Peter L. McCarthy, JD, CLU, ChFC

All employees want to be able to retire someday. We all want to reach a stage in life where we can work if we want to but not because we have to. Reaching this position seldom happens by accident. Building sufficient retirement resources takes a combination of thoughtful planning and disciplined execution.

The Tax Problem. Taxes make retirement planning more difficult. They directly affect both how much we may be able to save and how much of our retirement savings we'll be able to spend. Most employees have two primary ways to save for retirement; taxes impact both of them:

1. Saving Prom Salary. When saving from salary, people must pay income taxes on their entire salary first. Then they can save from the after-tax amount left over.

2. Saving Through Tax-Qualified Plans. People who participate in 401(k) plans can save by contributing part of their pre-tax salary into the plan. The income taxes on their contributions are postponed while those deferrals are in the plan. However, taxes on both contributions (plus any matching contributions from the business) and any earnings produced are due as plan funds are distributed. All the funds received from 401(k) accounts are likely to be taxed.

The bottom line is this: Taxes make it more difficult to retire. They directly impact how much we can save for retirement and how much spendable income we'll have.

Tax Rates Can Vary. Because taxes play a critical role in retirement planning, having workable strategies to minimize them is important. An important part of this planning is using assets that are taxed favorably. Different retirement saving tools and assets are taxed in different ways. Some produce growth that is taxed as ordinary income while others have growth that is taxed at capital gains rates. Still others produce growth that may not be taxed at all. To maximize retirement flexibility, we need to select our retirement assets carefully.

Cash Value Life Insurance. One asset that should not be overlooked in retirement savings is cash value life insurance. Most people understand that life insurance is an excellent tool for protecting their families should they die unexpectedly. Policy death benefits can help replace lost wages and help pay the expenses death triggers. They may not be aware that cash value life insurance has features and tax benefits with the potential to help them financially while they are living.

Because of its unique role in protecting families, Congress has given cash value life insurance a number of important tax benefits (including the potential to accumulate funds for supplemental retirement income).

These tax benefits include:

• Income tax free death benefits
• Income tax deferred cash value growth Potential for income tax free cash value distributions*
• Tax free chronic or critical illness payments (with appropriate policy language and riders)

Helping Key Employees. Smart employees understand they need life insurance and want to be able to use all its benefits over the course of their lives. Often the most difficult part of owning cash value life insurance is paying the premiums. Fortunately, there are several ways businesses can help key employees pay their life insurance premiums. Two options businesses have traditionally used are bonus arrangements and loan arrangements:

• Bonus Arrangements—the employer increases the key employee's cash compensation or gives him/her an additional bonus to pay the premiums. Essentially, the business gives the key employee a "raise" to pay all or part of the policy premium. Businesses can deduct bonus payments as long as the employee's total compensation is reasonable.
• Bonus arrangements work well but have two possible drawbacks: 1) the bonus belongs to the employee and the business can't get it back; and 2) there are no "golden handcuffs" on the key employee to prevent him from taking the money and leaving to start his own business or join a competitor. If either happens, the business could have spent a significant amount of money and have little to show for it.
• Loan Arrangements — Instead of paying a bonus, the business can lend the key employee part or all of the premium dollars. By providing the policy premiums through loans, the business has the ability to get the funds back. Loans give the key employee temporary use of the borrowed funds to grow the values in the life insurance policy over time.

Loan arrangements can be effective but also have potential disadvantages: 1) the business doesn't get an income tax deduction to reduce its costs; 2) interest on the loan must be accounted for; and 3) loan arrangements can potentially siphon off some of the business' capital which could otherwise be invested to increase the business' value.

A New Alternative—The Pre-Tax Equivalent (PTE) Bonus Strategy.
When neither a bonus arrangement nor a loan arrangement fits the business' objectives or funding capabilities, a third option should be considered—the pre-tax equivalent bonus strategy. This is a strategy that allows businesses to help key employees potentially increase the cash value accumulation without a large cash commitment. Essentially, it helps key employees fund their policies with the pre-tax equivalent premium.

What's the "Pre-Tax Equivalent Premium"? Suppose a key employee wants to pay a $20,000 premium and is in a 30 percent income tax bracket. Because life insurance premiums usually aren't income tax deductible, he would have to pay $6,000 of income taxes on the $20,000 of compensation/ bonus. Only $14,000 would be left over after taxes to pay policy premiums. However, the key employee really wants to have the full pre-tax equivalent premium of $20,000 working in the policy. The business can help.

Borrowing the Premium Differential. The business can lend the key employee the amount he has to pay in taxes on the premium portion of his compensation. In our example, the business could lend the employee $6,000 annually to make up for the income taxes. Although the loan balance will eventually need to be repaid and interest will have to be accounted for, lending the money to fund the policy with the pre-tax equivalent premium has the potential to generate more death benefit and cash value for the key employee. Borrowing the premium differential will make sense for the key employee if policy cash values grow at a rate greater than the loan interest costs.

Unfortunately, lending the employee the $6,000 premium differential could be problematic for the business. Although the $6,000 annual loan amount may initially seem small, over time it can become significant. After 10 years the loan balance would be $60,000 and after 20 years it would be $120,000. Further, if there is more than one key employee, the combined loan balances will tie up even more of the business' capital. At the same time, the key employee's interest payment gets bigger every year as a new $6,000 is borrowed. If interest rates increase in the future, the employee's out-of-pocket cost will increase.

Borrow From the Life Insurance Company. The business may not be the best source of funds for lending the premium differential to the key employee. Instead of borrowing from the business, it may make more sense for the key employee to borrow the annual $6,000 premium differential from the life insurance company as a policy loan. Of course, borrowing the premium differential from the insurance company isn't free—the insurer will charge interest annually on the policy loan balance.

Pay Policy Loan Interest With A PreTax Equivalent Bonus. The business can help the employee pay these interest costs by paying him an annual bonus equal to the amount. This is the pre-tax equivalent bonus strategy. Both parties could benefit. The key employee gets a cash value life insurance policy funded at the pre-tax equivalent level. The policy should provide more death benefit and more accumulation potential. In return, the business earns the key employee's loyalty by providing a tangible benefit at a reduced cost. Since the bonus will provide the key employee with the money to pay the interest costs on the policy loan balance, interest on the policy loans will not be accrued. The employee's only out of pocket cost is the income tax on the bonus. A "double bonus" could provide funds to pay these income taxes.

The Pre-Tax Equivalent Bonus Strategy In Action—The Joel Wilson Case
Joel Wilson is a key employee at Western Tech, Inc. Joel is 42 years old, married, with three children. He needs to increase his life insurance death benefit protection and accumulate more money for retirement. He wants Western Tech to help. The company wants to help but isn't in a position to increase Wilson's bonus or lend him the $6,000 annually to reach the $20,000 pre-tax equivalent. However, if Wilson can borrow the money as a policy loan from the insurer (or a traditional loan from someone else), it will bonus him funds to pay the annual interest costs while he works for the company.

These are the steps in Wilson's Pre-Tax Equivalent Bonus Plan:

1. Wilson will purchase a cash value life insurance policy on his own life.

2. He will dedicate $20,000 of his total annual compensation from Western to pay premiums.

3. He is in a 30 percent income tax bracket and will pay $6,000 in income taxes on the $20,000; he will pay the $14,000 left over after taxes into the policy annually until he retires.

4. Wilson will borrow $6,000 annually as a policy loan from the insurer to increase the premium back to the $20,000 pre-tax equivalent amount; the insurer will charge him 6% interest annually on the policy loan balance.

5. Western will pay Wilson a year-end bonus to help him pay the annual interest costs on the policy loan balance; Wilson will pay this sum to the insurer as the annual policy loan interest payment.

6. Although not required to do so, at retirement Wilson may elect to use policy cash values to repay the policy loan balance; he will be able to use the policy's net cash values as needed for supplemental retirement income.

7. If Wilson dies and a policy loan balance is still outstanding at his death, the policy death benefits will first be used to repay this loan balance; the remaining death benefits will be paid to his surviving spouse or other named beneficiary.

Impact on the Business. The pre-tax equivalent bonus strategy gives Western an effective incentive tool to retain Wilson as a key employee. It helps balance Western's dual objectives of creating a valuable benefit for Wilson and keeping its own costs under control. Its costs are summarized in Chart 1. In evaluating the pre-tax equivalent bonus strategy, these are some important factors to keep in mind:

• Because Wilson pays the interest on the policy loan balance each year (with Western's bonus), interest is not accrued on the loan balance.
  
• Wilson's interest costs increase each year as the loan balance goes up. Thus, he will appreciate (and need) Western's special bonus more and more as the years go by; if he leaves, the policy loan interest Western was paying for him will now accrue unless Wilson pays the loan interest himself.
  
• The bonus payments will be deductible to Western (as long as Wilson's total compensation is reasonable). The cost of the pre-tax equivalent bonus will be reduced by any income tax deduction it receives.
  
• When Wilson borrows the extra $6,000 in premium annually from the insurer, Western is not involved and won't have to tie up significant amounts of capital to fund the benefit.
  
• Although it increases annually, the net cost of the pre-tax equivalent bonus to Western Tech should be relatively small for the first 15 years.

Impact on Wilson. The primary goal of an incentive benefit is to provide the key employee with meaningful future benefits that are delivered in a way that keeps him happy, productive and committed to the business. The pre-tax equivalent bonus strategy gives Wilson both an immediate increase in the life insurance protection for his family and potentially an opportunity to have more supplemental income and financial flexibility during retirement. How much additional supplemental retirement income he receives depends on how the life insurance policy performs. Wilson's costs are summarized in Chart 2. From his perspective, these are some important observations:

• His cost is the annual income tax on the pre-tax equivalent bonus he receives from Western to pay the interest on the policy loan balance (since he is in a 30 percent income tax bracket, his annual out-of pocket cost is 30 percent of the interest cost on the policy loan balance).
• If the interest on the policy loan balance is 6 percent annually, his cost is 1.8 percent of the loan balance (6 percent interest times 30 percent income tax rate).
• He can potentially suffer a loss in years when the policy's cash values grow by less than his 1.8 percent out of pocket cost (in those years his income tax costs may exceed the growth in policy cash values).
• Because he is only borrowing from the insurer, subject to the terms of the policy, he has full access to the policy's net cash value (allowing for the policy loan balance). The policy is not collaterally assigned to Western and the company has no interest in it.
• Any cash value distributions Wilson receives during his lifetime should be income tax free as long as the policy stays in force.
• Any policy loan balance outstanding at the time of his death will be repaid with part of the policy's income tax free death benefit. The proceeds paid to his named beneficiaries will be reduced accordingly.

Conclusion.
The pre-tax equivalent bonus is a new selective benefit strategy businesses can use to help their key employees protect their families and save for retirement. The key employee borrows extra premium dollars from the life insurance company to increase total premiums to their pre-tax equivalent. The business bonuses the employee the funds needed to pay the interest costs on the policy loans. As a result, the employee has both more life insurance death benefit protection for his family and the opportunity to increase cash value growth for more supplemental income at retirement. This strategy lets the business show its appreciation for the key employee's good work by increasing their retirement readiness at a manageable cost.

We live in an unpredictable time. Unexpected events happen every day. Many aspects of our lies are simply beyond our control. Even so, there are a few things in life we can be certain about. These are the things we know are going to happen to us because they happen to everyone. And, because we can’t escape these things, we need to plan for them.

The Three Certainties

So, what is certain in life? Even though we are all different, there are three certainties we can all count on:

??Life is temporary; no one lives forever.

??Time is precious; none of us knows how much time we have left.

??No matter what we have, we can’t take it with us; what’s left over will be the financial legacy we leave to those we love.

Certainty planning is a practical approach to these certainties. Many of us are looking forward to retirement. Unfortunately, we can’t assume we’ll live that long. Every day we hear about people who’ve unexpectedly passed away, often through no fault of their own. If we’re married or committed to someone, our planning needs to consider that person’s future as well as our own. Responsible adults face the certainties of life and plan for them. Certainty planning does that by addressing four important questions:

??What assets will I pass along?

??What are my assets worth?

??How will my assets be passed along?

??Who will receive my assets?

??What problems could arise?

What Assets Will I Pass Long?

It is difficult to know today what assets we’ll pass along when we die. What assets we’ll leave behind depends on many factors, including how long we live, the expenses we’ll have and how we own our assets. Because we can’t pass on assets we don’t have, the place to start is with the assets we have today. Wise people look at the assets they own and decide: (1) which ones they should use up during retirement, (2) which ones they want to pass on, and (3) which ones should be repositioned to improve their financial position.

Retirement security is about ongoing spendable income. When we retire, we can’t just go out and spend our assets. We’ll first need to convert them into cash. Converting assets to cash could trigger a variety of taxes and costs that can reduce how much we have left over to pay our expenses. How large the taxes and costs will be depends in large part on what assets we’ve used to build our retirement nest egg. In order to estimate how much spendable income we’ll have, we need to consider the taxes and costs that come with converting our assets into cash. What assets we have and the sequence in which we convert them will directly impact what assets we’ll pass on.

Some Assets Will Likely Pass On More Value Than Others

When it comes to passing on value to other family members, all our assets are not equal. Some assets have the potential to pass on more value than others. That’s because different assets can be subject to different problems and expenses when they are passed on. We need to consider:

??Fluctuations in value. Very few assets have a fixed value; most go up and down in value as the markets change over time. We can’t be certain what individual assets will be worth when we die.

??Management, maintenance and fix-up costs. Some assets need regular maintenance or generate ongoing expenses. For example, residences, vacation homes and investment real estate all require regular upkeep, else their value may diminish. This is a reason many consider property valuation services as they may recommend new additions or certain fixes to the property to increase its value. There are also regular payments for insurance and property taxes to consider. These are also often tied to the assets’ worth.

??Taxes. Some assets generate taxes as they are converted into cash. For example, family members who receive distributions from our IRAs, 401(k)s and pensions must pay federal income taxes on them. The assets we pass on can generate taxes in a variety of ways. And since Congress changes the tax rules and rates with some frequency, we can’t be sure how much net value our taxable assets will deliver to our families.

In deciding what assets to pass on, it can be helpful to see our assets from our families’ perspective (i.e., what assets would they want to inherit?). Some assets may produce more net value for them than others. Other assets may be more likely to create conflicts and disagreements. Looking at our assets from their perspective may make it easier to make decisions about which assets we should use up and which ones we should pass on as part of our financial legacy.

