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A Dozen Uses of Life Insurance in Estate Planning

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1 A Dozen Uses of Life Insurance in Estate Planning
This Material is Not Intended for Use with the General Public Ed. 06/11 Exp. 06/13

This material has been prepared by The Prudential Insurance Company of America to assist financial professionals in obtaining continuing education credits. It is designed to provide general information in regard to the subject matter covered. It should be used with the understanding that it does not constitute legal, accounting or tax advice. Such services should be provided by the client’s own legal, accounting and tax advisors. Accordingly, information in this document cannot be used for purposes of avoiding penalties under the Internal Revenue Code. Life insurance is issued by The Prudential Insurance Company of America and its affiliates. All are Prudential Financial companies located in Newark, NJ, and each is solely responsible for its own financial condition and contractual obligations. Life insurance policies contain exclusions, limitations, reductions of benefits and terms for keeping them in force. A financial professional can provide a client with costs and complete details. The availability of other products and services varies by carrier and state.

3 Not Insured by FDIC or Any Federal Government Agency. May Lose Value.
IMPORTANT INFORMATION Life insurance policy cash values are accessed through withdrawals and policy loans. Loans are at interest. Unpaid loans and withdrawals cause a reduction in cash values and death benefits. In general, loans are not taxable, but withdrawals are taxable to the extent they exceed basis in the contract. Loans outstanding at policy lapse or surrender, prior to the death of the insured, will cause immediate taxation to the extent of the gain in the contract. For policies that are Modified Endowment Contracts, distributions (including loans) are taxable to the extent of income in the contract, and an additional 10% federal income tax penalty may apply. Clients may wish to consult their tax advisor for advice regarding their particular situation. Securities and Insurance Products: Not Insured by FDIC or Any Federal Government Agency. May Lose Value. Not a Deposit of or Guaranteed by Any Bank or Bank Affiliate. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities.

4 Benefits of Life Insurance
Death benefit generally received income tax-free under IRC §101(a) Death benefit can be structured to be estate tax- free Tax-deferred cash value build-up Generally can borrow cash value without tax Exception: modified endowment contracts Although the primary reason to purchase life insurance is for the death benefit, many policies provide the potential for cash accumulation

5 Benefits of Life Insurance
Notwithstanding the time value of money, periodic small gift transfers for premium can provide large death benefits Form of property people generally don’t mind giving away during lifetime Unique in its ability to provide instant substance (death benefits) where insured is prevented from doing so because of death (life insurance is self- completing)

6 #1 Income Replacement Life insurance death benefits can create a fund that survivors (beneficiaries) can access to help replace income lost at the death of a wage earner. Family with few assets dependent on the income of an insured Survivors (beneficiaries) who may be asset rich but income poor Inherited assets are low/non-income producing (i.e., land, minority interest in a closely held business) Trust beneficiary with minimal income distributions (i.e., income-only trust beneficiaries)

7 #2 Source of Cash Life insurance death benefits can instantaneously create a pool of cash at an insured’s death to help: Pay down or pay off mortgages or other debts Fund services provided by the deceased (house cleaning, child care, cooking, etc.) Fund for education Fund for the care of individuals who are physically or mentally not able to provide for themselves (i.e., children with special needs)

8 #3 Source of Liquidity Life insurance death proceeds can be a source of liquidity to help pay federal/state death taxes and other death-generated costs (final expenses, administrative costs). Typical plan for a married couple with large estate: An amount up to the applicable exclusion amount ($5M in 2011) passes to a bypass trust for benefit of family. This amount totally avoids federal estate tax. Balance of property passes outright, or in a qualifying marital trust, to a U.S. citizen spouse without estate tax. At spouse’s death, any property in excess of the spouse’s estate tax exemption amount is subject to estate tax. Result: Delays federal estate tax until death of the surviving spouse.

