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Turn common insurance mistakes into tax-free wealth…

Friday, March 27th, 2009

It’s frustrating. Year after year, our office is asked to give a second opinion on the completed estate plans of owners of family businesses.

It is very rare to analyze the estate plan, particularly the life insurance policies, of a real-life client and find that all is as it should be.

Typically, we find the wrong kind of insurance. Wrong ownership. Wrong beneficiaries. Wrong tax consequences. It goes on and on.

This is a big deal. We are talking big money. Typically, the IRS gets 50 cents to 55 cents out of every life insurance dollar. Imagine owning a $1 million policy, and the IRS gets $550,000, but your family gets only $450,000. It happens all the time. A needless tax travesty.

Let’s review the three biggest mistakes business owners make concerning life insurance.

• Mistake No. 1

A corporation should never own insurance on the life of a shareholder, particularly a majority shareholder. Why? The trouble starts as soon as the shareholder dies. The policy proceeds are subject to the claims of corporate creditors.

Worse yet, if a C corporation, the proceeds can be subject to the alternative minimum tax — which can steal up to 20 percent of the proceeds — and the net proceeds after the tax can only get into the hands of your family by paying a second tax via a taxable dividend. Ouch!

If an S corporation, the proceeds (although not subject to the alternative minimum tax) are still locked in the corporation and can only be paid out tax-free if all old C corporation surplus is first paid out as a dividend — a terrible and tax-expensive idea.

• Mistake No. 2

The life insurance policy is owned by you or your spouse. Someday the policy proceeds will be included in your estate. You just guaranteed the IRS a big, unnecessary payday.

• Mistake No. 3

The policy, with cash surrender value, is old and the cash surrender value is half or more of the death benefit. You no longer have a life insurance policy but a lousy investment.

What should you do? Here are the typical recommendations we give to our clients so that you and your family — instead of the IRS — win the insurance tax game.

In the case of mistake No. 1, transfer the policy from the corporation to your name, paying the corporation only the amount of the cash surrender value, a tax-free transaction. Next, transfer the policy to a wealth creation trust (an irrevocable life insurance trust that eliminates all income and estate taxes).

For mistake No. 2 transfer the policy to a wealth creation trust.

And for mistake No. 3, if you are insurable, dump the old policy and replace it with a new policy to be owned by a wealth creation trust.

First, if you are married, make sure that replacing the policy on your life is the right type of policy. About 80 percent of the time a second-to-die policy insures you and your spouse will get significantly more bang for your insurance-premium dollar.

Second, determine how to reduce the premium cost: (1) if your company has a 401(k) or other qualified plan look into a subtrust. The plan, not you, pays the premiums. Even your IRAs — traditional or rollover — can join in the premium-saving fun; (2) Whether you need single life (only you are insured) or second-to-die, check out premium financing. You don’t pay any premiums, nor do you pay interest, just the low fees to the bank to initiate and maintain the loan.

This article does not even begin to explore all of the economic possibilities and tax tricks that you should learn to win the insurance tax game. Also, there are exceptions and traps.

Here’s an easy way to get started: List the policies on your life and your spouse’s life, whether owned by you, your corporation, a trust or otherwise. Then ask this question about each policy: What is the ultimate tax cost — income and estate — while I’m alive? When I die? When my spouse dies? The answer should be zero. If not, do what is necessary to make the answer zero. This usually means implementing one or more of the recommendations listed above for each of the above mistakes.

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At last, a tax-deferred concept that gives high returns

Friday, March 27th, 2009

Tax-free investments are big.

The interesting ones are even bigger. Logically, tax-free should be No. 1. But the cruel fact is that with the exception of life insurance — you must die to get your tax-free reward — or municipal bonds (plagued by low return rates), there just isn’t much to talk about that is tax-free.

Tax-deferred is a different situation. That’s where the action is. The biggest tax-deferred “sandbox” is qualified plans.

Profit-sharing plans, 401(k) plans, IRAs of all sorts and others abound. Billions of dollars pour into these plans every year. Employer-sponsored plans are usually the tax weapon of choice. Non-employer plans, such as traditional and Roth IRAs, give every taxpayer an opportunity to play in this sandbox.

While IRAs have dollar limits, tax-deferred annuities have none. You can toss as many after-tax dollars as you like into annuities. Not one cent is deductible. But annuities are lower earners and result in severe penalties if withdrawn early. Simply put, there’s no liquidity.

So what’s the magnet that draws billions of dollars into this not-such-a-good-deal investment? Here’s the answer in one magic phrase: tax-deferred.

A word about annuity return rates:

• Fixed annuities are the most popular. They currently pay 3 percent to 3½ percent per year. Older annuities, purchased when interest rates were higher, paid more.