How Will My Assets Be Passed On?

After deciding which assets we want to pass along, we need to take the next step-making sure those assets actually get to those who should receive them. Not many people understand how assets are passed along at death. That’s because the asset transfer process can be complicated. The “how” of passing on assets depends in many respects on which assets we leave behind and how we owned them, which is why many people have turned to things like cryptocurrencies in order to organize their assets and make the transfer process quicker and less complex (click here).

However, many people think their wills will distribute their remaining assets. Often this isn’t the case. In fact, it’s quite possible our wills will have no impact at all on some important assets. Many people are surprised to learn there are three separate asset transfer systems that can impact how leftover assets are distributed. Many of us will leave behind some assets that will be transferred under each of the separate systems. Which system applies to a particular asset can depend both on the types of assets we own and how we own them. There are three general ways in which we can own our assets:

??Solely in our own names. These are the assets our wills should distribute (or our state’s intestacy law will distribute if we don’t have a valid will). These assets are handled under our state’s probate process. The probate process is designed to settle our financial affairs by paying off our debts and making sure our remaining assets are delivered to the people we’ve selected.

??Jointly with someone else (joint tenancy) with a right of survivorship. Assets owned in this manner are transferred to the surviving joint tenant by operation of state law. Many people own their homes, vehicles and bank accounts in joint tenancy with a right of survivorship. The terms of our wills generally don’t apply to these assets; state laws distribute our interest to the surviving joint tenant(s).

States that have adopted community property laws generally reserve for a spouse a 50 percent interest in community property assets (those acquired during t he course of a marriage and not subject to pre-nuptial or separate property agreements). Generally, wills only distribute the portion of community property assets that aren’t reserved for the surviving spouse.

??Under a written contract. Assets subject to the terms of a written contract are often transferred through written beneficiary designations. Examples include: IRAs, Roth IRAs, 401(k) accounts, annuities, life insurance policies and assets held in trust. When we die, the asset is distributed to the beneficiaries we’ve named.

The Asset Distribution Worksheet

To really see how our assets will be distributed, it can be helpful to organize our assets on a three column worksheet, one column for each of the three ways we can own our assets (solely, jointly or under a contract). In each column we’ll list both the assets we own in that manner and its approximate net value. Then we’ll follow these three steps:

?1.?Add up the net values of the assets listed in each column to determine the total net value of the column’s assets.

?2.?Add the total values of the three columns together to determine total net worth.

?3.?Divide each column’s value by total net worth to compute the percentage of total net worth in each column.

Our worksheet will show us what percentage of our assets will be transferred under each of three wealth transfer systems if we died today. We’ll see which assets our wills will pass on under the probate process, which assets will pass automatically by state law to surviving joint tenants, and which assets will be distributed through beneficiary designations. The illustration shows a sample Asset Distribution Worksheet.

After completing the worksheet, it’s important to step back and analyze the information it reveals. Which column has the most assets? Which column has the least? Look down the road five or ten years. What’s likely to happen to the assets in each of the columns? Which columns will likely have assets that grow in value, and which columns are likely to have assets that lose value or will be sold to pay expenses?

The Asset Distribution Worksheet may show us some things we hadn’t expected. Many people will have their highest percentage of assets in the “contract” column. Often the column with the smallest percentage is the “solely owned” column-the one in which assets are transferred by will. Many expect this column to transfer the most assets, not the least. It can be a surprise to learn that our beneficiary designations may pass on a larger portion of our wealth than our wills.

The Beneficiary Knowledge Gap

Beneficiary designations are often the weakest link in our certainty planning because they are easy to overlook. We set up our beneficiary designations when we open one of these accounts; then we often forget about them. Many of us spend less than five minutes deciding who to name as beneficiaries, and we may not review those decisions for many years. We aren’t aware of how important those decisions can be to our families in passing on our remaining assets.

Many people don’t have written copies of their beneficiary designations. In addition, they may also not know:

??Which assets allow them to name beneficiaries.

??That they may be able to name two kinds of beneficiaries (primary and contingent).

??That different beneficiaries can be taxed differently.

??That their beneficiary designations should be reviewed every two to three years.

??How to change outdated beneficiary designations.

??That their designations should be coordinated with their wills and trusts.

Who Will Receive Our Assets?

To know for certain who will receive our assets, we need to have the right paperwork. We can know what documents we will need by looking at our Asset Distribution Worksheet:

??Solely owned assets. These assets are transferred through the probate process. We’ll need an up-to-date will to distribute them.

??Jointly owned assets. For these assets we’ll need copies of the documents that establish the right of survivorship. With real estate, we’ll need our deed. Cars, boats and other vehicles we’ll need a state issued certificate of title.

??Contract assets. For each of these assets, we’ll need a copy of the beneficiary designation. That’s the only way to be certain who we’ve named as the primary and contingent beneficiaries.

The Beneficiary Folder

Although many people will pass on a significant part of their net worth through beneficiary designations, very few will have copies of them. Without copies, we can’t be sure who our beneficiaries are. Sometimes companies lose, misplace or never receive the beneficiary information. We may need to show written documentation to prove who we’ve named as beneficiaries. Lack of these records could create some difficult financial problems.

Considering the percentage of our wealth that will be transferred through our beneficiary designations, it’s surprising how little information most of us retain about them. An excellent way to have this information readily available is to keep a beneficiary folder. This is a file, notebook or other paper storage device with all our beneficiary information. For each contract asset listed on our worksheet, we should have a copy of our latest primary and contingent beneficiary designations.

Why Use An Advisor?

Our financial advisors should be able to help us build and manage our beneficiary folder. Many of them have experience with beneficiary designations. They may be able to suggest ways we could improve our designations. They may also be able to identify some assets we have that allow beneficiary designations we may have forgotten about. Working with an advisor to build our worksheet and beneficiary folder can save us time and strengthen our working relationship.

Also, if we can’t find copies of some of our beneficiary designations, the financial advisor could help. An advisor should be able to:

??Contact the asset provider on our behalf to get copies. We need to give them written authorization to get that information; or

??Prepare and file new beneficiary forms and make copies for our beneficiary folder. This alternative may be faster and easier than trying to track down and get copies of old designations. When properly executed and filed, a new beneficiary designation generally replaces and supersedes an older beneficiary designation. Before filing a new beneficiary designation form, it may be wise to check with an attorney or tax advisor to make sure the new designation is coordinated with wills, trusts and other documents.

What Problems Could Arise?

Planning for the certainties in life is all about being ready for the unexpected. An accident or illness can turn our carefully designed financial plans upside down. The best way to deal with the unexpected is to prepare for it in advance. Death may trigger a number of problems that could seriously impact people we love and care about. No one wants to leave behind a legacy of problems or cause family divisions. In our certainty planning we should consider these potential problem areas:

??Will there be enough left for my spouse/partner and my children? Will they be financially secure?

??Do I have any “problem assets” that could be difficult to deal with? Things such as:

?? ?Business interests

? ?Home or vacation home

?? ?Collections

?? ?Family heirlooms

??Do I have any heirs with special problems or concerns?

?? ?Special needs children

?? ?Children with emotional, marital, legal or dependency problems

?? ?Children deeply in debt

??Are there likely to be any conflicts between some of my family members?

?? ?Poor relationships between my current spouse/partner and my children

?? ?Strained relationships between children

?? ?Children born from different relationships

?? ?Children who have different amounts of financial resources

??Do I have causes or charities to which I would like to contribute?

??How much of my financial legacy might be lost to costs and taxes?

?? ?Income taxes on IRAs or qualified plan accounts

?? ?Estate/inheritance taxes

?? ?Administration costs, sales commissions or management fees

One financial vehicle that might be useful in dealing with some of these problems is life insurance. Policy death benefits (which are generally income tax-free under IRC Section 101) could provide funds to solve some financial problems. Life insurance could add flexibility to certainty planning and help solve problems which could arise.

Conclusion

We live in a rapidly changing world. Time and time again we’ve had to adapt to the unexpected. Still, even during times of continuing change, there are three certainties we need to acknowledge and plan for: (1) life is temporary; we will all pass away some day; (2) time is precious; we don’t know how much time we have; and (3) we can’t take our assets with us. None of us wants to leave our family with a legacy of conflict and division. Certainty planning helps us prepare for the certainties we all face and gives us an opportunity to improve the lives of the people we love.

Rewarding Commitment

Many businesses have several key employees who provide more value to the organization than others. Their skills and expertise are critical to keeping the business successful. Key employees are hard to find and difficult to replace. It could take a long time to recover if one of them leaves or joins a competitor. Businesses will provide extra financial incentives to retain and motivate key employees to stay with them for the long term.

But structuring these incentives can be challenging. Many businesses aren’t interested in incentive plans that require them to do all the funding. They want their key employees to be as committed to the plan as they are. They want incentive plans in which their key employees have “some skin in the game.” They want their key employees to be personally invested in the plan by contributing some of their own money.

“Skinny benefits” are incentive benefit arrangements in which businesses and key employees work together to build the employee’s net worth and retirement security. They both have “skin in the game.” Rather than being a handout from the business, “skinny benefits” are a jointly-funded strategy based on the idea that people appreciate benefits more when they pay part of the costs.

Cash value life insurance (CVLI) policies are often used in skinny benefit incentive plans. CVLI is regularly used because it provides several important potential benefits:

 • Income tax-free death benefits for an employee’s family if he dies prematurely.

 • Income tax-deferred cash value growth while the employee is working.

 • The potential for income tax-free distributions to supplement the employee’s retirement income.

“Skinny Benefit” Strategies

There are four commonly used skinny benefit strategies. We’ll review them in the context of Robert Smith (age 50), vice president for sales and marketing at ABC, Inc. During his five years with ABC, Smith’s efforts have helped the company triple its revenues. ABC wants to retain him and motivate him to continue this productivity until he retires in 15 years at age 65. One day ABC’s president asked Smith if he was saving enough so he could retire on schedule. When Smith admitted he wasn’t and needed to save more, the president said ABC would be willing to help. He asked Smith how much more he thought he could save toward retirement. Smith indicated he could save $10,000 annually to improve his retirement readiness.

 1. The Salary Deferral Match Plan. This strategy is sometimes known as a 401(k) look-alike plan. In it Smith and ABC enter into a written deferred compensation arrangement in which Smith agrees to defer $10,000 of his salary during the coming year and ABC agrees to match that deferral for a total of $20,000. ABC will use the $20,000 to purchase a cash value life insurance policy on Smith’s life to informally fund the plan. This annual deferral and match will continue until Smith turns 65. ABC will maintain a bookkeeping account for Smith which will be credited with the $20,000 in combined contributions. The agreement specifies how growth on these contributions will be credited in the bookkeeping account. Some options include using an agreed upon interest rate, the performance of a specified index (e.g., the S&P 500), or mutually agreed upon investments. When Smith retires, ABC will begin to pay him the bookkeeping account balance under the terms of their agreement. ABC can use withdrawals or loans from the life insurance policy to fund its payments to Smith.

This plan looks similar to Smith’s 401(k) account in ABC’s plan. However, because it’s a non-qualified plan, there are some important differences.

First, Smith doesn’t own either the 401(k) look-alike plan bookkeeping account or the policy. ABC owns the policy, pays the premiums and manages the policy as it sees fit. Second, Smith’s benefits are not vested. The agreement controls when and how Smith will receive benefits. He is a general creditor of ABC to the extent of the account balance. ABC may use the policy to fund Smith’s payments (after age 65) or it may use other assets. Third, if Smith leaves early, he may forfeit his benefits. ABC’s obligation to pay money to Smith only kicks in when Smith retires at age 65.

 2. The Loan Match Plan. Either Smith or ABC (or both) may decide that the salary deferral match plan doesn’t meet their objectives. Smith may not like having to wait fifteen years before starting to receive any benefits from his $10,000 salary deferral and ABC’s match. He may not like the fact that some of his benefits are forfeitable and that he may not have access to them in the event of a personal or financial emergency. On the other hand, ABC may not want to incur the costs and problems that can come from administering the plan. If Smith and ABC want a simpler, more flexible way to provide incentives, they may want to consider a different strategy that uses employment loans—the loan match plan. In this approach, Smith will own the life insurance policy and will pay the premiums from a combination of personal funds and a matching annual loan from ABC. The loan match  plan provides Smith with an ownership interest in the funding, but still provides ABC with some control over the benefit and the potential for cost recovery.

In the loan match plan, Smith doesn’t defer any of his salary. His $10,000 contribution comes from personal savings/assets or after-tax salary. ABC matches this with a $10,000 loan. This loan can be a demand loan or a term loan lasting for a specific number of years. It can bear an interest rate that is at the current market rate (as determined monthly by the IRS) or it can have a below market rate. It could even be an interest-free loan. Whatever method they use for interest on the lone, the annual interest costs must be accounted for. Smith could pay it personally or ABC could give him an annual bonus to cover the interest costs. Smith will execute a collateral assignment of the policy to ABC to secure repayment of the employment loans.

In this strategy Smith has $20,000 in contributions working for him in the policy immediately and ABC has a secured right to recover its outstanding loan balance. ABC gives Smith the use of outstanding loan balance which (depending on policy performance) could potentially grow into a significant sum over time. If Smith manages the policy correctly, cash value distributions he decides to take should be income tax-free.* The loan match incentive gives Smith an immediate life insurance death benefit and cash value benefits that aren’t available when ABC owns the policy under the salary deferral match plan.

*Income tax-free distributions are achieved by withdrawing to the cost basis (premiums paid) then using policy loans. Loans and withdrawals may generate an income tax liability, reduce available cash value and reduce the death benefit or cause the policy to lapse. This assumes the policy qualifies as life insurance and is not a modified endowment contract.

 3. The Bonus Match. The loan match plan can be effective, but over time the incentive it gives Smith may diminish. He may not find the additional life insurance death benefits and the use of ABC’s money to be a worthwhile incentive. If Smith owns the policy, ABC could make its contribution through a year-end bonus, instead of a loan. It could even elect to make the bonus large enough so that after paying the taxes due, Smith would net $10,000 after income taxes to match his own contribution of post-tax dollars. This is often called a “double bonus” plan. Smith would purchase a CVLI policy on himself with the $20,000 premium (the sum of his own savings and ABC’s after-tax bonus). He would own the policy personally and continue to pay both the premiums and the taxes on the bonus each year.

