Asset Repositions

How the Taxpayer Relief Act opened a different twist on estate planning

by Morgan F. Scott

Mr. Scott is  director, Advanced Marketing, The Prudential Insurance Company of America, Newark, NJ. Connect with him by e-mail:

In early 2013, the American Taxpayer Relief Act was signed into law, and among a variety of other provisions, the Federal transfer tax system was made permanent. While it is certainly good news to have permanency and predictability, the bad news for many financial advisors is that the increased lifetime exemptions ($5mm/individual, indexed for inflation), along with spousal “portability” of unused lifetime exemption amounts, means that most families will not need significant estate planning.

More specifically, their estates will not require the type of tax management and/or mitigation that they may have needed in the past. Nonetheless, there are still a number of threats to an individual’s ability to pass on a suitable legacy to their heirs. Of these threats, this piece will address two: (1) the effect of the federal income tax, and (2) the risk of chronic illness. Luckily, there is an approach that may benefit some of your clients.  Let’s examine the risks.

A client’s portfolio may contain a variety of investments, including but not limited to: stocks, bonds, mutual funds, cash, real estate, non-qualified deferred annuities, life insurance, IRAs, qualified retirement plans and Roth IRAs. Life insurance and Roth IRAs are generally received by the beneficiary income tax free. Assets such as stocks, bonds, mutual funds and real estate are taxed as capital assets. This means that when held until death, they receive a step-up in basis to the value of the asset as of the decedent’s date of death. When these capital assets are sold, they will receive long or short term capital gain or loss treatment, which is generally favorable compared to ordinary income tax treatment.

Asset Treatment

The treatment of capital assets with tax deferred investments such as non-qualified deferred annuities and IRAs differs. While these assets enjoy tax deferred growth – an excellent characteristic to promote accumulation – they receive no step-up in basis at death.  Furthermore, they are taxed at the beneficiary’s ordinary income tax rate at the time he/she receives the asset. Assets that are held –untaxed – by the estate are commonly referred to as Income in Respect to a Decedent, or IRD.  Typically, IRD assets are the least efficient wealth transfer vehicles.

The second threat to a client’s ability to pass on their wealth to their heirs is chronic illness.  According to the website,, chronic illness may be an alarming reality for many clients… 58% of men and 79% of women over age 65 will require treatment for a chronic illness, and the average cost of care could prove to be very expensive.  Having to liquidate assets to pay for an uninsured loss or expense, such as those related to chronic illness, could be highly damaging to one’s retirement and legacy goals.

Asset Repositioning

Fortunately, there is a solution which helps to mitigate these two threats. By reviewing a client’s asset mix, the financial advisor can assist the client in determining which assets are better used during life, and which assets are best used for wealth transfer. This may involve repositioning dollars from tax inefficient IRD assets, into a tax efficient asset such as life insurance.  This can help to mitigate the impact of income taxation on the client’s wealth transfer goals.  By utilizing a life insurance policy with an optional chronic illness rider, the client can provide themselves with additional liquidity should they become chronically ill, to help pay for the cost of care, and protect the remainder of their investments from liquidation.

Why life insurance?  Life insurance has a variety of benefits for eligible clients. Central to our discussion are income taxes. Permanent life insurance policies are tax deferred, and when the insured dies, the death benefit is generally received income tax free by the beneficiary. Life insurance death benefits can also be predictable.  If using a guaranteed life insurance product, the client can be assured that provided premiums are paid on the policy, the death benefit will be paid to their beneficiaries, without respect to the performance of the financial markets.

The treatment of capital assets with tax deferred investments such as non-qualified deferred annuities and IRAs differs

When considering these issues, we’re typically looking at client’s who:

  • Are age 59 ½ + and family oriented
  • Have sufficient net worth and liquid assets to support this strategy
  • Hold an IRA or Annuity not needed to support financial goals in retirement
  • Have sufficient retirement income from other sources, besides the IRA or Annuity.
  • Have a financial plan completed by a financial advisor
  • Have a desire to provide for children, grandchildren, and/or charity and consider the IRA or annuity as a “leave-on” asset for them

Here’s how this approach will look in practice:

The Case of Judy Hill

Our sample client is Judy Hill. Judy is 68 years old, a widow, and in relatively good health.  She is retired, and has assets including a $300,000 home (no mortgage), $1,000,000 of non-qualified investments, and a $500,000 IRA, in addition to a defined benefit pension plan that she anticipates will cover most of her retirement income needs. She has two sons who are the beneficiaries of her estate, and she would like to pass on as much of her assets as she can to them at death.  In fact, Judy has earmarked her IRA as a “legacy asset” for her two sons.  Judy is also acutely aware of the impact and cost of chronic illness.

Judy’s current plan is to reinvest RMDs into assets that fall into the taxable bucket, such as bonds and CDs.  Her heirs will be liable for income taxes from the IRA upon death which could reduce the value of assets ultimately received. Judy is interested in strategies that could help offset these income taxes for her beneficiaries following her death and enhance the amount she can pass on as a legacy. She does not need the income or principal from this IRA to live on, has a strong desire to leave more to her heirs, but is also concerned with having liquidity to address the potential impact of chronic illness.

Presently, Judy’s plan is to take her RMDs as required and reinvest them in her brokerage account. Judy’s IRA grows at a 5% gross rate.  Assuming she takes her annual required minimum distributions (RMD’s) and reinvests that amount at an annual gross rate of return of 5% after income taxes (assuming a flat rate of 30%), she will net a rate of 3.5%. Upon her death at age 86, the IRA value is $519,568, the reinvested RMD is $457,223, the income tax due (assuming a 28% income tax rate for the beneficiaries) on the IRA is $145,479 leaving $831,312 for her heirs.)

After consulting with her financial advisor, Judy settles on a different approach. She will begin taking withdrawals from her IRA, and use the after-tax proceeds to pay premium on a guaranteed universal life policy with a chronic illness rider.  In this hypothetical, a withdrawal of $28,571 will net $20,000 for annual premium.  This will purchase $721,561 of death benefit, with the enhancement of the chronic illness rider.  This chronic illness rider will permit her to access cash from her policy – should she be deemed to be chronically ill – by accelerating the death benefit.

These proceeds are generally received income tax free.  When she passes away, her heirs will receive what is left of her life insurance death benefit income tax free as well as the remainder of her IRA.  Upon her death at age 86, the IRA value is $347,305.  Add the death benefit of $721,561 and subtract the income taxes due on the remaining IRA balance ($97,245) results in $971,621 for Judy’s heirs.  That’s $140,309 more than under her previous approach assuming none of the death benefit was advanced during life under the chronic illness rider.

In conclusion, what has Judy done? She has repositioned a portion of her assets (that she had already earmarked for her heirs) from an income tax inefficient vehicle into an income tax efficient vehicle, and she has purchased an optional chronic illness rider that can help protect her estate from the high cost of chronic care. While this approach may not be for everyone, for those clients who fit the profile, it can be a terrific way for the financial advisor to add value.  Furthermore, the financial advisors who discuss this approach with their clients can differentiate themselves by approaching wealth transfer planning from a more holistic point of view.