 million through at least 2011 and 2012. (Read Bill Bischoff’s explainer on the estate tax deal.)
The Tax Blog brings together a team of award-winning tax journalists from the Dow Jones network and around the web to examine the tax issues, changes and legislation that affect families, investors and small business owners. Our contributors include Tax Report columnist Laura Saunders (WSJ), Tax Guy columnist Bill Bischoff and senior reporter Jilian Mincer (SmartMoney.com), retirement-focused reporter Anne Tergesen (WSJ), wealth management writer Arden Dale (Dow Jones Newswires), TaxWatch columnist Eva Rosenberg and personal finance reporter Andrea Coombes (MarketWatch), and reporter Alyssa Abkowitz (SmartMoney). They’ll provide the latest news and insight, mine the tax code for tips and loopholes, and answer your questions about tricky tax situations. Contact the The Tax Blog with ideas, suggestions or tax questions at email@example.com.