The bonus match strategy could be appealing to Smith and it could also have some benefits for ABC. Since ABC will not have a loan balance that needs to be repaid, Smith will receive more death benefit protection and own all the policy’s cash value. This strategy will likely grow Smith’s supplemental retirement savings faster. ABC will be able to deduct the bonus (assuming Smith’s total compensation, including the annual bonus, is reasonable), so its net cash flow will improve. The biggest disadvantage to ABC is that it will not be able to recover the bonuses if Smith dies or leaves the company.

 4. The Bonus/Loan Match. While Smith will like the bonus match strategy, ABC may find it less appealing. That’s because it retains no control over the benefit and can’t recover any of its costs when Smith retires or leaves. The bonus/loan match plan (also known as the hybrid executive benefit, or “HEX benefit” strategy) combines the loan match and bonus match strategies into a hybrid approach that has benefits for both Smith and ABC. Instead of contributing by either a loan or a bonus, ABC will do both—it will match Smith’s $10,000 with a $5,000 loan and a $5,000 bonus. Smith will execute a collateral assignment of the policy to ABC to secure repayment of the loan balance.

Businesses like this strategy for several reasons:

 • They get an immediate income tax deduction for the bonus portion of the premium.

 • They control the policy through the loan and the collateral assignment.

 • The plan is flexible so, from year to year, they can change how much they contribute and how it is allocated between loans and bonuses.

 • The loan balance is an asset on their balance sheet.

 • Administration is relatively simple—the loans need to be documented and interest must be accounted for.

 • The loan balance provides some cost recovery potential.

Key employees also like the strategy because:

 • They own the policy and its accompanying death benefits and cash values (subject to the collateral assignment).

 • Only the bonus portion of the policy is taxable.

 • The policy is portable so they can take it with them if they leave the company (the loan balance will need to be repaid).

 • Remaining policy cash values may help supplement their retirement income.

Adding Flexibility With Benefit “Ladders”

A valuable aspect of skinny benefits is that it is possible to string several benefits together to keep key employees engaged. These benefit strings are called “executive benefit ladders” and they can increase the overall value of the incentive plan to the employee over time. When used in a series, they can build on each other and give businesses more flexibility in providing selective benefits. These ladders can help businesses adapt to new situations and avoid a key employee’s “what have you done for me lately?” concerns.

This is apparent in skinny benefits in which the key employee owns the policy. For example, ABC can begin by offering Smith the loan match option. After several years it can “upgrade” Smith’s benefit by adding a bonus element to the match and reducing the amount of the loan component—the bonus/loan match (the HEX benefit). After several more years, ABC can upgrade the benefit again by eliminating the loan component and going to a bonus match plan. Finally, it could increase the size of the bonus enough to create a “double bonus” to help Smith pay the taxes.

Incentive plans in which the business owns the policy are usually more restrictive because they often fall under IRC Section 409A. Still, it is possible to build a benefit ladder. For example, ABC can begin the plan with the deferral match (the 401(k) look-alike plan). After several years it can add a protection component for Smith’s family by adding a death benefit only (DBO) benefit if Smith dies before retiring. Later it can upgrade this part of the plan by instituting an endorsement split dollar (ESD) plan which should make that pre-retirement death benefit income tax-free for Smith’s beneficiaries. ABC will own the policy at all times, but by adding DBO and then ESD elements, it can create more value for Smith and his family.

Conclusion

Most key employees will need to save money in order to enjoy a financially secure retirement. They’ll be able to retire sooner and/or more comfortably if their business is willing to help. Employers can work with their employees to help them build retirement funds while keeping the business strong and profitable. Businesses that understand the importance of recognizing their key employees’ work are open to creating incentives to motivate them to continue their high level performance. Skinny benefits are flexible incentive strategies that can help keep key employees engaged and productive for the balance of their careers.

These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor.

The Voya Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone. You should seek advice from your tax and legal advisors regarding your individual situation.

Employees are the backbones of every business – they make it work, and they bring in the profit the company needs. This means helping them learn the required skills is necessary for them to excel in their job. Some companies choose to do this with team-building exercises like the ones on sites like BreakoutIQ, others choose to have schemes in place within the business for praise or improvement. Every business has some employees who work hard every day and do their best to bring in sales. From the people doing your hong kong secretarial services to your sales team to your board members – everyone is striving to better the business and allow it to continue to grow. Without these employees, your business wouldn’t be where it is now. Unfortunately, there will be some employees who don’t work as hard and just do the bare minimum to get by. While it’s the job of the manager to work out how to tell an employee they are not meeting expectations, it’s also the job of the manager to reward the employees who are working extra hard to support the business. And many businesses have these small groups of key high potential employees whose skills, expertise and dedication are critical to keeping the business successful. Employees like these are hard to find and difficult to replace. It could take the business a long time to recover if one of them leaves or decides to join a competitor. To recognize their worth and motivate them to continue performing at a high level, businesses often give their key employees additional financial incentives.

Structuring incentive plans can be challenging. They need to be appreciated by the key employee and still make financial sense for the business. Businesses often use cash value life insurance (CVLI) policies as part of the funding for their incentive plans. CVLI is a popular funding tool because it has several important potential benefits: (1) income tax-free death benefits for an employee’s beneficiaries if he dies prematurely, (2) income tax-deferred cash value growth while the employee is alive, and (3) the potential for income tax-free distributions to supplement the employee’s retirement income.

Traditional Approaches

CVLI policies can be structured in a number of ways. They are often used in two popular incentive benefit strategies: 1) Section 162 Bonus Plans (Bonus Plans) and 2) Supplemental Executive Retirement Plans (SERPs). These strategies are very different. Here’s a short summary of each:

Section 162 Bonus Plans. In these plans the business pays the employee an annual year-end bonus over and above his normal salary and benefits. The employee pays income taxes on the bonus and uses the after-tax funds to purchase a CVLI policy. The employee owns the policy and the business has no interest in it. Bonus Plans give key employees death benefit protection for their families and the potential to use policy cash values for supplemental income during retirement. If the policy is properly managed, both the death benefits and supplemental retirement income can be received income tax-free. The business deducts the bonus payment (as long as the employee’s total compensation is reasonable). However, it generally can’t recover the bonus if the employee leaves the business.

SERP Plans. In these plans the business promises to pay the employee additional compensation starting at an agreed upon future date-usually the employee’s retirement date. The additional compensation can be forfeited if the employee leaves the business before retirement. The business owns and controls the funding for the benefit, including CVLI policies on participating key employees. The key employee often has to wait several years before receiving benefits. Policy premiums generally aren’t deductible and the business only gets income tax deductions when it pays benefits to participating employees.

Which plan is better? How effective a particular incentive plan is depends on the objectives a business and its key employee want to accomplish. Businesses generally prefer incentive plans that give them control of the funding (the policy) and the ability to change the benefit and payment schedule as circumstances change. They also prefer incentive plans that generate income tax deductions as they are funded (i.e., when life insurance premiums are paid).

Key employees have different objectives. They prefer incentive plans in which their benefits vest quickly and grow in value over time. They also prefer to control life insurance policies that insure their lives and other assets that fund their benefits. They want to delay income taxes for as long as possible and they want their benefits to be not forfeitable.

Unfortunately, neither Bonus Plans nor SERP Plans meet all the objectives of either businesses or key employees. SERP Plans generally favor the business because it owns and controls all the funding (including the life insurance policies) and the employee runs the risk of losing the benefit if he leaves the business or retires early, or if the business runs into financial difficulty. Unfortunately, SERP Plans are not very flexible under the tax law and income tax deductions for the business are delayed until the benefit is actually paid out to the key employee at retirement. Bonus Plans, on the other hand, generally favor key employees because incentive payments are received immediately and because the key employee owns and controls the policy. If he leaves the business he is able to take the policy with him. Unfortunately, key employees must pay income taxes immediately when the bonus payments are received.

A New Alternative: The HEX Benefit

The Hybrid Executive (HEX) Benefit is a new approach that avoids some of the problems of SERP Plans and Bonus Plans. It may do a better job of helping businesses and key employees meet their respective objectives. The HEX Benefit strategy is flexible and can be revised as needed to meet business and employee goals from year to year. It is a hybrid because it combines two distinct types of benefits. It combines bonuses and employment loans to retain and reward key employees. The employee purchases the CVLI policy that funds the benefit. The business provides funds for paying annual premiums through a combination of bonuses and loans. The key employee collaterally assigns the policy to the business as security for the repayment of the loans. From year to year the business can change both the amount of funding it supplies and how those funds are allocated between bonuses and loans. The business retains indirect control over the policy through the collateral assignment that secures repayment of the loan. It can deduct the bonus portion of the payments immediately. The CVLI policy gives the employee an immediate life insurance death benefit to protect his family, while policy cash values have the potential to grow in value over time to repay the outstanding loans and generate supplemental retirement income. Here’s an example of the HEX Benefit strategy in action.

Example. Robert Smith (age 50) is vice president for sales and marketing at ABC, Inc. During his five years with ABC, his efforts have helped the company triple its revenues. ABC wants to retain him and motivate him to continue being productive until he retires in 15 years at age 65. ABC is willing to allocate $40,000 annually as incentive compensation for Smith. Each year ABC expects to split that $40,000 equally between a $20,000 bonus and a $20,000 interest-free demand loan. Let’s assume the fair market interest rate is 3 percent annually for the 15 years and that Smith is in the 28 percent tax bracket. A summary of the year to year bonuses and loans and projected costs of the arrangement can be found in Table 1.

Smith buys a cash value life insurance policy with the death benefit set at an amount which maximizes cash value growth potential without causing the policy to be treated as a modified endowment contract (MEC). He contributes the $20,000 bonus and the proceeds of ABC’s $20,000 loan. He uses other funds to pay the income taxes due on the bonus and interest-free loan. Smith executes a collateral assignment giving ABC an interest in the policy to the extent of the outstanding loan balance. We will assume that Smith’s total life insurance death benefit protection is adequate. If he needs more, he can purchase additional coverage personally.

Splitting the $40,000 selective compensation budget into a $20,000 bonus and a $20,000 loan is merely a place to start. ABC can change both the amount and the split whenever it wishes. If either Smith or the company has a difficult year, the compensation budget for Smith can be reduced. On the other hand, in good years the compensation budget can be increased. Further, the bonus/loan allocation can be revised from 50/50 to 75/25 or something else from year to year. If there is “capacity” in the policy (without triggering MEC status), Smith may also contribute some of his personal funds into the policy. If he does a good job and stays with ABC until 65, he may use policy cash values to repay the demand loan balance. Remaining policy cash values could be used to supplement his retirement income.

ABC’s cash flow to provide Smith’s benefit is summarized in Table 2. At all times, ABC owns and controls the loan balance.

MECs. Distributions (withdrawals or policy loans) from life insurance policies treated as MECs under Section 7702A of the Internal Revenue Code are subject to less favorable tax treatment than distributions from policies that are not. If the policy is a MEC, distributions will be taxable to the extent that there is any gain in the policy. In addition, if the policyowner is under age 591/2 or is a corporation at the time of the distribution, there is a penalty tax of 10 percent on the taxable amount. Without regard to whether a policy is a MEC, a gain in the policy is taxable on full surrender of the policy.

Positive Features of the HEX Benefit Plan

To businesses:

??Control of the policy through the loan and the collateral assignment.

??Immediate income tax deduction for the annual bonus.

??Key employee incentive and loyalty; they are motivated to increase (1) how much money the business annually makes available for their benefit and (2) how that sum is divided between bonuses and loans.

??The loan balance is an asset on the balance sheet.

??No policy administration; the business only has to keep track of SD loans, interest due (if any) and the key employee’s taxable income.

??Partial cost recovery-the business can recover the SD loan balance subject to the terms of the loans.

??Flexibility-the business decides from year to year how much to pay the executive and how to divide it between bonus and loans; demand loans may be called at any time.

To key employees:

??Death benefit protection for the key employee’s named beneficiaries.

??Ownership of the policy and its cash values (subject to collateral assignment and repayment of loan balance).

??Cash values for potential supplemental retirement income.

??Only the bonus portion of the premiums are taxed immediately (the loan portion isn’t currently taxable, annual interest on the loans needs to be accounted for).

??Immediately portable (although demand loans will need to be repaid upon departure).

??Policy cash values may be available to pay off the loan balance.

??No IRC Section 409A or 101(j) reporting or potential penalties.

??May be able to use personal savings to make additional premium contributions (up to MEC limit).

Comparison to Bonus and SERP Plans

It is a balanced approach with features that are important to both businesses and key employees. The HEX Benefit is flexible and keeps key employees engaged. Here’s how it addresses business and key employee concerns about the two traditional plans:

Bonus Plans. Businesses are concerned about inability to retain control over the benefit and inability to recover any costs if the key employee leaves early. Structuring part of the payment as a loan preserves the business’ ability to recover some of the benefit costs. The collateral assignment preserves the business’ position and gives it the right to recover those loans before the key employee can access policy cash values for personal use. The loan balance remains an asset on the business’ balance sheet. Key employees are concerned about paying income taxes on bonuses they receive. By structuring part of the compensation as a loan, the HEX Benefit prevents the loan balance from being taxable (interest must be accounted for annually).

SERP Plans. Businesses are concerned that SERP Plans don’t provide any current income tax deductions; instead, deductions are delayed until the benefits begin to be paid out at retirement. The bonus portion of the HEX benefit creates an immediate income tax deduction (providing the key employee’s total compensation is reasonable). Also, the HEX Benefit gives businesses the option of avoiding plan administration costs by administering the plan themselves. All they need to do is to keep track of the outstanding loan balance, any interest due, and report the total income taxes generated. Key employees are concerned about having to wait until retirement to get any benefits. They have no access to or control over any of the benefit funding. They are totally reliant on the business to make the promised payments. They are at risk if something happens to the business or the funding before their payments begin. In the HEX Benefit they own the policy and receive the statements. They can verify that the business has paid its premiums and even if they leave, they can take the policy with them after the outstanding loan balance has been repaid. See Table 3 for a comparison of the three plans.

Conclusion

The Bonus Plan and SERP Plan strategies have traditionally been the most popular options for incentive plans. Both plans have some disadvantages which make it difficult for them to meet some important employer and key employee objectives. The HEX Benefit is a “middle ground” between them. The HEX Benefit strategy gives both parties much of what they want. It is flexible and can be adjusted from year to year to track business and key employee performance. In addition, it is easy to understand and simple to implement. The bonus portion of the plan gives the business an immediate income tax deduction. The key employee gets immediate death benefit protection for his family. The loan portion reduces the key employee’s taxable income and the collateral assignment that accompanies it gives the business control over the policy and the ability to recover some of its costs should the key employee decide to leave the business early.

