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Funding Your Client’s Estate Plan

IRAs, deferred annuities, municipal bonds and highly appreciated assets may help address some of your client’s cash flow issues.

By Yves Meheut, FLMI, CLU, ChFC

Let’s say that as a financial advisor, in conjunction with your client’s legal and tax counsel, you have developed an estate plan that addresses most, if not all, of your client’s goals and objectives during his life and at his death. Your client has agreed to a gifting and estate plan but is concerned about where the cash will come from to fund these recommendations. Now it is your responsibility, along with your client’s counsel, to implement the various components of this plan and address your client’s funding concerns.

Finding the money
Finding the dollars to fund a gifting plan can be one of the obstacles that a financial advisor may face with his clients. Your client’s illiquid assets, limited cash flow and other commitments to his standard of living, charitable donations or cash gifts to children may severely limit his ability to fund a lifetime-gifting plan and the life insurance necessary to provide for liquidity at death to pay anticipated estate taxes.

To help address these problems, we will explore various types of assets that may be in your client’s estate and could offer a potential solution to his cash flow problems. We will look at deferred annuities, municipal bonds, IRAs, highly appreciated securities, and the use of charitable remainder trusts.

A deferred annuity can be an effective solution to the client’s cash flow problems.

Deferred annuities
Deferred annuities can be found in many estates. They are typically purchased as a way to save and accumulate tax-deferred money. Clients may have originally planned for these annuities to supplement their retirement incomes or provide for other lifetime needs. However, your clients have successfully built a substantial estate that will adequately provide for those cash needs; they no longer need the annuity for income. They are not anticipating withdrawing any money from these annuities and are interested in passing them on to their families at death.

Problems with deferred annuities
There are two significant problems related to retaining deferred annuities in the estate until death. First, annuities are considered ordinary income assets and do not receive the favorable benefit of a step-up in basis at death, as is the case with other assets such as stocks or real estate. At death, the gain in the annuity will be income taxable to the beneficiary or beneficiaries of the estate in their respective income tax brackets. In addition, these annuities are included in the clients’ taxable estate and therefore could be subject to an estate tax as high as 55 percent. This double taxation makes deferred annuities undesirable assets to hold at death, reducing the amount ultimately transferred to heirs by as much as 75 percent. However, a deferred annuity can be an excellent source of income for making gifts into an irrevocable life insurance trust (ILIT), which, in turn, can be used to make premium payments to fund a life insurance policy on one or both clients.

A solution
The deferred annuity typically would be converted into a lifetime stream of income payable over the life expectancy of the client or the client and spouse (single premium immediate annuity (SPIA)). A portion of the income generated from the SPIA would be a return of the client’s cost basis, and a portion would be taxable as earnings. The net after-tax income from the annuity would then be gifted into the ILIT and used to purchase a life insurance policy that would be out of the client’s taxable estate. As the annuity income is payable only for the life of the client under, for example, a joint and survivor SPIA, there would always be an income stream available to pay premiums. Ultimately, at the death of the client or clients, there would be no residual left in the estate.

Therefore, using a deferred annuity can be an effective solution to the client’s cash flow problems. This approach reduces the taxable estate, provides cash for gifting and helps fund insurance outside the estate to meet liquidity needs at death.

The disadvantages of using this approach are that the client may object to the payment of current income taxes on a portion of the annuity income and may also have concerns over losing control of this asset by converting it into an SPIA. However, the ultimate outcome of this strategy is, in most cases, significantly better than retaining the annuity in the estate.

Municipal bonds
Another potential source of premium dollars is municipal bonds. Tax-exempt bonds issued by municipal governments represent another class of assets that the client may have purchased in the past to provide tax-free income to supplement living expenses or provide for other needs. Municipal bonds, similar to deferred annuities, may have had a legitimate basis as part of the client’s estate, but success and overall growth of the estate may have minimized the original anticipated need. Even if the client does require part or all of the bond income, there may be a more effective way to provide for this and still implement a lifetime giving plan.

Qualified plans can be undesirable assets to hold onto at death.