• The new darling is indexed annuities. Yield is pegged to some index, typically Standard & Poor’s, on an annual basis. Often in a loss year, indexed annuities guarantee a smaller yield, usually 1½ percent to 3 percent.

When the index rises to 4 percent, that is the percentage investors get. A large rise is capped at 6 percent to 8 percent. For example, at an increase of 14 percent, investors would receive only 7 percent.

What’s a tax-deferred investment that doesn’t have all the impediments of annuities and has a huge return rate without risk?

• The answer is senior settlements. The following example is the easiest way to explain.

Suppose Joe, 68, has a $400,000 life insurance policy with a cash surrender value of $50,000. Joe would like to stop his annual premium payments.

Instead of canceling the policy and taking the $50,000 from the insurance company, Joe sells his policy as a senior settlement and receives $120,000.

Joe’s a happy camper.

Investors bought Joe’s policy.

Senior settlements have been around for about 35 years. Their tax consequences are a delight. Tax liabilities on profits are completely deferred until the investor receives back the entire investment and profit.

There’s a public company that trades on the NASDAQ Stock Market offering senior settlements. The average rate of return is 16.36 percent per year and has been over 16 percent throughout the company’s 14-year history.

If your goal is to make a killing on your investments, senior settlements are not for you.

It should be noted that American International Group, the giant insurance company, and Warren Buffett’s Berkshire Hathaway invest in senior settlements.

But if an average return rate of more than 16 percent with no market risk is of interest to you, learn more about senior settlements. Just fax your name, address, phone numbers and estimated amount to invest to me at 417-9045.

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Senior settlements an easy way to get high rate of return!

Friday, March 27th, 2009

When giving my tax-planning, wealth-building seminars, I usually ask the audience, “Do you know the ‘Rule of 72′ and how it works?”

Typically, about one-third of the people raise their hands.

Then I explain the wonderful, helpful Rule of 72:

“Write the number 72 on a piece of paper. Assume you can get a 10 percent rate of return.

Divide 10 into 72. You get 7.2.

What that means is your principal sum will double every 7.2 years.

“For example, $10,000 compounding for a period of 36 years will double exactly five times and give you $320,000.

Stop for a minute — do the simple math yourself. Fun, eh?”

But wait! What if that 10 percent return was subject to a 40 percent state and federal income tax? Then you would have only a 6 percent return — 72 divided by six means 12 years to double your money.

Now your $10,000 will double only three times over the same 36-year period ($10,000 to $20,000, $20,000 to $40,000, and $40,000 to $80,000).

Compare that $80,000 with $320,000 when tax-deferred (or tax-free). A huge difference.

So, now we know two factors that are measurably important to creating wealth: rate of return and tax deferment.

Let’s explore tax deferment first.

If you have money in a qualified plan — 401(k), profit-sharing, IRA or other qualified plan — you are on the tax-deferred road. If you are the proud owner of a Roth IRA or the new Roth 401(k), you can wave your tax-free flag.

Now the hard part: the rate of return. How would you like to average more than a 16 percent rate of return per year? You can. The concept is called senior settlements, or SS.

Let me introduce you to senior settlements by quoting a May 18 article from The Wall Street Journal titled Moving the Market:

“AIG (the insurance giant) has bought less than 1,500 policies since 2001, according to spokesman Wil Nans.

“The industry’s annual returns of 10 percent to 15 percent first attracted European and Asian investors. And a few years ago, Berkshire Hathaway Inc., the investment vehicle of billionaire investor Warren Buffett, began buying life settlements, according to securities filings.”

A senior settlement is simply the purchase of an existing insurance policy from a senior (65 or older) by an investor.

The selling senior, who no longer wants to pay premiums, gets a much larger price for the policy than by taking the cash surrender value from the insurance company. The senior wins. The investor wins by making a large profit without risk (the senior is sure to die).

Can you become one of the investors? Yes. A public company trading on the Nasdaq makes it easy. The average rate of return on senior settlements is 16.36 percent per year and has been more than 16 percent throughout the company’s 14-year operating history.

You can become a senior-settlement investor in one of three ways: taxable, tax-deferred or tax-free. Following are the most common possibilities:

• Taxable. You use your own funds or funds you control, like your corporation or other business entities, family limited partnerships and any noncharitable trust.

• Tax-deferred. Almost everyone can play this profitable game via a qualified plan. The trustees of pension plans or other plans that are not self-directed can join the profitable fun by investing the plan funds in senior settlements for the benefit of all participants.

• Tax-free. A Roth IRA or Roth 401(k) can fatten your tax-free accumulations. Charitable entities — charitable remainder and lead trusts and family foundations — are a perfect fit.

As you can see, we have a very positive attitude toward the potential wealth-building power of senior settlements.

But since senior settlements are probably new to almost everyone reading these words, here’s a suggestion:

Show this column to you professional advisers — CPA, lawyer, banker, financial planner and others.