Many people don’t think they will need life insurance after they retire. They think its sole purpose is to protect their family if they die while they’re working. They love their families and want to protect them but don’t see a reason to continue their coverage after they’ve retired. A better understanding of retirement and the versatility of life insurance may help them reconsider.

Retirement Is Different. Retirement marks a big transition in our clients’ lives. Not only is it a transition in how they spend their time, it is also a transition in how they use and manage their money. While they were working, they used salaries to pay expenses and add to their savings. With retirement, salaries and benefits end. Clients will need to rely on savings to supplement income from Social Security and other sources. Saving will be much more difficult.

Building on these savings throughout your working life can help to make a big difference in the amount of funds that you can use in your retirement period. To give you a higher chance of being financially stable during these years, some people decide to make some investments in things such as bonds, stocks and precious metals, like gold. Any investments that you make can be saved into your personal IRA, (you can learn more here) which could be used as your primary source of income as you will have to rely on other sources as a retiree. The more money you save, the better chance you have of being financially stable.

When clients retire, their financial priorities and risks often change. Essentially, most of them will be switching from “offense” to “defense.” They’ll need to take the savings they’ve accumulated and “defend” it to maintain their standard of living. During retirement the major financial fear will shift from losing a job to running out of money. Clients will be playing “financial defense.”

Because retirement is a fundamentally different phase of life, we need to plan for it carefully. Here are some things to keep in mind:

Focus on Spendable Income. After retirement, clients start converting assets into income. They can’t actually spend most of their retirement assets; they will need to convert them into cash first. Costs and taxes can be triggered as assets are converted into income. They can only spend what’s left over after those costs and taxes are paid. Retirement security will depend on how much net spendable income they’ll have and how long they can make it last.

They Could Be Retired for a Long Time. Today an average 65-year-old American man should live to 84, while an average American woman can expect to live to 86. Studies indicate that one in four 65-year-olds will live past age 90. These averages may increase in the future with medical and lifestyle advances.

Savings May Need to Last for Two Lives. If clients are married or committed to a partner, they won’t want loved ones to be financially vulnerable if something happens. When that’s the case, clients will need to manage assets to produce enough spendable income to last for two lives. Studies show that married couples tend to live longer. For the average 65-year-old couple, there is a 57 percent chance that at least one spouse will live to age 90, and an 11 percent chance one will live to age 100.

Unexpected Things Will Likely Happen. Today seems to be a time of constant, unpredictable change. As a result, plans will need to have a margin for safety. It’s impossible to know what will happen to the world, the economy, the investment markets, taxes or one’s family while retired. Events no one could anticipate will probably occur. Flexibility is critical for retirements that can last 30 years or longer. Without good contingency planning, retirement security (and that of a spouse or partner) could be at risk.

Driving in the Mountains. Many people are so anxious to get to retirement that they don’t think about what will happen during retirement. Think of planning for retirement as driving through the mountains. We begin driving up the road. We keep our foot on the gas to make it up the hills and around the curves. Gravity tries to slow us down, but we keep our foot down. We navigate around the trucks, trailers and construction as we climb up the mountain.

Eventually, we reach the summit and start down the other side. But the trip down is completely different from the trip up. Gravity is now pulling us down the mountain. We’re going faster and faster. We’re scared of losing control. We take our foot off the gas and switch over to the brake. To keep from flying off the road, we pump the brakes and maybe even shift to a lower gear. We just want to get to the bottom in one piece.

Retirement can be like driving in the mountains. Our clients work hard for 35-40 years to get up the mountain. In spite of ongoing inflation, they earn enough to create a lifestyle, raise a family and build a retirement reserve. They can’t wait to get to the top of the mountain and retire. But after they get there, things change. They have to start living on what they have saved. To pay retirement expenses, they have to start converting savings into cash. Inflation will act like gravity. It made it hard for them to save while working. In retirement, it will increase expenses and the rate at which they’ll use up savings. Yes, retirement will be a different environment. They’ll face different risks and have different priorities than when they were working.

Cash value life insurance is a financial product that may be able to help on both sides of the “retirement mountain.” If clients die before retiring, policy cash values may help the family through financial emergencies and policy death benefits may protect the family’s financial security. If they make it to retirement, cash value life insurance has the potential to continue a family’s security and also supplement retirement income.

A well-designed and managed cash value policy can potentially be a flexible source of money both for the client and the family. Policy cash death benefits are generally income tax-free under IRC Section 101, and cash values have the ability to grow income tax-deferred under IRC Section 72. Subject to the terms of the policy, cash values may be withdrawn income tax-free up to the policy’s tax basis, and additional cash values may be distributed through policy loans. (Policy withdrawals and loans reduce policy death benefits and increase the possibility that the policy could lapse.) These tax benefits increase the potential these policies have to help maintain financial security both before and during retirement.

Living Benefits. We know life insurance death benefits can help protect families. However, to fully understand how cash value life insurance can potentially make clients’ retirement planning easier, clients need to understand what benefits it can provide. Clients want to know: “How can a cash value policy help me?”

In addition to protecting beneficiaries, cash value policies have the potential to provide important living benefits. As policyowners, some of the possible living benefits clients could enjoy include:

Source of cash for financial emergencies. In the event of a financial emergency, a client could withdraw or borrow cash values from his policy. In fact, he could use policy cash values for a wide variety of financial needs, including home repairs, college expenses, business operations, debt repayment, damage from storms or natural disasters, etc.

Supplemental retirement income. While retired, he could withdraw or borrow policy cash values to supplement income received from other sources (e.g., Social Security and pension benefits). Cash value distributions can be income tax-free as long as the policy stays in force.

Funds to help pay critical illness and long term care costs. Many cash value policies allow death benefits to be distributed before death to pay qualifying medical and long term care costs. These are generally known as “accelerated death benefits.” They make it possible to pay critical illness and long term care costs without forcing the client to sell other assets.

Waiver of all or part of policy premiums. Some policies have provisions that require the insurance company to take over payment of all or part of the premiums during periods when the insured is disabled (within the terms of the policy). This provision helps keep the policy in force and maintains policy cash values during times when a client might not be able to continue it himself.

Protection of policy benefits from claims of creditors. Some states have laws that protect some or all of a policy’s death benefits and cash values from claims by creditors. These laws restrict creditors’ access to policies’ values and may prevent them from seizing the policy to pay off a debt. The type and amount of creditor protection varies from state to state. Tax and legal advisors should be able to provide information on how much creditor protection is available.

Death Benefits for Spouses and Partners. In addition to living benefits while the insured is alive, the income tax-free benefits paid out by cash value policies at death can make a big difference to those to whom a client is closest in life-his spouse or partner. Those benefits will:

Strengthen their financial security. No one wants to die and leave his spouse/partner in a precarious financial position. Unfortunately, this can easily happen. Events beyond our control can erode retirement savings. If a spouse is the beneficiary, policy death benefits could help restore some of the retirement savings spent because of:

Inflation. The cost of the goods and services rises regularly. Inflation could use up retirement savings more quickly than expected.

Medical expenses and nursing home costs. Being injured in an accident, suffering an unexpected illness or just getting old could trigger significant medical costs and nursing home expenses. To the extent not covered by insurance, those costs would have to be paid out of retirement savings.

Sub-par investment performance. Retirement savings may not grow as expected. Investment losses from recessions, economic cycles and poor decisions could reduce the financial resources left behind.

Unexpected property disasters.Accidents or natural disasters could damage or destroy homes and other physical assets. Remember hurricanes Katrina and Sandy? To the extent losses weren’t covered by insurance, victims had to use savings to rebuild and replace the lost property. Homeowners who had equity tied up in their homes would have used it to rebuild or replace the damaged property that was affected by these natural disasters. Older homeowners may decide to release their equity, hoping to add it to their retirement plan, only to need it to fix any issues not covered by insurance. Typically an equity release would be added to retirement finances to ensure that any payments or unexpected bills would be covered. Retiree homeowners could be able to use an online equity release calculator to discover how much of their home’s value would be released and added to their finances for future use.

Final expenses. Dying can be expensive. It will take cash to pay funeral costs, debts and estate administration expenses. The money spent to close a client’s affairs will reduce what’s left for the spouse/partner.

Clients need to protect their spouses and dependent family members after they’re retired, just as they did while working. The potential for financial loss doesn’t retire when the client does. Cash value life insurance has the potential to provide ongoing death benefit protection to keep families financially secure. The fact that death benefits are generally income tax-free increases their value.

Replace lost Social Security benefits. Social Security benefits end when we die. If one dies during retirement, the spouse may be able to choose either a Social Security benefit based on his own work record or the benefit the deceased was receiving. If not married, a partner doesn’t get to make this choice.

For example, suppose a client is receiving a $3,000 monthly Social Security benefit and the spouse is receiving a $2,000 per month benefit. That’s $5,000 in total. When the client dies, his benefit stops. His spouse will likely take over his $3,000 monthly benefit. Unfortunately, total monthly Social Security benefits will be reduced by 40 percent, from $5,000 to $3,000. That’s a reduction of $24,000 per year, and $240,000 if the spouse survives another 10 years.

The income tax-free death benefits from a life insurance policy may help reduce the impact of this reduction in Social Security income.

Fund the conversion of a traditional IRA to a Roth IRA. Would you rather own a $250,000 traditional IRA or a $250,000 Roth IRA? In the event of your death, which type of IRA would your spouse and children want? Because Roth IRA distributions are generally income tax-free and don’t have to begin at age 701/2, most spouses would prefer to have a Roth IRA. If a client owns a traditional IRA when he dies and his spouse is the beneficiary, the spouse may be able to convert it to a Roth IRA. Life insurance death benefits may provide income tax-free funds to pay for the conversion.

As the IRA’s beneficiary, the spouse will have the ability to re-title it (roll it over) into his own name. As the account owner, the spouse may then elect to convert it into a Roth IRA. Of course, income taxes will need to be paid on the amount converted. The tax-free death benefits from a policy insuring the client may provide the cash needed to pay these income taxes. Other assets won’t need to be sold, nor will it be necessary to distribute money from the IRA to pay the taxes. Giving a spouse the opportunity to convert a traditional IRA into a Roth IRA should increase their financial security.

Minimize family conflicts in second marriages. When a parent remarries after a death or divorce, conflicts sometimes arise. Remarriage creates the potential for conflict between the new spouse and children from the first marriage. The children and the new spouse have different financial interests. The new spouse wants financial security, but the children don’t want the new spouse to take any of their inheritance. Animosity and ill will can easily develop. This is especially true if the new spouse is relatively young and has a long life expectancy. Do you remember the saga of Howard Marshall and Anna Nicole Smith? Life insurance on the remarried parent could provide the new spouse with financial security without threatening the children’s inheritance. Policy death benefits may help minimize financial conflicts between the new spouse and the children.

Death Benefits for Adult Children. What if a spouse/partner dies first or the client doesn’t have a “significant other”? How could life insurance help? In addition to the living benefits available to policyowners, policy death benefits could help surviving children or grandchildren. Some ways life insurance may help them include:

Leave the “right” inheritance. A client may want to leave children or grandchildren a specific inheritance, but may not want to change his lifestyle to do so. Life insurance coverage which continues during retirement may help. If the client has five children and wants to leave each one $100,000 when he passes on, he’ll have to refrain from spending $500,000 of his assets. As an alternative, he could purchase a $500,000 life insurance policy and divide the death benefit equally among the five children. All he would need to do is pay the policy premium. He wouldn’t need to set aside any other assets. Knowing that he has left the children what he wants, he could structure his will or trust to leave all remaining assets to charity.

Recover or replace income taxes. Many people save a significant portion of their retirement funds in IRAs, 401(k)s and other tax-qualified funds. These are popular retirement saving vehicles because contributions are made with pre-tax dollars and account earnings generally grow income tax-deferred. Unfortunately, distributions are fully taxable. We can only spend what’s left over after we’ve paid our federal (and sometimes state) income taxes. Depending on one’s marginal income tax bracket, somewhere between 15 and 40 percent of the account balance could be lost to taxes as distributions are received. Life insurance death benefits can potentially be used to recover some or all of these taxes. Policy death benefits can be paid to the family members to recover any income taxes paid to date, as well as those which may be due in the future as the account is distributed.

Increase the financial legacy of an unneeded IRA. Some of your clients may have built up balances in IRAs or other tax-qualified accounts which they may not need to use for retirement income. Because the growth in these accounts is income tax-deferred, they may want to pass them on to children or grandchildren. Unfortunately, all the distributions children and grandchildren eventually receive will also be fully taxable.

Life insurance may potentially help increase the amount children/grandchildren ultimately receive from the account. If insurable, a client could start taking distributions from the IRA after reaching age 591/2. After paying income taxes on these distributions, he could use the remainder to purchase a life insurance policy. This strategy is known as “Legacy Max” and it can be attractive when the policy death benefit exceeds the total net after-tax distributions the children are likely to receive from the qualified account. The amount of death benefit which may be purchased and its cost will depend on a number of factors, including age, health and finances.

Fund personal and charitable be-quests. Many clients have provisions in their wills directing executors/personal representatives to pay sums of money to friends, causes, charitable organizations and others who are important to them. These payments are known as “bequests.” Bequests reduce what is passed on to children. To make sure a bequest is paid, one must refrain from spending at least that amount of retirement savings. If our client’s will has bequests totaling $100,000, he should set at least $100,000 of the retirement savings aside to make sure it will be paid. Further, there will be $100,000 less for heirs to share.

Cash value life insurance policies may provide another way to pay the bequests we’d like to make. Suppose your client wants to leave $25,000 each to his college, his church, the Red Cross and the United Way. He simply purchases a $100,000 policy and names each of these organizations as 25 percent beneficiaries. If he decides to make a change in the future, he can file a revised beneficiary form. He won’t need to set aside a reserve to pay the bequests; the policy will essentially pay the bequests for him. His children will share the remaining estate.

Minimize conflicts between children. It’s not unusual for children to fight over money after a parent dies. Children often believe they are entitled to equal shares of their parents’ wealth. Sometimes, however, it may not make sense to divide a house, business, parcel of land or other asset into equal shares. Occasionally the nature of the assets and/or the children’s personal situations may make equal division unwise or impossible. In these situations, life insurance death benefits can provide additional funds to help equalize what the children receive. Policy death benefits could minimize these conflicts and hard feelings.