9 #3 Source of Liquidity (Continued)
Examples of techniques used to help pay death taxes: Second-to-die life insurance in an irrevocable life insurance trust Standby survivorship trust for clients who want to retain control over the policy (or avoid gifting) during the lifetime of both spouses “B” trust funding for insurance on widows with bypass credit shelter trust assets

10 #4 Noncitizen Spouse Marital Deduction
Life insurance proceeds can help address the marital deduction limitations of a surviving noncitizen spouse. To qualify for the unlimited estate tax marital deduction, property passing to a surviving noncitizen spouse must pass into a qualified domestic trust (QDOT). Distributions of principal from a QDOT during the life of the noncitizen spouse, except for hardship, are subject to estate tax. Assets remaining in QDOT at the death of noncitizen spouse do not qualify for that spouse’s estate tax exemption, rather they are subject to estate tax as if they were included in the estate of the prior deceased spouse.

11 #4 Noncitizen Spouse Marital Deduction (Continued)
Examples of methods to address marital deduction limitations of a noncitizen spouse: Not willing to create a QDOT: Assets passing to a noncitizen spouse and other heirs in excess of the applicable exclusion amount ($5M in 2011) will be subject to estate tax. Result: Tax triggered at death of first spouse. An individual life insurance policy insuring the deceased spouse can help pay estate tax. Noncitizen spouse can own insurance on other spouse to provide source of funds free of the restrictions imposed by the QDOT.

12 #5 Enhance an Estate Life insurance death benefits can help reduce estate planning problems where there is a need to instantaneously enhance the size of an insured’s estate. Commitments for substantial transfers (like those on the next page) in the future can be made with more modest current transfers for life insurance premiums.

13 #5 Enhance an Estate (Continued)
Examples of where life insurance’s unique ability to provide instant substance can help address estate problems when there is a commitment / desire to transfer substantial wealth in the future: Provide wealth for children of prior marriage Limitation of the QTIP trust solution Spousal rights in qualified plan balances Divorce and child support commitments Help pay for the purchase of a business interest Help “equalize” estates of heirs who do not work in the family business

14 #6 Stabilize a Business Interest
Life insurance death proceeds can help provide additional cash to help reassure creditors, vendors, distributors and employees that the business is financially sound. Help satisfy business debt Provide cash flow during the inevitable crisis that follows the death of a key person Create a “stay bonus” fund to retain key employees during a transition period of a business

15 #7 Mitigate Complex Trust Income Tax
A high cash value life insurance policy owned by a bypass or other complex trust can help to mitigate the impact of the compressed trust income tax rates. The combination of tax-deferred cash accumulation in the policy and the availability of tax-free loans offers the opportunity to mitigate the trust income tax rates during the life of the insured. Properly structured, trust beneficiaries receive the insurance proceeds estate and income tax-free (under IRC 101(a)). In contrast, trust assets not subject to estate tax do not receive a step-up in basis and will thus be subject to tax when sold.

16 #8 Enhancing Assets with Life Insurance
Assets may be enhanced to provide a potentially larger sum though the death benefit provided from the purchase of life insurance. Purchase of insurance on the surviving spouse’s life in the bypass trust (“B” trust) of the deceased spouse is a way of potentially leveraging the exemption amount of the deceased spouse. Insurance can potentially leverage the generation skipping transfer (GST), annual exclusion and gift tax applicable exclusion amounts of the donor.

17 #8 Leverage Assets (Continued)
Trusts having a generation-skipping ratio greater than “0” (thus subject to GST tax) can purchase insurance on the non-skip beneficiary to help pay the GST tax that will be payable when that person dies.

18 #9 Support Stretch of IRAs & Qualified Plan Distributions
Life insurance can help qualified plan participants and IRA owners maximize their ability to stretch distribution of qualified retirement funds over multiple generations. Basic “Stretch” concept: Delays distributions for as long as permitted Names a young beneficiary to minimize distributions Distributes only the minimum amount required Result: Compounded tax-deferred earnings potentially creates substantial wealth for future generations

19 #9 Support Stretch of IRAs & Qualified Plan Distributions
Example: Jack and Jill During Jack’s Life: Jack, IRA participant and his wife, Jill, is named as beneficiary of his IRA. Jack first distribution is due by 12/31 of the year he reaches age 70½. Jack can choose to defer his first distribution to April 1 of the year following the year he turned age 70 1/2, but he would still be required to take another distribution by 12/31 of the same year.

20 #9 Support Stretch of IRAs & Qualified Plan Distributions
Example: Jack and Jill (continued) After Jack’s Death During Jill’s Life: Jill elects to treat the IRA as her own, does not begin distributions until the year she reaches age 70½. Jill is now the owner of the IRA, names grandson John, as beneficiary. Jill receives distributions until death (including the year of death).

