Life Insurance

by Bruce Fenton

Congress has been asked to consider cutting estate taxes as part of its annual quest to provide tax relief to the masses. To some, cutting estate taxes is not relief for the “masses”—rather it appeals to the “classes” of wealthy with large enough wealth to qualify for this highest tax in the land.

However, it is the family business or farm owner and his trade associations that are pushing the legislative effort. Since a good part of their wealth is tied up in their business or farm, these groups face the unenviable prospect of having their survivors sell the business upon their death to pay estate taxes.

The problem is liquidity. Businesses, farms, and real estate are not liquid; yet, they can be highly valued in the estate which causes the tax to increase. Survivors have nine months from the date of the owner’s death to raise the cash to pay the taxes. This may require a forced sale of property, shutting down the family business, or taking on a large mortgage to meet the tax obligation.

An efficient way to raise the cash necessary to pay the taxes is by correct use of life insurance. A well thought-out life insurance plan can make the cash available—tax-free—to cover that tax check.

Several types of life insurance policies are available for estate protection plans.

A “First to Die” policy can be used by two non-related business owners to allow the family of the first to die to take cash for their business interest, leaving the surviving owner to run the business or farm intact.

A “Second to Die” policy is more often used by a married couple. Since the transfer of assets to a surviving spouse at the time of death is estate tax free, there is no need to purchase insurance to cover estate taxes after the first of the couple dies. However, when the second spouse dies, the couple’s combined estate will be subject to the estate tax. This plan provides the cash to pay the taxes due at the second death.

To be used correctly in estate planning, life insurance must be owned by someone other than the estate owner. Here is where most life insurance mistakes are made. Improperly owned life insurance in a taxable estate can add to the tax bill, not solve it.

If any incident of ownership, such as rights to change beneficiary, rights to cash value, history of making premium payments directly to the policy, or right to surrender the policy is retained by the estate owner, the proceeds of the life insurance will be taxed in his estate. If the estate has no ownership interest, the beneficiaries will receive the proceeds free of income and estate taxes.

The best way to ensure that life insurance is owned properly is to set up an irrevocable life insurance trust. The trustee (not the estate owner) applies for the life insurance on the life of the estate owner who will make gifts of cash or property to the trust. The trustee will use this cash to pay the insurance premiums. Upon the insured’s death, the insurance proceeds are paid tax-free to the trust. The trustee then distributes the proceeds according to the directions of the trust maker.

It is not uncommon for estate owners to attempt to avoid the costs of setting up a life insurance trust by having an adult child or children own the policy. This can be risky, since the ownership interests in the policy can be attached by the child’s creditors should financial problems arise in the future.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Life Insurance Beneficiaries

by Bruce Fenton

One of the seemingly easier tasks involved in the purchase of life insurance is naming the beneficiary. An agent with pen in hand asks the applicant, “Who will get the cash?” The applicant looks at his/her spouse and without a thought replies, “My spouse, of course.” However, as simple as it appears, choosing the beneficiary of a life insurance contract can be quite complex.

The beneficiary of a life insurance policy is the person named (designated) by the policy owner to receive the benefits payable when the insured dies. The right to name this beneficiary is, perhaps, the most important right the policy owner has.

Generally speaking, the person who applies for insurance on his/her own life can name anyone beneficiary. Dad can name Mom, kids, parents, etc., but there are limitations. For example, in community property states, if Dad buys a policy on his life using community property funds to pay the premiums and divides the death benefits between Mom and kids, only his half of the community property death benefit may be given to the children without Mom’s consent.

If the insurance is on the life of a minor, most states will not recognize the competency of minors to enter into a contract. Therefore, life insurance on a minor’s life is usually owned by adult parents or other relatives. In such a case, the owner may only designate the minor, parent(s), sibling(s), child(ren) or grandparent(s) of the minor as beneficiary.