Special needs children. Children and grandchildren who are physically or mentally challenged can present difficult financial choices. If they survive the parents, they may need money to be financially secure. A client may need to set aside a large part of his estate for their care. If he doesn’t have enough, he can’t expect his other children or grandchildren to use their financial resources. They usually have their own families to support.

Life insurance may help provide funds to support challenged children for the balance of their lives. Policy death benefits can help pay their living expenses. If the child receives disability, health care or other benefits from federal or state governments, policy death benefits may be directed into a specialized trust designed to manage and distribute the death benefits without negatively impacting the government benefits. These are sometimes called “special needs trusts.”

Why Cash Value Life Insurance? “I like term insurance-why do I need cash value life insurance?” Term life insurance can be a good vehicle for providing short term death protection. Unfortunately, when death benefits are needed for an extended period of time, term insurance policies may not provide as much overall value. There are several strong reasons why cash value life insurance is often more likely to accomplish the client’s objectives:

Term insurance offers death benefit protection but doesn’t provide policyowners with some important living benefits. Most term policies only provide death benefit protection. They don’t have cash values that can be used for supplemental retirement income or financial emergencies. Consequently they may not provide as much value to insured owners. Term insurance can be similar to “renting” life insurance protection, while cash value insurance is similar to “owning” it.

Term life insurance provides temporary death benefit coverage. Many insurance companies structure their term insurance policies to end before normal life expectancy. It can be difficult to purchase term policies that guarantee coverage after age 80 or 85. Unfortunately, healthy people often live past 85; if they use term insurance, their coverage may expire before they do. Then they will have wasted their money. Some term insurance policies offer owners the option to convert to cash value insurance when the policy term is up, but the premiums on the converted policy are often extremely high. People who use term insurance and live past the term have nothing tangible to show for the premiums they paid.

It is also important to remember that just because someone wants life insurance coverage doesn’t mean he’ll be able to get it. Insurance companies only want to insure healthy people; they don’t want to pay out lots of death benefits. In their underwriting they carefully review each applicant’s health, family and financial situation. Then they decide how much (if any) coverage they are willing to offer and what price to charge for it. As clients grow older and become less healthy, insurers may be less likely to offer the coverage desired. If they do, the price will likely be higher.

Your Client’s Situation. Every family situation is different. Each client needs to have a flexible plan that fits him and his family. The table on page 26 is a summary of the issues discussed in this article. To build a plan that works for your client it should be helpful to him to consider the issues from a personal perspective. His spouse/partner’s input could be helpful. For each issue about which he is concerned, simply write in an approximate number for the death benefits that may be needed. Then total the amounts listed. This total will serve as a starting point for determining how much cash value life insurance might be appropriate.

Conclusion. Good retirements seldom happen by accident. They need to be carefully planned. To succeed, planning should reflect some key facts: (1) the focus needs to be on spendable income, (2) savings may have to last a long time (sometimes for two lives), and (3) over 30 or more years of retirement some unexpected things are likely to happen. Consequently, a plan needs to have a margin of safety. As clients come down the “retirement mountain,” they’ll need to play solid “financial defense” in order to protect their income and lifestyle over two lives. They will need to use flexible financial tools that can help them both before and after retirement.

Cash value life insurance is a financial product clients should consider. Its tax-advantaged cash values and death benefits have the potential to help clients and their families both before and after retirement. During the 30 or more years a person may be retired, life insurance has the potential to strengthen financial security and create a margin of safety for spouses, partners, children and grandchildren.

For many Americans Social Security benefits are an extremely important source of retirement income. Four reasons Social Security is so valuable are:

 • The monthly payments continue for life.

 • Benefit payments can’t be reduced (market downturns and deflation don’t change benefits).

 • Benefits are usually adjusted annually for inflation (in financial terms, Social Security is like owning a lifetime annuity with an inflation rider).

 • The worker’s spouse may also claim benefits, and spousal benefits may continue after a worker’s death for the remainder of the surviving spouse’s life.

Social Security benefits vary from person to person. They are based on a complex formula that considers the age benefit payments begin and an individual’s “work record” (earnings from employment over a working career). Because people earn different amounts at different times over their working lives and begin taking their benefits at different ages, Social Security benefits will vary from person to person.

How much is a Social Security benefit worth? Of course that depends on the worker’s benefit and potential benefits payable to a surviving spouse. Take the example of a 66-year-old man who retires with a $2,500 monthly Social Security benefit. It would cost him more than $499,000 to purchase a single premium immediate annuity that would pay $2,500 per month as long as either he or his spouse is living. The ability to increase the payments annually for inflation brings the value of this Social Security benefit to more than $500,000.

Social Security Favors Married Couples

Social Security was designed to give married couples extra benefits. They have more flexibility in claiming their Social Security benefits and multiple options for maximizing them. Benefits for single individuals, on the other hand, are simple, straightforward and (once begun) inflexible.

Most married people who are 62 or older probably qualify for a Social Security benefit. At age 62 spouses can elect to receive either a personal benefit based on their own work record, or a spousal benefit based on their spouse’s record.¹ The spousal benefit is capped at 50 percent of the other spouse’s benefit amount at the electing spouse’s full retirement age (currently age 66). The ability of both spouses to receive separate monthly benefit payments can be very important to their retirement standard of living.

Spousal Survivor Benefits

Unfortunately, when one spouse dies, his Social Security benefits end. The surviving spouse must then deal with two losses: (1) the emotional loss of the partner and (2) the financial loss from the termination of the deceased spouse’s Social Security benefits. The surviving spouse may get some partial relief from the financial loss. After the first spouse’s death, the surviving spouse gets to choose between two benefits going forward. The surviving spouse may elect to receive either the benefit available under his own record or can decide to “step into the deceased spouse’s shoes” and receive the monthly benefit the deceased spouse was receiving at the time of death. This is an important election, and surviving spouses should consult with their financial advisors to determine which alternative is best for them.

Regardless of which Social Security benefit the surviving spouse elects, he will experience a significant reduction in overall family Social Security income. The loss of one Social Security benefit will likely result in a loss of several thousand dollars per year for the surviving spouse. In addition, future benefit increases from inflation adjustments will be smaller.

John and Joan Smith

The Smiths have been married for 30 years and are retiring at age 68. They are electing Social Security benefits based on their individual work records. John’s benefit is $2,000 per month and Joan’s is $3,000 per month. Thus, together they have a combined household Social Security income of $5,000 per moth. For simplicity, we won’t consider the inflation adjustments to their benefits. If Joan dies in five years at age 71, John will probably elect to receive a spousal survivor benefit of $3,000 (Joan’s benefit) and give up his benefits from his own work record. As a result, the total Social Security income available to John drops by $2,000 per month (from $5,000 to $3,000), creating a total income reduction of $24,000 per year.

If John dies first, Joan will suffer the same financial loss. She will continue to receive her $3,000 per month benefit (taking over John’s $2,000 monthly benefit won’t make financial sense because it is less than her current $3,000 monthly benefit). As a result, total monthly Social Security income will drop from $5,000 to $3,000. The resulting annual loss will still be at least $24,000 per year for the balance of Joan’s life. Thus it doesn’t matter whether John or Joan dies first. The income reduction will be the same, and it will be significant.

The permanent reduction in combined benefits at the first spouse’s death may have a serious long term impact on the surviving spouse’s financial security. Household expenses after the first spouse’s death may be smaller, but the reduction may not be enough to offset the reduction in total Social Security payments. In the Smiths’ case, living expenses probably won’t decline by $2,000 per month. Unless both spouses die simultaneously, there is sure to be a reduction in Social Security income. The ultimate amount of the total loss depends on how long the surviving spouse lives. Without replacement assets or a new source of income, the surviving spouse could be forced to liquidate assets or reduce his standard of living.

Life Insurance May Offset Some of the Loss

Since death is certain, the risk of reduced Social Security benefits is real. When the first spouse dies, total Social Security income will be reduced. The question is: What’s the best way to deal with this loss of income? One alternative is to use life insurance to make up for the lost Social Security benefits.

Although they may not have thought about it, every married couple has this risk. Those who aren’t doing anything about it are essentially self-insuring. If they are in good health they may have the option to transfer some of the risk to a life insurance company. A life insurance policy could give them an extra margin of safety by transferring the portion of the risk they don’t want to retain.

Cash value life insurance could give the Smiths the potential to protect the surviving spouse’s standard of living. Statistically, Joan is likely to survive John by 3 to 5 years.² If that happens, the $2,000 per month reduction in lost Social Security benefits at John’s death would lead to an income loss of $72,000 over three years and $120,000 over five years. If Joan survives John by 10 years her income loss will be $240,000 (without factoring in lost inflation adjustments). A life insurance policy on John could replace all or part of the lost benefits. If Joan dies first, John faces the same loss. A policy on Joan would replace all or part of the reduction in benefits he would face. If the non-insured spouse dies first, the policy remains in force and the surviving spouse may access available policy cash values to replace the lost benefits.

Joan and John could assess how healthy they are and decide to purchase a cash value policy on the one most likely to die first. Or they could purchase two policies—one insuring each of them. This two-policy approach would provide a death benefit to protect the survivor’s standard of living no matter which of them dies first. The surviving spouse would then still own a policy insuring his own life, which could be used to supplement other sources of retirement income (through cash value withdrawals and policy loans) or to provide a family or charitable legacy at death.

Conclusion

Many people focus their retirement planning on the first few years of retirement. They are focused on accumulating enough assets and generating enough income so they can afford to stop working. In their planning they need to look further down the retirement road. They also need to anticipate threats to their retirement income and adopt a viable strategy to defend it. Once they retire, maintaining their retirement income in the face of unexpected and inevitable events may be difficult.

This is especially true for married and committed couples whose standard of living is based on their combined Social Security and pension benefits. They need to plan for a retirement that will last for two lives, not just one. Smart couples look down the road and envision what their retirement situation could be 10 or 20 years into the future and the problems that could emerge over that time. They structure their retirement plans with a margin of safety to protect their lifestyles. It is inevitable that one of them will die first and that the survivor will suffer a reduction in Social Security income. If the survivor’s standard of living will be threatened without that income, they need to have a workable strategy to replace it. Cash value life insurance is a planning option they should consider. It can be a flexible way to help protect their retirement income.

Footnotes:

 1. For spousal benefits to be paid, the worker must have filed for his own benefits or “file and suspend” the payment of benefits.

 2. Centers for Disease Control and Prevention, National Center for Health Statistics, National Vital Statistics Report, October 2012.

These materials are not intended to and cannot be used to avoid penalties and they were prepared to support the promotion or marketing of the matters addressed in this article. Each taxpayer should seek advice from an independent tax advisor. The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone.

What Will Retirement Look Like for Our Children? If you are like most working people, from time to time you think about retiring. You may wonder what your life will be like and what your standard of living will be. Sometimes you may try to look even further into the future and think about what retirement will look like for your children. Will they be able to retire 20, 30 or 40 years from now? What will their standard of living be?

Retirement planning could be a lot different for our children—possibly a lot harder. The world seems to be changing in profound ways: Competition is increasing. Technology is rapidly transforming many businesses and industries. Good paying jobs are harder to come by and require more skills. The workers and entrepreneurs of the future will need to be intelligent, quick learners who are both skilled and flexible.

A big part of our retirement cash flow will likely come from Social Security and work-based retirement plans (e.g. pension, profit sharing, 401(k), 403(b), HR-10, IRA plans, etc.). Will the same be true for our children when they retire? When we stop to think about their futures, there may be reason to worry. Retiring could be harder for our children for several reasons, including:

 • On average they should live longer, so their savings may have to last longer.

 • On-going inflation means the cost of living should keep rising.

 • Retirement benefits from employers and Social Security payments may be smaller.

To retire comfortably, our children will probably have to be more self-reliant. If they get less from Social Security and company retirement plans, they will need to provide a larger portion of their own retirement income through savings and investing. To have a secure retirement, they will need good financial habits, self-discipline and effective money management skills.

What Big Inheritance?

Because we love and care about them, we want to help. We’d like to leave them a big inheritance to supplement their retirement savings, but we may not be able to. We don’t know how much we’ll be able to leave them because we don’t control some important factors, including:

 • How long we live.

 • Inflation—how much our cost of living will increase from year to year.

 • How well our own qualified and non-qualified investments perform.

 • The cost of health care and how much of it we will need.

Life Insurance May Help

Many adult children need life insurance on their own lives. If they are married or have children of their own, they may already own life insurance policies. Often they use term insurance or work-based group term insurance for their life insurance protection because in the short run it is usually less expensive. Cash value life insurance may be less commonly used because it costs more and many adult children need to carefully manage their expenses.

Many adult children who own only term insurance may not be aware of the benefits cash value insurance could provide them in the long term. A well-structured cash value policy may be able to recover some of their premium costs. In addition, policy cash values may be a helpful source of cash during financial emergencies and may also produce supplemental retirement income.

If our children had an additional source of cash to help pay cash value insurance premiums, they could have both death benefit protection for their families and the long term potential for supplemental retirement income.

Consider a Shared Dollar Life Insurance Arrangement

Most parents want to encourage their children to save for the future. They can give their adult children some strong incentives to do that by helping them develop a retirement game plan. One way to do so is  to partner with them in a strategy designed to supplement their retirement savings—shared dollar life insurance.

Many working children participate in their employers’ 401(k) retirement plans, which gives them a chance to defer some of their salaries into pre-tax investment accounts with retirement investment options. Many companies match a portion of each employee’s salary deferral as an incentive for them to participate in the plan.

Shared dollar life insurance arrangements help parents do something similar. These are arrangements in which parents and their adult children work together to pay for cash value life insurance designed to develop significant cash values over time. The children will usually be the insureds and the policyowners, while the parents will provide some of the premium dollars.

It’s easy for adult children to take parental gifts for granted. That’s why shared dollar arrangements are structured so the child pays part of the cost and the parents provide the remaining premiums through a “family match.” Paying part of the policy premiums can increase both the child’s retirement readiness and appreciation for the potential advantages the parents are providing.

Some possible alternatives for the parents’ “family match” include:

 • Match premium costs 50/50 each year.

 • Parents provide funds to pay the premiums for a specified number of years (e.g., 5 to 10 years) and the children pay the premiums thereafter.