Under this approach, the municipal bonds are sold and the bond proceeds invested in an immediate life annuity on the life of the client or the client and spouse. By providing a life-only income, at the death of the client, there will be no residual remaining to be included and potentially taxed in the client’s estate. And, in many cases, there will be enough after-tax income generated from the SPIA to replace not only the bond income the client was previously receiving, but also additional after-tax income. This can be used to make annual exclusion gifts to an ILIT. The ILIT can then use those gifts to purchase life insurance to assist in the liquidity needs of the client’s estate. This life insurance death benefit will be received by the trust free of income and estate taxes under current law.

Individual retirement accounts (IRAs) can represent another significant asset in your client’s estate. It is possible that in a large estate your client may not find it necessary to draw upon these funds to meet his lifetime income needs. He may anticipate passing them on to his heirs. But, as with deferred annuities, qualified plans can be undesirable assets to hold onto at death.

Qualified plans such as IRAs are subject to income tax exposure in the hands of the beneficiaries and are includable in the client’s taxable estate. Although the distribution of IRA assets can be spread out over the life of the beneficiaries, all payments received are subject to income tax. Also, qualified plan assets do not receive the favorable step-up in basis at death afforded other assets in the client’s estate.

Another issue is that IRAs are subject to minimum distribution requirements commencing at age 70. Even if your clients do not need the income, they will be required to take distributions at some point. Taking early distributions from a qualified plan and using the after-tax gifts to pay for life insurance within an irrevocable trust may provide significant leverage as opposed to holding on to the asset and passing it on at death. This source of income should be closely examined to determine whether it will be an effective method to provide for the needed dollars needed to implement estate plan recommendations.

Highly appreciated assets
The last group of asset classes we will examine consists of assets that are highly appreciated, such as stocks or real estate. If your client does not have deferred annuities, municipal bonds or qualified plans as part of his estate, but has low-yielding stock or nonincome producing real estate, which is highly appreciated, it may be worthwhile to examine the use of charitable remainder trusts as a method of increasing cash flow. This may provide the dollars to implement the recommended gifting plan. Selling those assets in the estate to generate additional cash flow may not be effective because all gains from the sale will be subject to capital gains tax.

I should emphasize that for this strategy to succeed, your clients should be charitably inclined. It is possible through this method to not only increase income to the clients and provide for significant benefit to their heirs, but also offer a substantial endowment to your clients’ favorite charities.

Charitable remainder trust
A charitable remainder trust is a trust set up with qualified public or private charities or a private family foundation as the ultimate beneficiary or beneficiaries of the trust corpus. Typically, during the lifetime of the donors, the CRT pays out a designated percentage of the trust value to the noncharitable beneficiaries, usually the donors. After the trust is established, the donors gift into the trust the appreciated stock or real estate. The trustee of the charitable remainder trust then subsequently sells the assets, and there is no capital gains tax on the sale because the CRT is tax exempt.

The entire proceeds are available to be invested. The after-tax income payable to the donors can then be gifted into an ILIT and used to purchase insurance for the client’s heirs that could replace the asset going to charity. The insurance could also provide additional liquidity to pay estate taxes.

Under this scenario, you have removed an asset from the estate, thereby reducing estate taxes. You have also avoided capital gains taxes on the sale of the asset, provided a significant charitable income tax deduction, provided additional income to fund the recommended gifting plan, and ultimately given a significant gift to charity.

Exploring the options
There are several options that can be used to provide the funds needed to implement estate plan recommendations. All of the types of assets discussed in this article may not be in every estate, but it is quite probable that at least one is. There are software programs available from advanced marketing organizations that specialize in estate planning that enable you to develop a client-specific presentation that can effectively demonstrate these planning options and their respective financial impact on your client’s estate. You will then be able to assuage your client’s concerns about his cash flow and illustrate how your proposals will benefit him and, ultimately, his family.

Overcoming this obstacle will make it possible for you and your client’s advisors to move forward and implement the plans that will help your client achieve his goals and objectives.

Yves Meheut, CLU, ChFC, FLMI, is a senior advanced markets consultant with Manulife Financial, Boston. He is responsible for providing the Manulife field force and distribution channels with advanced case design. You can contact him at


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