1. Trieschmann, Hoyt & Sommer Financial and Estate Planning Chapter 21 ©2005, Thomson/South-Western

2. 2 Chapter Objectives Explain the differences between the goals of financial planning and estate planning List three factors that may result in estate shrinkage Describe the nature of death taxes and explain the basic approach for computing federal estate taxes Explain why a will is an important estate planning tool Provide an example illustrating how gifts can be used to achieve estate planning goals List the basic elements of a trust and explain how trusts can be used in estate planning Analyze a family situation and make recommendations to deal with the risks of premature death and loss of health Explain the important factors in selecting an insurer, an insurance policy, and appropriate ways to compare the costs of different policies

3. 3 Financial Planning The term financial planning achieved widespread usage during the 1970s and 1980s –Individuals sought ways to deal with the effects of high interest, inflation, and taxation To some people, financial planning primarily involved schemes to shelter income from taxes –To others it was synonymous with investment activities –And to others it was merely another term for insurance sales

4. 4 Financial Planning Agreement has emerged about some aspects of the concept and about those who call themselves financial planners Financial planning is defined as a process involving –The establishment of financial goals –The development and implementation of a plan for achieving those goals –The periodic review and revision of the overall plan

5. 5 Financial Planning Many similarities exist between the financial planning process and the risk management process –But risk management is properly classified as a subset of financial planning A complete financial plan also involves analysis of elements not associated with pure risk –Examples include cash flow management, income taxes, investments, and estate transfer plans Recognition of the overall financial planning context should lead to a better understanding of the ways in which life and health insurance, annuities, and employee benefits can best be used to solve personal risk management problems

6. 6 Estate Planning An executor fund is one of the financial tools often associated with death Estate planning –Advance arrangements designed to ensure that assets are preserved and distributed in the manner the owner intends Objectives of estate planning are –Minimizing the cost of transferring property to heirs –Providing liquid funds to pay transfer cost in the most economical way possible –Assuring that estate assets will be transferred to the desired beneficiaries –Planning for the most efficient use of estate assets

7. 7 Estate Transfer Costs Several factors may cause a reduction in the size of the estate distributed to the heirs –Sometimes known as estate shrinkage The reduction is caused by one or more of the following –Debts –Costs incurred by the person administering the estate –Taxes

8. 8 Debts At death, existing debts must be paid before remaining assets can be distributed Typical debts include –Mortgages, charge accounts, income taxes due, and installment obligations As a percentage of the estate’s size, debts average from 4 to 8 percent of total assets

9. 9 Administrative Costs The executor of an estate is the person appointed to carry out the terms of the deceased person’s will If a person dies without a will, he or she is said to have died intestate –Courts will appoint an administrator to handle the duties that otherwise would have been performed by the estate executor Depending on the types of property owned and the complexity of the plan for distributed estate assets –Sizable administrative costs may be incurred by the estate executor or administrator that usually must be paid in cash Examples include appraisal fees, brokerage fees, court costs, legal fees, accounting charges, premiums for property and liability insurance on estate assets, and fees to compensate the executor or administrator for services rendered

10. 10 Death Taxes A major reason for estate shrinkage is taxes Federal law allows for an estate tax on the right of a decedent to transfer property at death States may also levy estate taxes If the estate is not sufficiently liquid –Assets may have to be sold in order to pay estate taxes Some states levy an inheritance tax on those who inherit property

11. 11 Death Taxes The first step in computing the federal estate tax is to calculate the value of all property owned by the decedent at the time of death –If the property was jointly owned with others, only the decedent’s interest in the property is counted –From this total, the costs associated with the decedent’s funeral and burial, debts, and estate administration are subtracted –Two major categories of deductions are then considered If the decedent was married at the time of death, all the estate assets left to the surviving spouse are deductible –It may be possible to use the marital deduction to effectively eliminate all estate taxes payable upon the death of the first spouse who dies A charitable deduction is also allowed if estate assets are left to charitable organizations If the decedent made any gifts after 1976 that exceeded the allowable gift tax exclusions –The total of those gifts must be added back to the estate and considered in computing the estate tax payable

12. 12 Death Taxes The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 made massive changes in federal estate tax rules –Before its passage, the maximum estate tax rate was 55% –After its passage the maximum rate is scheduled to gradually fall to 45% by 2009 Then to 0% in 2010, when all estate taxes will be repealed –The unified transfer tax credit effectively eliminates all estate taxes for taxable estates up to a certain dollar amount Prior to EGTRRA this exemption amount was $675,000 –Scheduled to gradually rise through 2009 and become irrelevant in 2010 once estate taxes are repealed –See Tables 21-1 and 21-2