Discuss senior settlements from at least these two aspects concerning your investments (taxable or otherwise):

1. The next time you are about to make an investment, determine how senior settlements compare with other possible investment choices.

2. Compare existing investments with your long-term (don’t forget to apply the Rule of 72) and short-term (about three to five years) goals.

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Charity and life insurance can help you conquer estate tax.

Thursday, March 26th, 2009

When it comes to the wealth-robbing estate tax, almost every reader of this column who calls me asks this or a similar question: “Irv, can you help me avoid (or beat, kill, finesse, etc.) the estate tax?” Often, an obscenity or two regarding how the caller feels about the estate tax is tossed in for good measure.

If you are worth around $6 million or less, the answer is almost always yes. If you are worth more, the answer is usually no.

Let’s talk real numbers. Consider that taxpayer Joe is worth $10 million and his neighbor Jack is worth $20 million. Both men are married. Joe’s estate tax estimate, using 2011 rates, would be around $4 million.

Jack’s would top out at a tragic $9.5 million.

The higher your wealth, the lower your chance for avoiding the estate tax.

But there are ways to entirely avoid the impact of the estate tax.

If, for example, you are worth $8 million, there are ways to get the full $8 million (all taxes paid in full) to your family. Similarly, if you are worth $80 million, the entire $80 million can go to your family. It can always be done, whether you’re single or married, young or old, or even insurable or uninsurable.

Let’s play the game together.

Substitute your own numbers into the little example that follows.

Suppose you are worth $12 million and married. First, subtract $2 million ($1 million if you’re single), which leaves $10 million. Multiply $10 million by 50 percent to get your bitter estate tax bite. Finally, add 55 percent for your worth in excess of the $10 million.

Now, here’s the secret for legally avoiding the estate tax and creating tax-free wealth. There are two ways: charity and life insurance. If you do them right, both put you in a tax-free environment.

Here’s a real-life story of Joe.

He’s a 63-year-old business owner from Nebraska who winters in Florida and is married to Mary, 62. Joe and Mary are worth $23 million. Using our little example above, the estate tax monster would eat $11.05 million of their wealth.

We designed a comprehensive and coordinated succession plan and estate plan for Joe and Mary that included four significant strategies: an intentionally defective trust to transfer Joe’s business to his kids tax-free, a family limited partnership for their investment assets (a stock and bond portfolio and real estate), and the two different life insurance strategies, which are described below.

A side note before continuing: Every case is different. Different people have various businesses situations and factors. A big factor for Joe and Mary was their excellent health for their age. So insurance was front and center.

Now, to the third strategy: Joe had $600,000 in his company’s 401(k) and $1.5 million in various IRAs, which we transferred into the 401(k), a tax-free transfer. Then we created a subtrust for the 401(k) that purchased $6.5 million of second-to-die life insurance on Joe and Mary. Because of double taxation, first income tax and then estate tax, the $2.1 million in the 401(k) without the subtrust would net only about $600,000 for Joe’s heirs. Sorry, but the tax collector would get the rest, $1.5 million.

The subtrust allows the entire $6.5 million of life insurance to go to Joe and Mary’s heirs tax-free. In effect, we turned $600,000 into $6.5 million. Neat!

One more point: We showed Joe how to invest his $2.1 million in his 401(k) in TIPs, or transfer insurance policies, a form of senior settlements.

TIPs earn in excess of 16 percent on average per year, without risk. Joe’s investments were averaging only 7 percent per year with stocks, bonds and mutual funds

Ask your professional to check out subtrusts and TIPs.

The final strategy: Joe and Mary needed an additional $5 million of life insurance. At their ages — if you don’t use a subtrust — the premiums are steep. We used a strategy called premium financing, or PF, to buy $5 million of life insurance on Joe’s life. PF allows you to buy life insurance without paying your premiums in cash. Instead, premiums are paid though a trust you create that pay each premium by the trustee signing a nonrecourse note to the lending bank.

Interest is added to the loan.

All premium loans, plus accrued interest, will be paid out of the death benefits when Joe dies. The only costs paid by Joe are to the banks for initiating and maintaining the loan equaling about $60,000 paid the first year and an additional $180,000, which will be paid in small amounts each year to age 100.

It’s an economic home run that nets $5 million tax-free to Joe and Mary’s heirs for a small out-of-pocket cost of $240,000 or less, which is paid over a 30-year period.

No question about it, PF is the most inexpensive way to buy life insurance (whether you buy $5 million, $10 million or more). You must qualify to use PF, be creditworthy and be worth a minimum of $5 million.

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Don’t flip your lid if you have too many FLIP accounts.

Thursday, March 26th, 2009

Professionally, my second love is writing this column; my first love is consulting with the people who read it.

Every family I work with is different. So are its business, its situations and its problems. Despite these differences, I’m rarely surprised by anything totally new. But one reader sent me something I had never seen before.

