Q: I have a client who is a surviving spouse, and beneficiary of an AB trust. She is in her forties and entitled to income from the B trust, however she does not need it. What is a tax efficient solution to this situation?
A: The first step is to decide what is the best way to invest the assets in the “B” trust, given the clients individual goals, objectives and health condition. Often the assets are placed in vehicles where the client’s advisors have the most experience, be it stocks, bonds, mutual funds, wrap accounts or real estate. But before you leap at the familiar, I’d like to suggest another vehicle–life insurance.
Life Insurance’s Financial Advantages. Now before you discount the thought of suggesting your client put X amount into a life policy, consider the financial advantages. The life insurance “B” trust funding vehicle would accumulate tax deferred. It would be income- and, if properly structured, estate tax-free at death of the surviving spouse and have some liquidity features if the need arises. In addition, life insurance has potential to provide leverage, so the surviving spouse could spend down the remaining assets in the “A” trust without worrying about decreasing the potential inheritance to the heirs.
Life insurance has been granted favorable tax status and whether in a trust or owned personally, generally there is no income tax on the proceeds at death. Money growing inside the policy accumulates on a tax-deferred basis so if funds are not withdrawn or the policy is surrendered, there are no income tax consequences. Clearly, if the assets are legacy assets and are not needed now or in the future to provide for the surviving spouse, then it may make sense to purchase life insurance on the surviving spouse in the “B” trust. The “B” trust often is funded with an amount equal to the estate tax applicable exclusion amount, thereby “leveraging” the transfer tax exemptions and sheltering the “B” trust assets and their appreciation from estate taxes at the second spouses death. Leveraging the applicable exclusion amount by purchasing assets with growth potential allows for a bigger inheritance to the children or grandchildren.
Thinking Outside the Box. If you have never considered life insurance as a “B” trust funding vehicle, you’ll be surprised at the potential advantages.
When properly structured, “B” trust funding with life insurance offers these potential benefits:
- Life insurance proceeds payable to the “B” trust are not subject to estate taxes.
- Life insurance premiums are paid by “B” trust assets and therefore don’t trigger gift taxes.
- Life insurance cash values grow income tax-deferred in the trust.
- “B” trust assets may be used by the trustee to provide lifetime benefits to the surviving spouse, with the remainder distributed or held for the benefit of trust beneficiaries (per terms of the trust document).
- Life insurance death proceeds are generally received income tax-free under IRC 101(a) and whether in a trust or owned personally there is no income tax on the proceeds at death.
To summarize, life insurance can satisfy clients looking to the “B” trust to pass growth assets to favored beneficiaries with a minimum of transfer taxes and enough flexibility to provide for the needs of a surviving spouse. In addition, the tax-advantaged benefits of life insurance deserve attention from the financial professional and his or her high-net-worth clients.