13. 13 Table 21-1: Unified Rate Schedule for Estate and Gift Taxes, Pre-EGTRRA

14. 14 Table 21-2: Estate Tax Rates and Exemption Amount Under EGTRRA

15. 15 Death Taxes Two other credits are available to reduce the actual estate tax that must be paid –If any gift taxes have been paid in the past They are subtracted from the estate tax payable –The amount of state death taxes payable is credited against the federal tax due Subject to specified maximums

16. 16 Wills A will is one way to transfer ownership of property at death To be valid a will must usually be in writing and witnessed by two or more persons Because each state has specific laws regarding wills –Each time an individual moves from one state to another, his or her will should be reviewed for changes that may be necessary or desirable When a person with a will dies, the will’s validity is established through process called probate –In a special court called probate court Which also oversees the work of the estate executor throughout the estate settlement process

17. 17 Wills The existence of a valid will is important for ensuring that a decedent's property is distributed in the way desired –Rather than in the arbitrary manner that might otherwise be dictated by state intestacy laws However, not all property owned at the time of death necessarily is governed by the terms of a person’s will –For example, when property is owned jointly with the right of survivorship, ownership automatically transfers to the surviving owners when one of the owners dies

18. 18 Wills Policy proceeds that are payable to a named beneficiary are not part of the decedent’s probate estate –The simple act of naming a beneficiary in a life insurance policy may result in administrative savings during the estate settlement process A valid will is considered to be an essential part of most effective estate plans Wills provide security about the distribution of estate assets and facilitate some cost-reducing estate planning tools

19. 19 Life Insurance Unless sufficient liquidity exists within an estate –Other assets will need to be sold to pay estate taxes and other transfer costs –If these assets are not readily convertible into cash, forced sales may result in unnecessary losses for the heirs However, if life insurance proceeds are payable in an amount approximately equal to the transfer costs –The estate will have liquid resources available precisely at the time that they are needed

20. 20 Life Insurance The unlimited marital deduction for federal estate tax purposes is helpful to most couples’ financial and estate plans –But it may lead to a very large estate tax liability after the second spouse dies Sometimes the payment of estate taxes will require the liquidation of family businesses or other assets that the couple would have preferred to keep in the family –To overcome this problem, insurers offer survivorship life insurance Sometimes referred to as second-to-die life insurance They insure two lives but pay only after both insureds have died Coverage is generally less expensive than either an equivalent amount of insurance on one spouse’s life or half the amount on both spouses

21. 21 Life Insurance Life insurance can also be used as a risk management tool to safeguard the continuation of a business –Small businesses face loss exposures arising out of the death of a sole proprietor, partner, or major stockholder One method of addressing this problem is for the owners to enter into buy-sell agreements while all of them are still alive and well

22. 22 Life Insurance Buy-sell agreements state that a deceased owner’s share in a firm is to be purchased by one or more specified individuals during the estate settlement process –The buyer agrees to buy and the seller agrees to sell With the sale price or the method for determining the price specified in the agreement –Even with such agreements in place, a remaining element needed to ensure business continuation is a way to fund the sale This need is often met through the purchase of life insurance

23. 23 Gifts Reducing an estate through gifts while the owner is still alive is another way to reduce estate transfer costs Federal gift taxes may apply to living transfers Individuals can give up to $11,000 per donee per year without incurring any gift taxes Gifts from one spouse to another and to charitable organizations are fully excluded from gift taxes

24. 24 Gifts Gifts of life insurance policies can be especially effective for estate planning purposes –Because such gifts are valued at their pre- death values –In most cases, that amount approximately equals the policy’s cash value at the time the gift is made and is considerably less than the face amount that might otherwise be included in the decedent's estate for tax purposes

25. 25 Trusts Involves the transfer of property from a donor to a trustee for the benefit of one or more of beneficiaries Trustees have legal ownership of the trust property –But they are required by law to manage and distribute in accordance with the instructions specified in the trust agreement If the trust is set up while the donor is still alive –It is called an inter vivos or living trust If the trust is created at the donor’s death through a will –It is known as a testamentary trust

26. 26 Trusts Life insurance trust –Will collect, invest, and distribute the policy proceeds when the insured dies –An individual, a bank, or another financial institution is specified as the trustee –The trustee is the beneficiary of the life insurance policy The trust agreement specifies how the proceeds should be used The donor can specify how the proceeds are to be invested by the trustee