Life insurance policies owned by someone other than the insured also have restrictions on beneficiary designations. In the early history of life insurance, it was not uncommon for people to wager on the lives of others by buying life insurance on a third party without that person’s knowledge or consent. This led to the nasty practice of speeding up the demise of an insured in order to collect on the death benefits.

Insurers stopped this practice by requiring that owners of life insurance policies on another person only name a beneficiary who has an insurable interest in the insured. The generally accepted definition of insurable interest is “any reasonable expectation of benefit or advantage from the continued life of another person.” Put simply, one might say the insured is worth more to the beneficiary alive than dead.

To qualify for insurable interest, the beneficiary may be a person related by blood or law, or someone who has a lawful or substantial economic interest in the continued life of the insured. This may include a business partner, or in the case of a corporation, the corporate entity itself for purposes of funding a partnership buy-sell or stock redemption agreement.

The wording of the beneficiary designation is important. Consider the designation that reads, “Mary Jane Smith, wife of the insured.” Let’s say the insured later divorces Mary Jane and marries Sue Ellen. Prior to changing his life insurance beneficiary designation, he dies. Sue Ellen attempts to collect because the beneficiary designation reads “wife of the insured.” However, the law gives the money to the named beneficiary, “Mary Jane Smith”—not the descriptive phrase. The ex-wife gets the money as a taxable gift from his estate, payable by his estate.

Children may be listed as beneficiaries either by name or by class. If children are listed by name, those born later must be added by change of beneficiary; if listed by class, all children including those born later are included. However, this raises a number of questions and problems for insurance companies. First, they have no way to identify all of the children, especially if death happens many years after the policy is started. All children must be located and identified before the insurance proceeds can be paid out. Second, the definition of “children” is often in question. For example, do illegitimate children count?

It is no surprise that the best “policy” to make sure your loved ones receive the full intended benefits of your life insurance proceeds is to seek professional advice. There’s more to the process than simply writing a name on a sheet of paper!

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Insurance Companies and the Stock Market

by Bruce Fenton

Hurricanes aren’t the only natural disasters that haunt insurance companies. Low interest rates and an anemic stock market can be just as disastrous when it comes to insurance company finances.

Automobile, homeowner’s fire and property damage, and a variety of professional insurance coverages have made the news of late for either restrictive underwriting or skyrocketing premiums. Part of the blame lies in the low returns offered by the financial markets.

Insurance companies count on an investment return from premiums advanced on policies as part of their cash inflow. Actuaries calculate the risk of a payout for loss, taking into account investment returns. When investment returns are low, as they have been for a number of years, insurance premiums will rise. The probability of a loss in a large universe of insured's is generally fixed, and if the amount of the loss as measured in dollars is increasing due to inflation, the insurance company has no choice but to raise premiums for everyone.

To deal with that inevitability, consumers should become wise buyers of insurance. Here are a few tips that will help.

First, be a comparison shopper. According to J. Robert Hunter, director of insurance for the Consumer Federation of America (CFA), a nonprofit public interest group, premiums vary widely and, depending on the insurer, you can easily pay twice as much as you need to.

Next, shop for discounts. Simple things like a good home security system or side airbags in a car can trigger discounts. Parents footing the insurance bill for a student may get a break if the student is on the honor roll. Try enrolling all family drivers in a defensive driving course.

There are also some benefits to age. Some companies reward older drivers who drive less with lower rates. This also works for the retired, who are likely to spend more time at home and take better care of their property.

Raising deductibles is another way to cut costs. Insurance should be used to cover the infrequent but expensive loss. If you are willing to pay more on the front end of a claim, you may reduce your homeowner’s or auto premiums, according to the CFA.

Carrying collision coverage on an older vehicle may be a waste of money. If you have a loss, by the time you pay the deductible and the insurance company calculates the depreciated value of the car, chances are the insurance will only cover a small part of the loss. You may be better off pocketing the premiums and going without collision coverage.

