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Myths and Realities of Estate Planning – ILIT’s and RLT’s

The objective of this discussion is to review some of the myths and realities of estate planning. A number of articles have been written on the subject but let’s see if we can’t put a different spin on it by keeping it simple. By dispelling some of the common misconceptions, we will have a better understanding of how important it is to take positive action to keep our estate plans in order.

The Economic Growth and Tax Reconciliation Relief Act of 2001 (EGTRRA) threw many individuals for a loop when it came to estate planning. Tax laws are never simple but EGTRRA added a level of confusion rarely seen in advanced planning. For instance, between now and 2011 the federal estate tax is scheduled to decrease, disappear and then spring back to life. According to a Wall Street Journal article dated May 11, 2005, the “…current estate tax law puts estate-tax planners in an impossible situation…”. With such uncertainty, some potentially damaging estate planning myths have surfaced. These financial “urban legends” stand in the way of prudent estate planning.

Myth. Because of tax law uncertainty, you should avoid using life insurance trusts.

The irrevocable life insurance trust (ILIT) is probably the most significant insurance related estate planning tool available to you. The irrevocable nature of the trust can provide estate tax savings while the insurance provides a cost effective way to pay estate taxes (depending on age and health). The appeal of an irrevocable life insurance trust is that the death proceeds of the policy are not included in the insured’s estate. If kept out of the decedent’s estate, the death proceeds will not increase the estate tax burden. The irrevocable life insurance trust is a double winner because, not only are the death proceeds outside the insured’s estate, but the proceeds can be available to meet estate liquidity needs.

To insure that the life insurance proceeds will be excluded from the insured’s estate, two of the primary requirements that must be met are that the insured must not have any incidents of ownership in the policy and the trust must be irrevocable. Some people believe that, in the face of tax law uncertainty, clients should avoid using ILITs. These same people fear that once a policy is placed in an ILIT, the policy is locked in the trust forever, even in the unlikely event that the estate tax is repealed.

Nothing could be further from the truth. In reality, ILITs can be drafted with flexibility. Some ILITs today are being drafted to give the trustee the discretion to distribute the cash surrender value of the insurance policy to trust beneficiaries during the trust creator’s lifetime. This “escape” language builds flexibility into ILITs.

Myth. Estate tax reform, or repeal, would signal the end of charitable giving.

Giving to charity is emotionally rewarding. The IRS also gives you income tax breaks for charitable donations. You may utilize charitable giving strategies as a technique to reduce or freeze the value of your estate. Some people have bemoaned the possibility of estate tax repeal or reform, claiming that it will significantly reduce charitable giving. The argument posed is that if fewer estates are subjected to the estate tax, then fewer people will be inclined to make charitable gifts as an estate tax reduction strategy.

The numbers tell a different story. Since 2001, the estate tax exemption amount (the amount of property each person can pass free from federal estate taxes) has more than doubled. According to the myth, the increasing estate tax exemption amount means that fewer people will be inclined to give to charity. The reality is that during the same time period, charitable giving nationwide rose by nearly $90 billion! If the myth was correct, how could this be?

The steady rise in charitable giving is based upon the fact that charitable giving is a grass roots effort. The vast majority of charitable gifts are made by individuals. Private foundations and corporate gifts account for relatively small slices of the charitable giving pie. 77% of all charitable gifts are made by individuals and there is no indication to believe this trend will reverse itself. America is truly a philanthropic country; estate tax reduction is rarely the primary motivating factor for making a charitable gift.

Myth. Revocable Living Trusts reduce taxes.

A revocable living trust is a separate legal entity that you create to own property, such as your home, other property, or investments. You transfer some or all of your property to the trust. During your lifetime, you control the trust; you can change the trust terms or terminate the trust at any time and take the property back. At your death, the trust becomes irrevocable and may continue to exist for many years. People create living trusts because they’re able to retain control over their assets while achieving other goals, such as controlling the manner and timing of asset distributions to heirs, providing for asset management during periods of incapacity, avoiding probate and/or serving as a will substitute (among other things). A common myth is that revocable trusts save taxes.

In reality, for tax purposes, transfers to revocable living trusts are incomplete transfers for tax purposes and do not save any taxes. Revocable trusts may offer many other benefits to a trust creator, but tax savings is not one of those.

Myth. Estate planning is dead.

There is no greater myth than the misperception that estate planning is dead.

Even if the federal estate tax was repealed (which is highly unlikely), there are many reasons for us to continue with our estate plans. Some of those are:

  • Asset protection
  • Family business planning
  • Multi-generational planning
  • Privacy
  • Income replacement
  • Equalization of inheritance
  • Special needs dependents
  • Charitable giving

Life insurance is often a crucial component of many, if not all, of these estate planning goals.

Everyone has an estate plan; it’s just a matter of how well your plan fits your goals. You owe it to yourself and your family to make sure your estate plan is in order. Conversation is fine, but taking action is crucial. Make the commitment to take at least one step in your estate planning efforts in the next three days. It could be as simple as organizing your paperwork, compiling a list of your assets and/or updating your beneficiary designations. If you do not have an updated will, you should make that a priority. You should also take steps to have sufficient death benefit protection structured in the most tax-efficient manner to achieve your goals.

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