27. 27 Trusts Credit shelter trust –Possible to decrease taxes while still retaining most of the same advantages for a surviving spouse –To implement this arrangement, both spouses can insert provisions into their wills that would establish a credit shelter trust when the first of them dies –Instead of transferring ownership of all assets directly to the surviving spouse Some of the assets owned by the first of them to die would be placed into the trust –With the remaining assets given to the survivor The amount placed in trust should equal the amount exempted from estate taxes –The marital deduction eliminates all taxes on the assets transferred immediately to the surviving spouse »The unified transfer tax credit exactly offsets the estate tax that would otherwise be due on the amount placed in trust –See Table 21-3

28. 28 Table 21-3: Illustration of Estate Transfer with and without Credit Shelter Trust

29. 29 Considerations in Buying Life and Health Insurance Many individuals conclude that insurance is an appropriate risk management tool for their particular situations That conclusion must be implemented with the selection of a particular insurance company and a specific insurance contract Assumptions that all insurance companies and policies are the same may lead to inefficient purchases and unnecessary future problems

30. 30 Coverage Needed Some people mistakenly assume that all insurers offer the same coverages However, some insurers write only very basic forms of insurance while others offer many innovative variations of the basic policy forms Some insurers have developed expertise in specialized niches

31. 31 Evaluating Financial Strength An insurance policy is of little use if the insurer selling it does not have the financial strength to pay losses when they occur Two important factors in assessing an insurer’s financial condition are –The quality of its investments and the relative size of its surplus –All states regulate both of these factors But concern does exist about the ability of states to adequately regulate the solvency of large insurers

32. 32 Evaluating Financial Strength Most insurance purchasers are ill-equipped to analyze the financial strength of insurers directly Several secondary sources of information are available –Best’s Insurance Reports Reports financial and operating information about many insurers along with a rating of the financial strength for most insurers that have been in business at least five years and have annual net premiums of at least $1.5 million –Standard and Poor’s Corporation –Moody’s Investors Service, Inc. –Duff and Phelps, Inc.

33. 33 Evaluating Service The element of service in the selection of an insurer may have two aspects –The service provided by the agent Sometimes agents act merely as order takers while at the other extreme they may develop and maintain comprehensive plans of insurance designed to meet changing client needs for a lifetime Agents may sell policies that come closest to meeting the real needs of their insureds or they may sell policies that provide themselves with the highest commissions regardless of whether the policies are appropriate –Service provided by the insurer’s home office

34. 34 Evaluating service Perspective insureds should ask questions about the degree of service that can be expected of an agent In judging the quality of service that may be received from an agent, some factors to consider are –The methods employed in selling the coverage –The length of time the agent has been in business –References from impartial sources –Evidence of professional accomplishments, such as possession of CLU or ChFc designations Life and health insurance policies often are long term contracts involving 30 or 40 years of premium payments to the insurer and 20 or 30 years of benefit payments to the insured or to beneficiaries –Thus, service from the insurer’s home office is also important

35. 35 Selecting a Contract Two important considerations in buying life and health insurance are –A good understanding of the goals and purposes the buyer wants to achieve For example, if the goal is to increase the estate’s liquidity for the payment of estate taxes, some form of permanent life insurance might be an appropriate choice –A general idea as to how much can be spent on premiums If premium dollars are scarce and the primary goal is to provide additional income for survivors until children are old enough to support themselves –Decreasing term insurance would probably be the best decision

36. 36 Contractual Provisions Relatively few basic types of life and health insurance exist –Literally hundreds of different arrangements of these basic types are sold Before comparing the cost of two whole life insurance policies, for example –One must make certain that each has the same waiver of premium provision, settlement options, policy loan clause, and nonforfeiture and dividend options Before comparing prices for disability income policies, one must ensure that the following components are comparable –Elimination period, definition of disability, maximum period for the payment of benefits Comparing health care policies can be even more complicated

37. 37 Cost Factors If two health insurance contracts are sufficiently alike to warrant comparison the next step is to compare their premiums Some policies may be participating –Dividends are payable periodically if experience warrants –Such policies usually have higher gross premiums than comparable nonparticipating contracts But may be less expensive after dividends

38. 38 Cost Factors Comparisons of life insurance costs are more complex –One cost comparison method that has achieved some acceptance within the industry is the net payment index This method computes the level annual payment that, if invested at a stated interest rate for a specified time period, will accumulate to the same total as would the policy’s net premiums if invested in the same way

39. 39 Cost Factors Another life insurance cost comparison method is the surrender cost index –Incorporates consideration of a policy’s cash value at of a particular point in time –Most appropriately used to compare policy costs when an individual plans to keep a policy in force until a specified time After which it will be surrendered for its cash value A drawback of this method is that it can be manipulated by insurers through the judicious specification of their cash values at intervals most likely to be selected by buyers for surrender cost index comparisons It is used because of its relative simplicity –If an insured intends to keep their coverage in force until death The net payment index is a more appropriate method to use