 • Parents pay a declining percentage of the premiums over time (e.g., 75 percent for years 1 through 3, 50 percent for years 4 through 6, 25 percent for years 7 through 10, and zero thereafter).

 • Parents pay the “term insurance” portion and the children pay the balance.

A Two Policy “Combo”

Shared dollar arrangements should be structured to help adult children meet both death benefit protection and cash value accumulation needs. Because death benefit protection needs sometimes decrease with age, in some cases it can be more efficient to use two policies: term insurance for short term death protection needs (those not expected to last more than 20 to 25 years) and cash value insurance for long term death benefit needs and supplemental retirement income. The term insurance policy will end when its death benefits are no longer needed, and the cash value policy will continue.

A “combination approach” using both term and cash value policies sometimes produces a better long term result and can be an effective way to maximize use of premium dollars.

An Alternative: Insuring the Parent

Insurance on adult children isn’t the only option. In some cases insuring either or both parents may be a better alternative, especially when a child is uninsurable or the premium cost is high. Death benefits payable at the insured parent’s death could provide a substantial retirement income supplement. In this approach either the parent or adult child could own the policy and the premium costs would be shared.

Keep in mind that there may be some drawbacks to insuring a parent rather than an adult child. The amount of insurance protection on a parent may not be enough to adequately protect an adult child’s spouse or dependents. Also, when a parent is the insured, the child must wait until the insured parent dies to receive any benefit. Cash values in a policy insuring a parent may not grow to a high enough level to make much of a difference in the child’s retirement. When an insured parent lives past normal life expectancy, the children could be retired for many years before death benefits would be paid. Cash values in policies insuring the children are likely to grow more quickly because the child’s mortality costs are likely to be lower.

Potential Advantages of Shared Dollar

A shared dollar life insurance arrangement with cash value insurance on an adult child has several potential advantages, including:

 • The existence of policy cash values increases the chances the child’s life insurance protection will stay in force to protect his/her spouse and family.

 • The child may use policy values for both unexpected pre-retirement financial emergencies and supplemental retirement income.

 • When parents pay part of the premiums, the child’s potential internal rate of return on his portion of the premiums will be higher.

 • By paying part of the cost, the children should have a greater appreciation for the benefits that the parents are providing.

Potential Disadvantages

 There are also several potential disadvantages, including:

 • The life insurance policy may not perform as anticipated or as illustrated.

 • The parents may not be able to contribute to the premiums as long as expected.

 • The adult child may not be able to contribute his share of the premiums if he becomes unemployed or suffers financial reverses. There needs to be an understanding of what will happen in those situations.

 • Cash value distributions may decrease death benefits payable at the child’s death.

 • If premiums aren’t paid in any year, cash values for supplemental retirement and/or policy death benefits would be reduced, or the policy could lapse.

Alternatives to Gifts: Loans or Split Dollar

The shared dollar strategy may be appealing to many parents. Many will like the idea of giving their children a direct incentive to save more for retirement. They should also like the fact that they won’t have to pay all policy premiums themselves. Their children can elect to participate at a level that works for them.

Still, some parents may not be comfortable making gifts. They may be worried that someday they may need to use the funds themselves. They may not want to take the chance that they won’t have access to their contributions if their circumstances change.

Fortunately, there are premium payment alternatives for parents who want to retain access to their money. Instead of using gifts, parents can pay their share of the premiums through intra-family loans or through a split dollar arrangement. Loans are usually a more flexible option because they can be structured in several different ways and can be more easily customized to fit the family’s situation.

Split dollar arrangements are usually more expensive and less flexible. They are legal documents which should be drafted by an attorney. Parents have the most security and control in an endorsement split dollar arrangement in which they own the policy and the death benefit is split.

The parents’ estate receives death benefits equal to the greater of the policy cash values or the premiums the parents paid and the child receives the remaining death benefits. If the child is to own the policy, the collateral assignment method can be used, but then another document—a collateral assignment—must be prepared and filed with the insurer to protect the parents’ rights.

Two other disadvantages to using split dollar are: (1) The parent is deemed to make an annual gift equal to the economic benefit value of the life insurance protection. (2) The parent owns or controls all the policy’s cash values; consequently those cash values aren’t available to the insured child for use as supplemental retirement income.

At some point parents may review their financial situation and decide they have enough assets and will no longer need to be able to use the policy cash values. If this happens, they can elect to transfer their interest in the policy to the child by forgiving repayment of the loan or terminating the split dollar arrangement. These will be treated as gifts to the child.

Flexible Premium Payment Options

Each year a new policy premium is due, the parents have the flexibility to choose how much to pay and the form in which they will make the payment. From year to year their contributions can vary in amount and in form. The strategy can be revised to fit their financial circumstances and those of participating children. Each year they do contribute, they can choose whether to make a gift, a loan, or a combination of the two.

Motivating the Children

It’s natural to assume that because shared dollar arrangements are designed for the benefit of adult children, they will jump at the opportunity to participate. This may not be the case. In reality, some children may be hesitant to participate. This could be the case for a variety of reasons, including:

 • Fear of not having enough discretionary income to pay their share of the premium now or in the future.

 • Uncertainty that paying part of the premiums is a good use of their own money.

 • Familiarity with other retirement vehicles, but not with life insurance.

Because of concerns like these, it is important that the shared dollar strategy is carefully explained to the children. In particular they need to understand: (1) why the parents want to do this, (2) why they’ve chosen to use life insurance, (3) the details of the arrangement and (4) how the child, spouse and children stand to benefit. In particular, they need to understand exactly what their risks are and why this strategy is a “good deal” for them. One of the best ways to show how they might benefit is to show them an internal rate of return (IRR) analysis on their share of the premiums.

Implementing the Arrangement

Families that are interested in this concept often wonder what they need to do to make it a reality. Shared dollar arrangements can be structured in a variety of ways ranging from formal agreements to informal understandings. They can be customized to fit the goals of those participating. Here are some of the options for putting an arrangement in place:

A Formal Agreement. The parents’ attorney draws up a written agreement and it is signed by the parent and the child. The agreement should address all the possible issues, including ownership, premium payments, policy beneficiaries, assignments, cash value access, etc.

Child Ownership. The child could be the policyowner and pay his share of the premiums directly. The parents’ share could be provided by gifts or loans to the child; the child’s share of the premiums could be added to the parents’ contributions and the child could pay the total combined amount to the insurer. If the parent is making loans to the child, the parent could receive a collateral assignment to protect that interest.

Parental Ownership. The parent owns the policy and makes the total premium payment to the insurer. Each child pays his share of the premiums either from personal savings, parental gifts, parental loans or a combination. When a child is the insured, he is the contingent owner of the policy and takes over ownership at the parents’ death. This approach allows the parents to control the policy and to be sure the child is paying his share of the premiums.

The Trust Approach. Parent establishes an irrevocable life insurance trust (ILIT) to own and manage the policy. Parent pays part of the premiums as gifts or loans to the trust and the child’s portion of the premiums is gifted to the parent who then contributes it to the trust. Having all contributions come to the trust through the parent may prevent the child from being considered a grantor of the trust for income tax purposes. The trustee manages the policy under the terms of the trust and makes distributions as needed to accomplish the trust’s objectives. By using an ILIT, the terms of the trust control distributions after the parents’ death and protect the death benefits from potential claims from the child’s creditors.

A Shared Dollar Arrangement in Action

Suppose Jane and Joe Smith are each 66 years old and want to give their two children, Vince and Violet, some strong incentives to save for retirement. They decide to use shared dollar arrangements.

Vince is married and has two children, while Violet is married with four children. Vince needs $500,000 of death benefit coverage, while Violet needs $800,000 of coverage. Vince will purchase a $300,000 cash value policy and a $200,000, 20-year term policy. Violet will purchase a $300,000 cash value policy and a $500,000, 20-year term policy.

Jane and Joe decide to make a commitment of $5,000 to each of them annually for 10 years. Jane and Joe will review their financial position each year and decide whether to make their $5,000 contributions by gift or by loan. Their annual contributions will go into the cash value insurance policy.

After 10 years have passed, Jane and Joe will decide if they are able to continue making contributions. Vince and Violet each agree to pay the term insurance premiums from their own funds and also to contribute at least $4,000 to their cash value policy. They can contribute more if they wish. If either Vince or Violet is unable to pay their share of the premiums in any year, Jane and Joe have the flexibility to lend that child his share of the premium.

Because of their parents’ generosity, Vince and Violet will have adequate life insurance protection for their young families, as well as the potential to build significant cash values for potential supplemental retirement income. Exactly how much supplemental retirement income will be generated depends on how the cash value policies perform over time. Vince and Violet both understand that the annual $5,000 subsidy from their parents effectively gives them a 50 percent “discount” in the cost of their coverage. They also understand they have the option of increasing their premium contribution in future years if their finances permit.

Decision Checklist for a Shared Dollar Arrangement

Who will be the insured(s)?

What type of life insurance policy(ies) should be used?

How should the strategy be implemented (formal contract, child ownership, parent ownership, ILIT ownership, informal, etc.)?

How large should the policy death benefit be (one policy or term-perm combo)?

How much will the annual premiums be?

How should the premiums be shared (what should the “family match” be)?

From year to year, how should the parents pay their share of the premiums—gifts, loans or combination?

Each year a loan is used, should it be structured as a demand loan or term loan?

When loans are used, what should the interest rate on the loan be?

How should the annual loan interest be handled?

Conclusion

Shared dollar arrangements give parents an opportunity to help their adult children without decreasing their own retirement security. Shared dollar arrangements are a flexible way for parents to work with their children to create a unique retirement income supplement. From year to year parents have the flexibility to change how they structure their share of the funding and they can position their contributions so they can get them back should they be needed.

The “family match” component of a shared dollar arrangement gives children strong incentives to participate and potentially realize a good internal rate of return on the funds they contribute.

Shared dollar arrangements can be useful strategies that allow parents to help their children protect their families and build funds for retirement.

Neither ING nor its affiliated companies or representatives offer tax or legal advice. Clients should consult with their tax and legal advisors regarding their individual situation.This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding their individual situation. These materials are not intended to and cannot be used to avoid tax penalties.

As a financial advisor, you’ve probably talked to many business owners. Some of them are probably your clients. No doubt you’ve asked them about their succession plans. If they didn’t have one, you probably told them they should.

When you stop and think about it, you’re probably a lot like many business owners. Many of them have built their businesses around selling their knowledge and personal services (e.g., attorneys, accountants, dentists, doctors, chiropractors, manufacturers’ representatives, etc.). Like them, you sell your knowledge and personal expertise. You know how much time, energy and hard work it takes to build a profitable practice.

 If through the years you have also built a profitable business, then:

 • Have you taken your own advice?

 • Do you have your own succession plan?

 • If you do, are you taking maximum advantage of it?

A number of recent surveys report that many financial advisors don’t have succession plans in place for their own businesses. In fact, many suggest that the lack of business succession planning by financial advisors is alarmingly common.

While implementing a succession plan isn’t easy, failing to do so may have negative consequences. There are at least three reasons financial advisors should have a succession plan.

Reason 1: Preserving Your Business’ Value. This is the standard reason for having a buy/sell plan, the one you talk about with your business clients and prospects. Like them, the day will come when you will leave your business; it’s inevitable. It’s not a question of if you’re going to leave, rather, it’s a question of when.

Accidents don’t always happen to someone else; sometimes they happen to you. If you don’t leave because of retirement, disability, burnout, boredom or other circumstances, you will leave when you die. Because you are human, your eventual departure is certain.

Because of this certainty, you must decide if it is worth spending some time and money to retain some of your business’ value for your retirement or for your family. If this doesn’t matter to you, then do nothing. Don’t have an agreement to sell it when you retire or die. Instead, just close the doors and walk away.

A funny thing about our industry is that there’s often another good advisor close by. When you’re no longer in business, your customers can probably find someone to take your place.

If, instead, you want to retain or pass on some of your business’ value, you need to plan for it. You need to find a buyer and negotiate reasonable terms. A smooth transition to a new owner(s) is important when you need to convert your service business into cash.

Reason 2: Retaining Client Service Opportunities. Smart clients select their financial advisors carefully. Smart advisors know that they owe it to their clients to build strong service relationships with them, delivering successful results. For many years they will continue to evaluate you.

Consider how many policyholders simply buy a financial product and forget about the transaction beyond premium payments—and their advisors are okay with that. However, as a conscientious advisor, your clients are more likely to continue to evaluate you and the benefits of working with you—and may be concerned about the future of your working relationship.

Some of your clients may be concerned about the future of the relationship. Even happy clients may ask themselves: “What will happen to me if something happens to him/her?” As much as they value you, they want to be sure they won’t be at risk if you die, retire or become disabled.

If they haven’t asked you this question directly, they still may be thinking it. It may be wise for you to bring it up. To address their concerns and to fend off possible overtures from other advisors, you may need to show they will be okay if something happens to you. Talking with them about your succession plan shows you are concerned about protecting their interests. This discussion could strengthen their bond with you and it will certainly provide a chance for you to make sure they understand how important they are to you—beyond a premium payment!

Of course, showing them that you have a plan is only the first step. Your clients need to be comfortable with your succession plan. Even the best plan may not retain clients if they don’t know who your successor(s) will be or they aren’t comfortable with them. To retain clients, you have to introduce your successor(s) and allow them to demonstrate their own skills and expertise. This can be difficult.

Many clients love you and want to work with only you. The relationship transition needs to be tested and completed before you leave the business. The value of your business depends in large part on your ability to transition your clients to your successor(s). The simple fact is that although your clients weren’t consulted, they do get to “vote” on your plan. If they don’t like it, they will vote with their feet and leave.

Reason 3: Generating New Sales. So far we’ve been talking about defense—using a succession plan to protect the value of your business. Let’s transition to offense and see how your plan may help increase your business’ value. You can use your plan as a marketing tool that shares your knowledge and experience. As such, it can help you make new sales. Not many financial advisors take advantage of this opportunity, but it is sitting there, waiting to be used.

Put yourself in your clients’ position. Succession planning can be intimidating because it’s something outside the scope of their normal business activities; they don’t do it very often. Their tax and legal advisors may talk to them in language that is complex and terms that are hard to understand. Making sense of the legalese in a buy/sell agreement can be challenging. You are a layman, like them. Your experience may help you explain things in a way that might be easier to understand.