21 #9 Support Stretch of IRAs & Qualified Plan Distributions
After Jill’s Death: John, elects to take distributions over his lifetime extending income tax deferral over his life expectancy of many years. Estate taxes are paid from other funds. A survivorship life insurance policy insuring Jack and Jill can help provide John the liquidity needed to pay estate taxes. Jack's unneeded RMDs could be used to help pay premiums.

22 #10 Replace Assets Lost to Tax on IRD Assets
The death proceeds on an individual life insurance policy can be a source of cash to help replace assets lost to income tax on “income in respect of decedent” (IRD) assets. IRD assets are subject to income tax even if the estate is not subject to estate tax. Example of IRD assets: annuities, traditional IRAs, qualified retirement plans (i.e.,401(k), SEPs, 412(i) etc.).

23 #10 Replace Assets Lost to Tax on IRD Assets
To calculate income tax on IRD Calculate the estate tax on the total taxable estate including qualified plans and IRAs. Calculate the estate tax without the qualified plans and IRAs. Deduct this difference from the qualified plan/IRA balance. Calculate the income tax on the remainder.

24 #10 Replace Assets Lost to Tax on IRD Assets
Roth conversion opportunity IRA owner names spouse as beneficiary. At IRA owner’s death, spouse converts IRA to Roth IRA in spouse’s own name. Spouse names children or grandchildren as beneficiaries. No minimum distributions are required during lifetime of surviving spouse allowing for tax-free compounding of Roth assets. Entire IRA amount can be passed on to younger beneficiaries income tax-free if all requirements are met

25 #10 Replace Assets Lost to Tax on IRD Assets (continued)
Roth conversion opportunity Requires cash (preferably from sources outside of the traditional IRA) to pay taxes due at time of conversion. To help pay the tax due at conversion, purchase life insurance on the life of the traditional IRA owner with spouse as the beneficiary. Depending on estate value and growth of Roth, there may be a need for life insurance on spouse’s life to pay estate taxes.

26 #10 Replace Assets Lost to Tax on IRD Assets
Example: Jack and Jill Roth Conversion After Jack’s Death During Jill’s Life: Jill receives IRA at Jack’s death Jill converts to a Roth IRA, pays income tax from other funds in year of conversion. Jill makes Roth IRA beneficiary payable to a trust for the benefit of John. No RMDs required during Jill’s lifetime. After Jill’s Death: Distributions to John after Jill's death are tax-free if account is 5 years old or older. Estate taxes are paid from other funds.

27 #10 Replace Assets Lost to Tax on IRD Assets
Life insurance on Jack's life can help provide Jill the liquidity needed to pay the income tax on the conversion of the IRA to a Roth. Jack's unneeded RMDs could be used to help pay premiums

28 Summary: Use of Life Insurance in Estates with Qualified Assets
The key to maximizing the sum left to the beneficiary of an estate with qualified retirement assets is to make sure the beneficiary does not lose benefits to taxes. For all estates with qualified retirement assets, it means having funds to offset the loss caused by income tax on IRD. For an estate subject to estate tax, it means there must also be adequate funds to provide estate tax liquidity without using qualified retirement assets to pay estate taxes.

29 #11 Estate Freeze Life insurance proceeds can provide funds to purchase “hot” assets (high appreciation assets), removing them from survivor’s estate. Death proceeds from an individual life insurance policy owned by an insurance trust is used to purchase “hot” assets received by the surviving spouse as part of the marital deduction bequest. Result: Because of step-up in basis, no income tax is due if purchase is made at fair market value. “Hot” assets are moved outside of the estate. Surviving spouse receives insurance proceeds with less growth potential.

30 #12 Charitable Wealth Replacement
Life insurance can help to fulfill a desire to make a substantial gift to charity. Many people don’t make gifts/bequests to charity because they fear their family will be deprived of an adequate estate or family members will be unhappy about being deprived of the assets left to charity. Life insurance can help alleviate these concerns Charitable Remainder Trust: Insurance purchased to replace some or all the asset passing to charity Testamentary Charitable Lead Trust: Insurance provides source of income to family while trust income diverted to charity

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