Utilizing life insurance and annuities to reduce complex trust exposure to income taxes
by David GreshamMr. Gresham is advanced markets analysis manager with OneAmerica Financial Partners, in Indianapolis, In. Connect with him by e-mail: firstname.lastname@example.org
Most of us are aware that federal income tax rates have increased, with the top marginal federal income tax rate now at 39.6 percent. In addition to increased marginal rates, the so-called “Affordable Care Act” put in place a 3.8 percent surtax on Net Investment Income (NII) which has the effect of placing investment income of wealthier taxpayers in a 43.4 percent marginal federal income tax bracket.
Furthermore, state income taxes have been steadily increasing with many states now having top marginal rates over 8 percent.
California’s top marginal rate is currently 13.3%. The average top marginal rate for the 50 states and District of Columbia is 5.5 percent, and this takes into account that 7 states assess no income tax. The average of all states that assess income tax is 6.37 percent.1 Local income taxes are also assessed in numerous areas of the nation.
The result of this combination of taxes is that many high income taxpayers are facing the loss of half their ordinary income to federal, state and local governments. This combination is particularly devastating to complex trusts and estates which are subject to very compressed federal income tax brackets.
In 2016, the 39.6 percent federal income tax bracket for trusts and estates begins at $12,400 of income, and the 3.8 percent NII tax applies to income taxed in the top bracket. Hence, trusts and estates encounter the highest tax rate at a very low level of income.
This reality can present difficulties to the trustee who is investing trust assets in situations where complex trusts are not distributing current year income to trust beneficiaries.
The following is an example:
A husband’s will created a bypass trust at the husband’s death. The trust provisions provide that the trustee may pay income and principal to the surviving wife for the wife’s health, education, maintenance and support. At the wife’s death the remainder of the trust is to pass to the couple’s children. The surviving wife, however, has sufficient income from other sources and does not require or request any distributions from the trust. The wife desires that the trust funds be allowed to grow so that distribution to the children after her death is maximized.
The wife and children are not in the highest federal income tax bracket. However, the trust, because of the compressed brackets, is subject to a 43.4 percent federal tax rate. When the federal, state and local tax exposure is considered, the trustee faces the loss of half of the trust income to taxes. If the trustee distributes current income to the beneficiaries the tax burden is lowered to the beneficiaries’ rates. However, distribution of current income does not accommodate the wife’s desire that the trust principal be allowed to grow.
In these situations the trustee may feel that something has to give. Either the tax exposure is lowered by making distributions currently, in which case the wife’s desires are not honored, or the trust pays income tax at the highest rate but honors the wife’s desire that trust principal be allowed to grow.
In situations such as this, the investment of trust assets in life insurance and deferred annuities may be a good choice. Both products enjoy tax deferral as their cash values increase, and a life insurance policy death benefit is received income tax free.2
The technique and the result
If the surviving spouse is healthy enough to pass an insurance exam and receive standard or better rates, the leverage of buying life insurance can be substantial. A permanent life insurance policy will have a cash value that can be accessed if the financial situation of the surviving spouse changes and trust distributions are needed.
If no distributions are needed and the policy pays the death benefit at the surviving spouse’s death, the funds are received income tax free by the trust. The distribution of these death proceeds from the trust to the trust beneficiaries will, likewise, be income tax free to the beneficiaries. The result is a double win for the trustee. Loss of trust income to taxes is minimized and the beneficiaries receive a legacy income tax free.
In situations where the surviving spouse is uninsurable or highly rated, deferred annuities may be a viable alternative. Normally, a deferred annuity owned by a non-individual does not enjoy tax deferral on gain in the contract.
However, trusts that hold deferred annuities “as an agent for a natural person” do enjoy tax deferral.3 The IRS has ruled that bypass trusts, that hold deferred annuities on the lives of trust beneficiaries, are holding as agent for natural persons and the contracts enjoy tax deferral. Also, when a trust owns a deferred annuity, the mandatory payment at death rules are triggered by the death of the annuitant, whereas the death of the contract’s owner triggers payment when the contract is owned by an individual.4
This combination of rules can work to the trustee’s benefit when investing in deferred annuities. The trustee can purchase a deferred annuity for each beneficiary naming that beneficiary as the annuitant. When the surviving spouse dies, mandatory payment of the proceeds is not triggered because the annuitant has not died.
The trustee may then distribute the deferred annuity contracts, in kind, to the annuitants who are the beneficiaries of the trust. The transfer to the beneficiaries will not trigger taxation, but instead the beneficiaries will enjoy tax deferral until they begin withdrawals from the contracts. Hence, tax is not avoided. However, the trust has minimized its exposure to income taxes and the beneficiaries enjoy deferral until annuity distributions are made, at which time income tax is based each beneficiary’s own tax rate.◊
These concepts were derived under current tax laws. Any future tax law changes may adversely affect the effectiveness of these concepts.
Withdrawals and loans from a life insurance police reduce the life insurance policy’s death benefit and cash value. Life insurance is not a retirement plan, investment, or savings account.
Neither the companies of OneAmerica nor their representatives provide tax or legal advice. For answers to specific questions and before making any decisions please consult a qualified attorney or tax advisor.
1. Based on, “State individual income taxes for tax year 2016”, Federation of Tax Administrators, January 2016.
2. Internal Revenue Code section 101(a)(1).
3. Internal Revenue Code section 72(u)(1).
4. IRS Let. Rul. 199905015.