More often than not, life insurance is purchased to provide financial relief to dependents in the event that a family's breadwinner(s) prematurely dies. This is the most significant use of that product. Yet, in the following example, we'll review an effective planning tool in which the income and/or tax savings from establishing a charitable remainder trust can be used buy life insurance to replace the asset given away. Also, life insurance, when held in an irrevocable insurance trust, allows the death benefit to pass to heirs free of estate taxes.
Mr. and Mrs. Smith, both age 55 and in excellent health, were recently offered $2 million for their closely held company and an additional $1 million, each year, for a 2 year consulting agreement. Their cost basis in the stock is almost zero and even at a reduced rate of 15%, for federal taxes, and 5.75%, for Virginia state taxes, the tax on capital gains portion would be $415,000. On top of that, they can expect to pay another $450,000 in taxes on the ordinary income generated from the consulting agreement. In addition, they care for their community and would like to make a substantial gift to their favorite charities to support some community needs they feel passionate about.
Their creative thinking financial advisor suggested that they look at a charitable remainder trust to alleviate the tax burden and support their philanthropic wishes. They decide to establish a $2 million charitable remainder unitrust and, using their after-tax income, buy a $2 million second-to-die life insurance policy naming their heirs as beneficiaries.
The suggested action steps look like this:
- The Smiths create a CRT and transfer their company stock to the trust. At the same time, they arrange for an independent trustee and money manager.
- When the company is sold, the trust receives $2 million in cash for the company stock.
- The money manager conservatively invests the cash in a portfolio designed to preserve capital and generate returns to pay the Smiths 7.5% annually.
- The Smiths contribute approximately $22,000 each year to a wealth replacement trust in order to fund a $2 million second to die life insurance policy.
- After Mr. & Mrs. Smith are deceased, the remainder interest will be transferred directly to the charities or to a private family foundation designed to assist with the community's charitable needs. And, at the same time, the heirs will receive $2 million on life insurance proceeds tax free.
One of the first axioms of financial planning states, "It's not how much you make that counts; it's how much you keep." In charitable gift planning that phrase could be modified to, "It's not how much you give that counts; it's how much it costs you to give!" This is not to suggest that charitable giving is motivated primarily by tax considerations; however, it does suggest that to be good philanthropic stewards, donors should take full advantage of the tax laws to optimize their gifts.