Our homeowner’s and auto coverage are bundled together into one policy. This not only saves us some money, but it means I am dealing with only one agent who knows my complete risk picture.

Speaking of agents, it pays to find a good one who can keep you informed of changes in coverages and things you can do to reduce your premiums. Don’t expect much in the way of insurance cost reductions until we see higher interest rates and a stronger stock market.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Second Marriage Planning

by Bruce Fenton

Handling the money in a second marriage takes planning and thought to avoid potential potholes on the road to marital bliss. The financial planning issues in second marriages can be broken into two parts: those required to conduct the everyday affairs of the marriage; and those relating to property ownership and estate planning.

In the case of the former, two separate and independent economic entities have to be merged to operate as one. Usually two incomes have to be combined to pay the bills—his, hers and theirs. Savings have to be allocated for two separate retirement plans. It is not uncommon for both to own their separate residences.

An easy way to deal with the bills and money is to set up one joint checking account, with each of the spouses keeping their separate checking account. Common expenses and common savings can be paid from this account. Each is responsible for contributing a set amount into this account. What remains in each separate account is theirs to spend as they wish.

This arrangement is simple, easy to manage and facilitates record keeping for tax preparation. More important, it leaves each with an element of financial freedom to spend the leftover money in their separate account without having to account to the other spouse.

When both bring personal residences into a marriage, property ownership and management are an issue. Suppose they decide to live in one and rent the other. Suppose both contribute to the mortgage payments of the residence through the common checking account. The rental income goes into the joint account to help cover the costs of the household. Such an arrangement will quickly create a joint ownership situation for both properties where none existed before. Because of the co-mingling of income and expenses, before long both properties could be considered community property.

If the parties wish to continue owning their respective properties as their separate property, they will need a pre- or post-nuptial agreement to do so. Separate property will not be subject to division in a divorce and it allows them to appoint the full value of their property as either gifts or inheritances to heirs.

It is important that all retirement plans and life insurance contracts be reviewed to ensure that beneficiary designations are correct. It is not uncommon among second marriages to find old IRA or life insurance policies with the first spouse named as the beneficiary. Retirement plans, IRAs and life insurance policies, which name anyone other than the current spouse as a beneficiary, create a potential estate tax liability upon the death of the owner. This can be avoided by either removing the life insurance policy from the estate by gifting or change of ownership, or changing the beneficiary to the new spouse.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Life Insurance and Spousal Trusts

by Bruce Fenton

Don’t throw away your life insurance trust and its expensive life insurance policy just because the estate tax is going away. Like a bad dream, in ten years it could be back.

The much ballyhooed estate tax reform and potential repeal is just that… potential. Congress made the tax law change subject to reversion to the existing law by 2011 unless modified by a future legislative act. And, the chances of this tax being eliminated, in my opinion, are very slight.

Our booming economy has deposited trillions of dollars of wealth in the hands of the Bob Hope generation. That generation came back from the world’s greatest war and set about building this country and this economy… and quite successfully. Now they are about to join the Henry Ford generation in demographer’s heaven, leaving a legacy of success and wealth to be managed by the next generation, our Baby Boomers.

There is a problem with this scenario. This successor generation is the largest single generation this country has ever known. When they pass into retirement in ten to fifteen years, they leave behind their productivity, their knowledge, and their leadership as they begin drawing upon a social security system into which they have paid all these years.

Generation X, coming next, will face the onerous task of paying the taxes required to pay the country’s bills, and, as a smaller generation, with fewer, less productive workers. Now, intuitively you should be able to get the picture: fewer workers, less wage base, more social security payouts, and more taxes.

Congress will have three choices: deficit spend and kill the economy, tax the living or tax the dead. Obviously the dead don’t complain or vote, so their first choice for raising taxes will be to go after estate transfers.

The need to estate plan is as great as ever. The uncertainty of the current laws make it imperative that larger estates take into consideration the prospect of future taxation. It would be a little tough to announce to Dad on Christmas of 2010, that his New Year’s Eve gift to the family is to check out for good since the law is coming back and there is no estate plan.