One key to being comfortable with buy/sell agreements is to understand how they are usually structured. Although these agreements often run from five to 25 pages, they are often organized to address several specific issues. Boiling agreements down to these issues makes them much simpler to understand and navigate. The most important issues often include:

 1. Who is the buyer(s) and seller?

 2. What property is being purchased?

 3. What events will trigger the buyer’s obligation to buy and the seller’s duty to sell?

 4. How will the value of the business be determined, and how much will the buyer pay?

 5. When, where and how will the buyer make the payments?

 6. What happens if the buyer or seller doesn’t keep their promises?

These six components represent the skeleton of many buy/sell agreements. The agreement consists of the details that address these issues. Many attorneys don’t take the time to simplify the agreement and explain how it works. Your experience can help you explain it to clients in a different way.

In general, there are two things to consider in evaluating a buy/sell agreement. First is to determine what its terms actually mean. Buy/sell agreements establish the parties, the price, the triggers, and the terms and payments. Once these terms are understood, it’s important to consider what’s not in the agreement. What isn’t in an agreement can be extremely important.

One issue that may not be addressed in an agreement can be critical: Where will the buyer get the money to complete the purchase? Some agreements simply assume the buyer will have the money or will be able to get it. This can be a dangerous assumption.

Some agreements require the buyers to purchase life insurance on the seller. Life insurance can be an excellent funding tool when the purchase is triggered by the seller’s death. But many buy/sell agreements are triggered while the seller is alive. When this happens, there won’t be any death benefits to fund the purchase. Policy cash values may help pay the purchase price, but death benefits will only be available when an insured seller dies. It may not be possible for buyers to keep their promises when there is no plan for those promises to be backed up with money. This gives you an opportunity to explain how you’ve addressed the problem of funding the purchase price in your personal succession plan.

A Good Succession Plan Is Much

More Than A Buy/Sell Agreement

Buy/sell agreements establish the terms for the transfer of an ownership interest, but a workable succession plan requires more. An effective plan considers other components critical to the future of the business and binds them together. In addition to the buy/sell agreement, a good succession plan provides for:

 • Emergency funds to provide flexibility in the event of unexpected developments.

 • Funding/financing to make sure the promises in the agreement can be kept.

 • Continued loyalty from the key employees necessary to keep the business profitable.

 • Support of spouses and other family members.

Sharing how your succession plan addresses these issues may put you in a position to sell a variety of financial products. Money needs to be available to fund the purchase and meet unexpected events that may arise. In addition, valuable non-owner employees need to have incentives to remain with the business and to continue to give their best efforts. Thus, life insurance sales opportunities include:

 1. Death benefits and cash values to help purchase a departing owner’s ownership interest.

 2. Death benefits for “estate equalization” when there is a family business and some children are not going to share in the future ownership.

 3. Key person insurance to pay for new expenses and lost profits resulting from a key employee’s death.

 4. Policies to fund non-qualified key employee incentive and retention plans (key employees can be important in retaining clients after an owner dies, retires or leaves).

Why Your Plan Can Be A Useful Marketing Tool

The potential ability to leverage your own succession plan and your experience into new sales should make you anxious to have your own succession plan. Many financial advisors haven’t taken advantage of the opportunity to use their own plans to strengthen client relationships and produce more business. If you are willing to share the thinking you used in negotiating your own succession plan, you could potentially benefit in these ways:

 1. Change the Sales Discussion to a Conversation Between Equals. Talking about your own business and your own plan positions you to talk to other business owners as a peer. You are sharing information with them as a fellow business owner, not as a salesperson. You have a lot in common with them. Like them, you sell your knowledge and experience. Like them, you have to find good customers and convince them to use your services and pay for them. Even though the services you sell are different, your succession problems are similar to theirs. You are equals sitting on the same side of the table.

 2. Increase Your Credibility. When you share your own succession planning strategy, you aren’t talking in the abstract. Clients and prospects often wonder if you use the same products and strategies you are recommending to them. It’s powerful when you can honestly say, “I did the same thing for myself and my business.” Your credibility increases when you can show them you eat your own cooking!

 3. Position Yourself as a Resource with Valuable Knowledge. When you have your own succession plan, you have accumulated some valuable resources. You may have sample documents or know experienced attorneys, CPAs or business valuation consultants who have expertise in succession planning. Sharing your resources may speed up the planning process and may make things easier and less expensive for them. In addition, experience may help them avoid making some mistakes. Consider using some of the questions in the exhibit to help your clients see some potential problems which may merit their attention.

Twenty Important Succession Planning Questions

Listed below are specific questions that may help you in talking with business owners about their business succession plans. If you’ve addressed these questions in your own succession plan, you’ll have an opportunity to share your personal perspective.

  1. What triggering events does your agreement cover?

  2. What happens if an owner is disabled for a long period and can’t work?

  3. Will the purchase be mandatory or optional? If optional, who has the option?

  4. Could the purchase result in a change in voting control?

  5. Will the buyers get an increase in their cost basis for tax purposes?

  6. Does the agreement favor either the seller or the buyers?

  7. What’s the procedure for determining the value and price to be paid for an owner’s interest?

  8. How often will the purchase price be reviewed and/or updated?

  9. Are the key employees locked in with non-compete agreements? Do they support the plan?

 10. What incentives do key employees have to work hard after the change in ownership takes place?

 11. Does the agreement have any provisions concerning an owner’s divorce?

 12. Are the interests of the owners’ spouses accounted for (community property or pre-nuptial agreement)?

 13. Does the agreement prevent you from transferring your interest to your spouse or children?

 14. From where will the money to complete the purchase come?

 15. Will the purchase price be paid immediately or will it be paid in installments over several years?

 16. Will the buyers be giving the seller personal guarantees of payment?

 17. Will the buyers indemnify the seller if something goes wrong?

 18. Will inflation decrease the spending power of the installment payments? How much?

 19. What happens if a buyer defaults?

 20. What happens if a buyer dies before all his/her payments have been made?

Conclusion

Completing your own plan is tantamount to taking a personal course on business succession planning. But it’s a more meaningful course because it’s a plan for your business. In addition to protecting your own business, having your own succession plan positions you to talk about this planning in a unique way. You’ll be able to give clients better, more practical advice. You’ll likely retain clients longer and you’ll likely make more sales. You’ll also be in a position to use your plan as a marketing tool that could help increase your business’ value. Implementing your own succession plan won’t be easy, but you receive multiple benefits when it’s completed. Promise yourself that you’ll update or finalize a plan for your business in 2013.

These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor. The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws may change and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding their individual situation.

In January Congress stepped back from the fiscal cliff and passed The American Taxpayer Relief Act of 2012 (ATRA), which answered questions about the Bush tax cuts by making most of them permanent.* Many people and organizations have published good summaries of ATRA’s provisions. This article tries to focus on how it impacts life insurance and wealth transfer opportunities. If this article fails to clear up how this legislation affects your life insurance policy then it may be worth speaking to a life insurance expert similar to those found at Tempe Insurance.

Life Insurance Income Taxation Un-changed. Over the years, Congress has granted life insurance policies a unique combination of valuable income tax benefits. Whenever politicians talk about increasing taxes and raising revenue, there is always concern that some of life insurance’s tax benefits may be reduced.

Fortunately, ATRA makes no changes in how life insurance policies are taxed. Income tax-free death benefits, tax-deferred cash-value growth, 1035 exchanges and the taxation of cash value distributions all remain the same under federal tax laws.

New Income Tax Rates for High Income Taxpayers. ATRA left income tax rates unchanged for all taxpayers except those with large taxable incomes. Single taxpayers earning more than $400,000 and married couples filing jointly earning more than $450,000 will be subject to a marginal rate of 39.6 percent on the portion of their income which exceeds these limits. ATRA also increases tax rates on capital gains and dividend income to 20 percent for these high income taxpayers.

Transfer Tax Rules Made Permanent.* ATRA ends the 12 years of regular change and uncertainty on the taxation of wealth transfers during life and at death. It retains the concept of unification of the gift, estate and generation skipping transfer (GST) taxes by setting their top marginal rates at 40 percent and establishing their 2013 exemptions at $5.25 million (which will be adjusted annually for inflation).

The ATRA provision that adjusts these exemptions annually for inflation is important because it gives these exemptions the potential to keep growing year after year. ATRA also simplifies wealth transfer planning for married couples by making permanent the portability of the estate tax exemption to a surviving spouse.

The Transfer Tax Landscape in 2013. Now that the phase-ins, phase-outs and sunsets have ended, 2013 may be the beginning of a new era in wealth transfer planning. Legal and tax advisors retained all their planning tools and now they have increasing exemptions with which to use them:

Lifetime Gifts*

Annual Exclusion Gift Limit (per donee) $ ? 14,000

Lifetime Gift Tax Exemption 5,250,000

GST Tax Exemption on Gifts 5,250,000

*Married couples can work together to combine their gift tax annual exclusions and lifetime gift tax exemptions through coordinated separate actions or through “split gifts” under IRC Section 2522.

Transfers At Death*

Estate Tax Exclusion $5,250,000

GST Tax Exemption on Death Transfers 5,250,000

*Married couples may use the “portability” feature of the Act to defer use of the estate tax exemption of the first spouse to die until the death of the surviving spouse.

General Impact on Wealth Transfer Planning. ATRA simplifies wealth transfer planning in several important ways:

?1.?Fewer people will need to plan and position their assets to avoid federal estate and GST taxes. Establishing the gift, estate and GST tax exemptions at more than $5 million per person and indexing them annually for inflation likely means that less than 1 percent of estates will be subject to federal estate taxes.

With inflation indexing, these exemptions will keep growing year after year. As a result, only the very wealthy (currently individuals with estates in excess of $5.25 million and married couples with estates in excess of $10.5 million) will have federal estate tax problems.

?2.?Portability of estate tax exemptions between spouses, now permanent, could change how many married couples decide to transfer their wealth. Permanent portability could greatly simplify planning for wealth transfers between spouses.

When a federal estate tax return is filed at the first spouse’s death, the surviving spouse will be able to use two estate tax exemptions instead of one. As a result, married couples shouldn’t need to divide their assets to make sure each has enough to use their individual exemptions. When portability is used, the order of spouses’ deaths is irrelevant for estate tax purposes. Both exemptions can potentially be used, regardless of which spouse dies first.

?3.?Opportunities to transfer wealth by making large gifts have been reinforced. By indexing the lifetime gift tax exemption for inflation, taxpayers will have new and recurring opportunities to make large gifts (even those who may have “maxed out” their gift tax exemptions in previous years).

Because of these changes, many attorneys could change how they draft wills, revocable trusts and other wealth transfer documents for married couples. Portable estate tax exemptions allow married spouses the convenience of full use of the marital deduction without any increase in estate taxes.

Consequently, the need for credit shelter trusts (also known as “bypass” trusts and “family” trusts) may be significantly reduced. Instead, more people may use the so-called “I Love You” plans in which the first spouse leaves everything to the surviving spouse. If a spouse wants to limit the amount of control a surviving spouse has over estate assets, he could use any of the different marital trusts, including qualified terminal interest property (QTIP) trusts.

The potential simplicity and relative ease of using portability will change how many married couples implement their wealth transfer plans. Portability could allow these couples to postpone some difficult decisions about distributing assets until the second spouse’s death. Many couples could benefit from a review of their current wills, revocable trusts, beneficiary designations and other wealth transfer documents to see if portability will help them meet their wealth transfer goals.

General Impact on Income Tax Planning. ATRA’s increase in income taxes on high income taxpayers, coupled with the 3.8 percent increase in taxes on investment income under the Affordable Health Care Act, may also have a significant impact. Many high income taxpayers may be interested in strategies to offset their tax increases.

?1.?Changing the makeup of their asset portfolio and shifting some of their holdings into assets with the potential to provide tax-deferred growth but which don’t generate current taxable income.

Cash value life insurance is an asset with this potential. High income taxpayers who also have a need for death benefits may wish to use life insurance to “warehouse” funds that they don’t expect to need in the near future. Life insurance cash values are generally quite liquid and have the potential to grow in value over time.

Long term irrevocable trusts might also benefit from using cash value life insurance to reduce income tax exposure. Trusts that don’t distribute their income annually are taxed at a 39.6 percent rate on all taxable income in excess of $11,800. When an insurable interest is present, cash value life insurance could help reduce the impact of income taxes on these trusts.

?2.?Income tax savings could become an incentive for lifetime gifts. High income taxpayers could elect to make gifts of income-producing assets to children and grandchildren who are in lower-income tax brackets than the donor. Income from the gifted assets could avoid both the new 3.8 percent tax on investment income and the 39.6 percent marginal income tax bracket, as long as the child’s/grandchild’s taxable income stays below the $400,000 to $450,000 threshold.

?3.?Using “portability” at the first spouse’s death. That potential income tax advantage is a possible “double” step-up in basis. Many assets in the first spouse’s taxable estate will be eligible for a step-up in basis, and any of those assets still owned by the surviving spouse could receive another step-up in basis at the spouse’s death.

For example, suppose a husband acquired $500,000 of IBM stock and when he dies the stock is worth $1 million. At his death, under the terms of his will, the IBM stock goes to his wife. She takes it with a stepped-up basis to $1 million. If the stock has grown in value to $2 million at her death, her heirs will get another step-up in basis to $2 million. They could sell it immediately and avoid capital gains tax on all the stock’s growth. If the spouse earns less than that, they could be eligible for an LCGE (Lifetime Capital Gains Exemption) on their taxes, it is best to check with your lawyer if this applies to you.

Impact on Life Insurance. Life insurance comes through ATRA unchanged. It continues to offer protection against potential financial problems caused by an insured’s death. Over the years life insurance has been very effective in helping people accomplish important financial objectives, including: (1) replacing future earnings that could be lost through premature death, (2) solving equalization problems arising when assets won’t be divided equally, (3) serving as a source for supplemental retirement income, (4) providing liquidity to pay estate settlement costs and expenses, and/or (5) transferring wealth at death.

ATRA does not change the ability of life insurance to accomplish any of these important financial goals. In fact, the market for four of these five uses of life insurance remains unchanged.

The only use of life insurance negatively impacted by ATRA is the estate liquidity market (number 4 on the list above) and only part of that market has been hurt by the new wealth transfer tax rules.

Life Insurance and Estate Liquidity. A portable and inflation-indexed estate tax exemption of $5.25 million per person ($10.5 million per married couple) will likely reduce the number of people who will have federal estate tax concerns. And lowering the maximum estate tax rate to 40 percent reduces how much federal estate tax will be due from the few taxpayers with taxable estates in excess of the exemption. (Estates of decedents residing in the 20 states that have estate/inheritance taxes will still need liquidity to pay those taxes.)