Here’s the story. After about an hour on the phone, Sam, calling at the request of his dad, Joe, agreed to send me the typical information: some tax returns and financial statements and a copy of the existing estate plan.

About one week later, a large, heavy box arrived with a 5-inch stack of documents. Most of the documents had to do with nine separate family limited partnerships, or FLIPs. All were identical, except each FLIP owned a different asset, like the family business, a residence or investments.

As I thumbed through the papers, I couldn’t help thinking about the drunk who was told, “A shot of whiskey each day is good for you.” The guy who did Joe’s estate plan was clearly FLIP drunk.

One thing should be made clear: I am an enthusiastic cheerleader for the use of FLIPs in estate planning. I use ‘em all the time. But this overkill of a single strategy just didn’t do the best possible job.

The proof: Using the computations of the adviser, the IRS still would cash in for more than $2 million in estate taxes.

Another $1.1 million of IRS enrichment was likely because of a gross misuse of the FLIP strategy.

What does a FLIP accomplish? It allows you to totally control the use of any asset transferred (a tax-free transfer) to the FLIP as the general partner, yet reduce the value of the bundle of assets transferred for tax purposes.

For example, $1 million of assets transferred to a FLIP is usually worth only about $650,000 for tax purposes. That $350,000 discount in a 55 percent estate tax bracket will reduce your estate tax burden by $192,500. Not bad!

A FLIP also is a great asset-protection strategy. Creditors can’t get at the assets in the FLIP. Neither can divorcing spouses of your kids, who are usually the limited partners.

Used properly, a FLIP is almost a perfect tax tool.

In general, a FLIP should not be used to own the stock of your family business. Nor should it be used for non-income-producing personal as sets, like a residence or auto.

It’s a valuable strategy for almost every other asset you might own — publicly traded stocks and bonds, real estate, you name it.

In short, we terminated the FLIPs that held the family business and two family residences.

The business elected S corporation status and was transferred to an intentionally defective trust (IDT), and the residences were transferred to qualified personal residence trusts (QPRTs). An IDT and a QPRT are similar concepts that allow you to heavily discount the value of the assets transferred to them.

We used the liquid assets in two other FLIPs to pay the premiums on second-to-die life insurance (on Joe and his wife), which was owned by an irrevocable life insurance trust (ILIT) that we created. An ILIT removes life insurance from the taxable estate of the husband and wife.

When all the smoke clears, Joe and his four children, including Sam, will be enriched $4 million to $7 million more than the original overkill FLIP plan (depending on how long Joe and his wife live).

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Try two winning tax strategies with a life insurance product.

Thursday, March 26th, 2009

Want to make a grown man cry?

Tell him that all those beautiful dollars in his qualified plans — profit-sharing, 401(k), IRA and the like — are worth only 27 to 30 cents after taxes. Sorry, but it’s true.

The IRS hits you with two taxes: income tax (up to 40 percent or more, including state and federal) and estate tax (up to 55 percent using 2011 rates). Then, depending on where you live, your city, county or state gets a piece of the action.

Outrageous!

The first order of business is to get a fix on how much of your plan money is destined to wind up in some tax collector’s pocket. A call to your plan adviser is all it takes.

Just to get some numbers on the table, suppose you have $1 million in all your plans combined and the estimated tax burden is $730,000. Only $270,000 goes to you and your family. Ouch!

Can anything be done about it? Yes. But you must be proactive.

There are many strategies, but let’s take a look at the two most common: the junk-money strategy and the subtrust strategy.

Both are very complex and need an expert to cover all the details. Yet the wonderful benefits are easy to understand and attain. Think of it as enjoying the ride when you drive a car, but not knowing how to build one.

Both strategies use a common denominator: a life insurance product (usually second-to-die). The eventual proceeds of the life insurance, say $1 million, go to your family free of the income tax and estate tax. Simply put, you have turned $270,000 of after-tax value into $1 million tax-free.

There’s usually still plenty of money left in the plan. For example, as I write this, the cost of a second-to-die policy for a husband and wife, both age 65, is only in the $15,000-per-year range. You must get your own quote.

The junk-money strategy starts by using your plan dollars to buy an annuity — a tax-free transaction. A portion of the annuity is used to pay the life insurance premium.

The subtrust is created as part of your qualified plan (actually the current plan — usually a 401(k) plan or a profit-sharing plan — is amended or a new plan is created). Then your plan trustee transfers the necessary premium dollars to the trustee of your subtrust to pay the policy cost.

As far as I know, there is nothing better in the tax law than these two strategies to snatch a tax victory out of the snarling jaws of a sure defeat. If you have $350,000 or more in your qualified plans — rollover IRA, traditional IRA, 401(k), profit-sharing and the like — you owe it to yourself and your family to look into both strategies.

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