Life insurance remains one of the most important tools in an estate plan. Life insurance leverages pennies into dollars for the purposes of paying transfer and income taxes that are the byproducts of life’s success. If life insurance is owned outside of the estate of the decedent, it goes to the named beneficiary free of income and estate tax. The most common form of life insurance ownership for estate planning purposes is in an irrevocable life insurance trust.

Typical planning has the trustee of the trust applying for a life insurance policy on the life of the estate owner. The policy is payable at death to the trust. The trustee then uses the proceeds to supply liquidity to the estate for the payment of estate expenses, including taxes.

The problem with this planning is the lack of flexibility in a changing world and tax environment. Assets are usually out of reach of the beneficiaries until the insured dies and the trust collects on the policy. And, to give the spouse access to the life insurance cash value could cause the proceeds to be included in the taxable estate.

One solution is to set up a Spousal Support Trust (also known as a Spousal Access Trust) as the owner of the life insurance. This is the same irrevocable trust. However, by properly structuring and administering the trust, the assets in the trust would be accessible by the spouse and excludable from the estate of the insured, and that of his/her spouse. The non-insured spouse and the children could draw upon the assets of the trust during the lifetime of the insured for living and education expenses.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Deferred Compensation for the Small Business

by Bruce Fenton

Not every business can afford to reward key employees with the largess of a Tyco or Enron. Yet rewarding key employees is very much a fact of life for many small business owners. Since planes, homes, boats, and forgiven loans are beyond the reach of most small business owners, a simple deferred compensation plan can do the job.

The tax code provides that compensation to an employee be considered taxable income to the employee and a tax-deductible expense to the corporation. Unfortunately, the code does not allow a business owner to defer compensation in such a manner that the employer can get a tax deduction while the employee escapes taxes.

If the employee has any rights of ownership, the employee is said to have constructive receipt, which in turn triggers income taxation. Therefore employers who set up deferred compensation plans must fund the plans with after-tax dollars. The employee has no ownership interest until the deferred compensation is paid, at which time the employee is taxed for the income received and the employer receives a corresponding tax deduction.

These plans can be used to provide supplemental retirement benefits and as a tool to provide extra rewards to key employees. Most commonly, a life insurance policy is used as a repository for the money.

Because these plans are not subject to the ERISA restrictions of most qualified pension and profit-sharing plans, the deferred compensation plan allows businesses to design a truly individualized plan to meet very specific compensation goals.

The plan starts with the employee agreeing to defer a percentage of his or her pre-tax salary or bonus. In return, the employer provides a supplemental disability or retirement income for the executive and his or her family.

Depending upon the specific goals and time horizon of the executive and the employer, the employer uses the executive’s deferred compensation money to purchase and pay premiums on a cash value life insurance policy for the executive.

The employer is the owner of the policy and names itself as the beneficiary. The executive is the insured.

The life insurance policy provides a tax-free death benefit to the employer as well as accumulates a tax-deferred cash account. Premium payments made by the employer are not tax deductible. At this time the cash value remains an asset of the corporation.

When the executive retires, becomes disabled, or at another specified date, he or she may begin receiving the deferred compensation from the employer. This payout is taxable income to the employee and represents a tax-deductible expense to the employer.

Upon the death of the employee, his or her heirs will receive a taxable income or a taxable lump sum depending upon the design of the plan.

The advantages of such a plan to the employer are that there are few ERISA requirements, it can be provided for select employees, and it can be used as a tool for recruiting and retaining key employees. The advantages to the employee are that deferred comp plans are not subject to qualified plan deposit restrictions, the money can be used to supplement other retirement income sources, and the income accumulates tax deferred until withdrawn.

Most important of all…such a plan will not make headlines on a police blotter!

Bruce Fenton is a financial consultant, a writer, and the president and founder of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.