The bottom line here is that only people with very large estates will need to plan for federal estate taxes. As a result, there will likely be fewer opportunities to sell life insurance for federal estate tax liquidity.

?Although fewer people will need to pay federal estate taxes, many will still have significant liquidity needs at death. Life insurance death benefits can still provide funds for a number of death-related liquidity needs, including:

??State estate/inheritance taxes

??Income tax liabilities

??Funeral expenses

??Debts

??Nursing home costs

?Medical expenses

??Estate administration expenses

??Cash bequests

??Property management fees

??Charitable bequests

Change in Marketing to Part of the High-Net-Worth Market. The increase in exemption limits should change how life insurance is sold to the segment of high-net-worth market that no longer has a federal estate tax problem. Even though they may not need as much estate liquidity, they may still enjoy significant benefits from using life insurance.

Financial advisors will simply need to discuss life insurance in a different way. They will need to design their presentations to demonstrate how life insurance can help them meet their wealth transfer objective more easily and efficiently.

Why Life Insurance May Be a Useful Wealth Transfer Tool. Over the years many high-net-worth people have used life insurance to accomplish many different goals. With their tax and legal advisors, they’ve adopted customized plans to pass on their wealth. Although many different financial products and strategies are available to them, when they are in good health, they often use life insurance in their planning.

Why? Because life insurance offers them a unique combination of potential advantages:

??Predictable Value-a policy can be structured to pay a known death benefit amount when the insured dies.

??Death Benefit Value Not Linked to Market Performance-a policy may be structured so that the death benefit is a fixed amount which is known in advance.

??Liquidity-death benefits are paid in cash when the insured dies; generally no taxes, costs, commissions or fees are subtracted.

??Growth/Leverage-premiums paid for death benefit protection may provide a reasonable rate of return through life expectancy.

??Federal Income Tax-Free Payment-policy death benefits (including the amount in excess of premiums) are generally federal income tax-free under IRC Section 101.

??Avoids Probate-Death benefits may be structured to be paid directly to the beneficiaries (or a trust for their benefit) without the costs and delays that often impact assets distributed through probate.

Most high-net-worth people and their advisors are careful people. They didn’t accrue their fortunes by being reckless. Many don’t need to make more money. Often protecting what they have is more important to them. Consequently, they are usually interested in products and strategies that offer protection and minimize risk. Before they act, they carefully analyze available alternatives and the potential risks associated with them.

Every financial product and strategy has an element of risk, and life insurance is no different. However, when properly designed and implemented, policies issued by financially strong insurance companies can be reliable financial tools. Although results will vary with a variety of factors, when premiums are paid in a timely manner and the policy is well managed, life insurance can provide a reasonable rate of return through life expectancy. An internal rate of return analysis can help show the financial benefits a life insurance policy has the potential to deliver.

The changes the American Taxpayer Relief Act makes in the federal estate tax could actually make it easier for some high-net-worth people to benefit from using life insurance. People who don’t have a federal estate tax problem may not need an ILIT to own the policy; instead, they may be able to own the policy themselves. Personal ownership makes life insurance more attractive and easier to use in several ways:

?1.?Eliminates Extra Costs-when insureds can own their policy, they don’t need to pay an attorney to draft an ILIT and they don’t have to pay a trustee to administer it.

?2.?Easier to Pay Premiums-gifts or loans to supply premium dollars to a trustee aren’t needed; Crummey withdrawal powers aren’t a problem. Insureds can pay their premiums directly to the insurance company.

?3.?Privacy-owning a policy personally means no one else has to know about it; there are no trustees or trust beneficiaries with a right to know about the policy or to ask questions about it.

?4.?Control-when insureds own their own policy, they are in full control; within the limits of the policy they can exercise all policy rights, including changing the death benefit, premiums, primary and contingent beneficiaries, 1035 exchanges, etc. Unlike ILIT ownership, policyowners can manage their policies to fit their needs and make adjustments whenever they wish. If they wish to control how policy benefits are delivered to family members, they can create a trust in their will and name it the policy beneficiary. And they can retain the ability to change the terms of the trust as long as they live.

Conclusion. The American Taxpayer Relief Act is good news for life insurance! It doesn’t change any of the advantages life insurance policies have enjoyed or the ways in which they can help clients accomplish their financial goals. In addition, ATRA opens up new opportunities for high income and high-net-worth individuals to use life insurance. Although some high-net-worth individuals may not need as much life insurance for estate tax liquidity, the increased gift, estate and GST tax exemptions make life insurance for wealth transfer simpler and easier to use. The opportunity for some to own policies personally without increasing their transfer taxes increases its attractiveness. The ability to retain control and privacy without the need to pay for complex trusts creates new sales opportunities.

We’ve entered a new era of wealth transfer planning-2013 is a great time to show your high-net-worth clients the many reasons they’ll want to use life insurance as part of their legacy.

*Many of the provisions of ATRA are considered permanent enactments. This does not mean that these provisions cannot be changed by Congress in the future (even this year). To designate a provision as permanent indicates only that the provision will not expire unless Congress acts to change it.

Many economists say the American economy is meandering along at a tepid pace. But there is at least one group of American businesses that seem to be performing very well. You might think it is manufacturing, high tech, professional services or precious metals trading. But no! It is one of America’s most basic businesses-farming!

American farmers who are avoiding the drought seem to be doing quite well. The problems and opportunities they are dealing with may provide useful lessons to other business owners.

Good News!

From many reports, this appears to be a great time to be a farmer. Statistically, many farmers’ net worths seem to have grown substantially over the last decade. Smarter management practices such as crop protection and increasing prices for crops and commodities have helped farm values consistently increase across much of the country. Generally speaking, the appraised value of farm land in many states has more than doubled during the last 10 years. In some cases appraised values currently exceed $4,500 per acre! See Table 1, which shows selected state values from the U.S. Department of Agriculture’s National Agricultural Statistics Service.

Bad News!

Sometimes you can have too much of a good thing. Drinking too much alcohol-even the very best quality-can cause a painful hangover. Although an increased net worth is good for most farmers, in several respects increased land values actually may create some new financial problems that may need immediate attention-a “financial hangover.” Among those potential problems are: (1) finding funds to pay federal and state estate/inheritance taxes and (2) designing a family wealth transfer plan that is fair to both on-farm and off-farm children.

Increased Federal (And Perhaps State) Estate/Inheritance Taxes

If the value of a farm has doubled during the last 10 years, it is likely that federal estate taxes due at the farmer’s death could also increase significantly. This can be especially troubling if the federal estate tax exemption is reduced and federal estate tax rates increase. That’s what is scheduled to happen on January 1, 2013.

The estate tax exemption is to be reduced from $5.12 million per person to $1 million per person and the maximum federal estate tax rate will increase from 35 to 55 percent. Higher land values could also increase state estate/inheritance taxes in states that impose such taxes.

In order to reduce federal and state estate/inheritance taxes, it may be wise for farm owners to make some gifts before January 1, 2013. That’s because the lifetime gift tax exemption is $5.12 million in 2012 but will be reduced to $1 million in 2013.

A married couple owning farmland could combine their lifetime exemptions to gift land and/or other assets worth $10.24 million gift tax-free in 2012 before the lower exemption limit kicks in during 2013. In addition, any growth in value of gifted assets after the date of the gift will be passed on to the donee free of transfer taxes.

Unfortunately, many farm families who could potentially benefit from gifting strategies may not make gifts before the end of 2012. It is often physically and emotionally difficult for farm owners to give away part of their farm. Like most business owners, farmers have a reputation for wanting to retain full personal ownership and control over their land and business for as long as possible.

A Liquidity Analysis

Regardless of whether farm owners decide to make gifts, they need to understand how much it will cost to pass on their farms and other assets. Just like you would when you’re thinking about investing in assets like real estate, carrying out a liquidity analysis in this situation can help them get a feel for the potential costs, and this will help to determine why liquidity is important as you continue through the process. To sum it up, a liquidity analysis estimates the potential costs that may be triggered when the farm is transferred to the next generation, and 2012 presents a unique opportunity to offer to do a liquidity analysis.

Most farm families don’t want to sell their farm; they want to keep it in the family. The increase in the value of farm land, the scheduled decrease in the estate tax unified credit and increase in the maximum federal estate tax rates likely mean that transfer tax costs will increase and more cash may be needed to keep a farm in the family.

Families who conducted liquidity analyses several years ago may benefit from reviewing them. Increasing farm values may have made an earlier analysis outdated. Farmers without a liquidity plan should consider adopting one now. A useful liquidity analysis does more than estimate the costs of passing down the farm; it also considers alternatives for reducing and paying those costs over a period of years. Special use valuation and installment payment of taxes under IRC Section 6166 are sometimes appropriate.

For a farm owner in good health, life insurance death benefits should be one of the alternatives considered in the plan. A farm owner’s life insurance policies that are owned in an irrevocable life insurance trust (ILIT) or by an adult child designated as the farm “successor” could provide part or all of the cash needed to pay the federal and state transfer taxes and other costs due at the farm owner’s death.

If a workable liquidity plan is not in place and a farm owner’s estate doesn’t have enough cash, the farm may have to be sold to outsiders to generate the funds needed to pay the tax. A sale of all or part of a farm will likely be the end of that family’s farm legacy. The same is true for all business owners who haven’t adopted a workable liquidity plan.

A Family Buy/Sell Arrangement

For many families it is important to transfer family wealth in a way that treats all children equally. This usually means transferring the same amount of wealth (although not necessarily the same assets) to each child after the parents are gone. One way to do this is to leave each child an equal percentage of all the assets, including the business. For example, if there are four children, each would get 25 percent of the business whether they were involved in operating it or not.

Shared ownership of a farm is often a highly emotional issue to both those children working in the business and those who are not. Those in the business usually don’t want the others involved in daily operations and those outside the business don’t want to inherit assets they can’t sell. Instead, they want to inherit cash or assets which can be easily converted into cash. Shared ownership by children working in a business and those who are not could easily damage or destroy family relationships.

In order to preserve family relationships, a workable strategy for cashing out the interests of non-business children needs to be in place. One alternative is a buy/sell arrangement between the children themselves. Let’s look at an example. Suppose only one of the four children (a son) works on a family’s farm. He inherits his pro rata 25 percent share of the farm directly. If he has an agreement with each of his three siblings (or with the estate of the parent), he can have the ability to purchase the 25 percent each of them inherits when the last parent dies.

This purchase right can be given by the parent in the estate planning documents or can be individually negotiated among the adult children. If the parent is in good health, a farm-based child may be able to purchase a life insurance policy on the parent’s life to fund the purchase.

Of course, the on-farm child needs cash to pay the policy premiums. If he doesn’t have enough cash to pay the premiums personally, the parent could potentially supply the funds through annual exclusion gifts or advance them through inter-family loans or a private split dollar agreement. There is also the possibility of using a combination of gifts, loans and/or advances. If adequately funded, this approach allows the off-farm children to be cashed out and the child on the farm winds up with 100 percent ownership.

In addition, the farm-based child doesn’t need to purchase the entire farm from the parent’s estate. If he inherits his portion of the farm directly, he needs to buy the remaining interests only. In our example, the son inherits 25 percent and thus only needs to buy the remaining 75 percent. This approach may also work for non-farm businesses.

Families who have existing buy/sell arrangements in place need to consider whether the increase in farm land prices (or other business assets) negatively impacts their ability to follow through on the terms of their agreement. If the value of the business has increased, additional life insurance coverage may be needed to fund the promises made in the agreement. It may also be wise to get a new appraisal.

Sometimes it makes sense to purchase the interests of the children outside the business from the estate, before distribution. If the on-farm child purchases the remaining 75 percent of the farm from the deceased parents’ estate before the 25 percent units are distributed to the non-farm children, then the estate may have enough liquidity to pay federal and state estate taxes and other costs of estate administration. That is not to say that the burden of estate taxes and administration should fall exclusively to the off-farm children. The parent’s wealth transfer plan may require that some assets (which might have otherwise been designated for the on-farm child) may be used to pay his share of the estate’s taxes and other costs.

Five Lessons for All Business Owners

The current success of family farmers offers several lessons for other business owners:

?1.?The value of a business will change over time. Sometimes a business becomes more valuable; other times its value falls. Owners need to keep a close eye on their business’ value so that liquidity plans and business succession plans remain realistic and appropriately funded. It is probably wise to have the business’ value reviewed by an expert every three to five years.

?2.?Every business owner is mortal; have a plan ready. All will eventually leave their businesses, whether they want to or not. They just don’t know when-sometimes they get to choose the time; sometimes they don’t. To preserve the value they’ve built and to protect the people they love, realistic and funded succession plans are needed.

?3.?A liquidity analysis and cash reserves are important. By their nature, most businesses are illiquid. Some cash will likely be needed to pay debts, taxes and transfer costs. A liquidity analysis estimates these costs and identifies from where the money to pay them will come. Plans need to be backed up by money in order to succeed.

?4.?Wise planning considers what is best for the entire family. Just because it’s a family business doesn’t mean everyone in the family should be in it. Putting every family member in the business can be devastating to both the family and the business. Have an exit strategy for family members who shouldn’t be in the business.

?5.?Talk is cheap; only action counts! It’s important to have a long term vision for the future of a business. However, a long term vision can’t implement itself. Owners need to take action and put the necessary legal and financial tools in place if their vision for their family and their business is to become a reality.

Conclusion

Now is an excellent time to talk to farmers and other business owners about business succession, wealth transfer planning and estate liquidity. Many businesses are worth more than they have ever been. Although business owners are traditionally asset rich and cash poor, many of them have more cash and liquid assets than they have had in some time.

Increased business values may result in increased federal and state wealth transfer taxes. If the $5.12 million per person lifetime gifting exemption is going to help them reduce their wealth transfer taxes, they need to act before the end of 2012. A liquidity analysis can estimate how much may be needed to pay state/federal transfer tax obligations and estate administration costs. Different alternatives should be considered for providing the funds that will be needed.

Life insurance is one of the financial tools which should be considered. A family buy/sell agreement could also be part of a workable strategy for providing the needed liquidity and converting the interests of the non-business children into cash. With sound planning the business can continue in the family, and family relationships can be strengthened.

These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws may change and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding their individual situations.