The Role of Life Insurance in Non-Traditional Planning
Advising for diversity
Grantor Retained Income Trusts
A Grantor Retained Income Trust, or GRIT, is an excellent estate planning tool for non-traditional couples. GRITs have been around for many years. Prior to 1990, they were commonly used by families to transfer assets to the next generation while minimizing gift taxes. However, this wealth transfer strategy was severely curtailed by the Revenue Reconciliation Act of 1990 because it worked too well.
The law amended the Internal Revenue Code to eliminate the use of GRITs between family members. Since non-traditional couples are not considered married under federal law – even if they reside in states that recognize same-sex marriage, or in the case of opposite-sex couples, common-law marriage – they are not considered family members. Thus, GRITs remain an extremely useful tool for transferring wealth between non-traditional couples. A GRIT is an irrevocable trust in which the grantor – such as the wealthier partner – transfers assets to the trust while retaining the right to receive all of the net income from the trust assets for a fixed term of years. The net income is distributed by the trustee of the GRIT to the grantor annually, or on a more frequent basis, pursuant to the trust agreement. At the end of the trust term, the remaining trust principal is either distributed to the beneficiaries (such as one’s partner) or may be held in trust for their benefit. Additionally, if the grantor survives the trust term, the principal of the GRIT is excluded from her or his estate for federal estate tax purposes. Where does life insurance come in? It is generally advisable for the grantor to create an Irrevocable Life Insurance Trust (ILIT) to own a policy on her or his life. This will provide liquidity to pay any estate taxes that may be owed if the grantor does not survive the trust term. Remember, non-traditional couples do not benefit from the unlimited estate tax marital deduction at the first partner’s death, so adequate life insurance is critical to meet any estate tax liabilities (and other liquidity needs, such as income for the survivor).
Charitable Remainder Trusts and Wealth Replacement Trusts
A great option for non-traditional couples who face potentially significant estate tax exposure, but who also have specific philanthropic objectives, is a Charitable Remainder Trust (CRT). A CRT allows an individual to make gifts to a charity of his or her choice, while also naming someone to receive income from the donated property. A CRT is an irrevocable trust with significant income tax advantages. It is often referred to as a “split-interest trust” because it has both charitable and non-charitable beneficiaries. A CRT also serves dual purposes: 1) To provide the donor and his or her partner with a stream of income – the income interest – for a certain term of years or for their lifetime; and 2) To have the balance of that asset – the remainder interest – eventually go to their favorite charity. A CRT allows your clients to make a gift to the trust in return for a stream of income. The income stream can be a fixed-dollar amount (also referred to as a Charitable Remainder Annuity Trust or CRAT) or a fixed percentage of the assets in the trust (a Charitable Remainder Unitrust or CRUT). When the gift is made into the trust, a current charitable income tax deduction will be allowed based upon the present value of the remainder interest that will ultimately pass to the charity. Income earned by the trust is not currently taxable. Instead, the income tax recognition may be spread out over the number of years in which the income stream is paid. The trustee sells the transferred assets at full market value with no current capital gains tax liability. The proceeds are then utilized to purchase an investment that will provide income for your client’s lifetime or for a period of years depending upon how the trust was designed. The income is paid on a yearly basis until the end of the trust term.
As with the GRIT, a CRT’s effectiveness can be enhanced in many cases with life insurance by creating a Wealth Replacement Trust (WRT), an ILIT that has significant estate tax and legacy benefits. It allows for the purchase of life insurance inside of the trust, thereby keeping the insurance proceeds out of the insured’s taxable estate. The beneficiary of the trust, however, is the insured’s partner so the insurance proceeds can “replace” the assets that were donated to charity using the CRT technique. The premiums for the insurance are paid using a portion of the income stream received from the CRT, resulting in no out-of-pocket expense. The overall result of this strategy is that the assets used to fund the CRT can be used to provide your clients with an income stream and to benefit their favorite charity, all without reducing the legacy ultimately left to the surviving partner. Charitable Lead Trusts and Wealth Replacement Trusts
Like a CRT, a Charitable Lead Trust (CLT) is considered a “split-interest trust” since the interest is divided between both a charitable and non-charitable beneficiary. However, unlike a CRT, a CLT pays the charity a stream of income first. The income stream can be a fixed-dollar amount (also referred to as a Charitable Lead Annuity Trust or CLAT) or a fixed percentage of the trust assets (a Charitable Lead Unitrust or CLUT). When the charity’s interest ends, the remaining trust estate is paid to the surviving partner as the non-charitable beneficiary. While CLTs come in many forms, one of the most common types is a testamentary CLT. A testamentary CLT is typically created by the wealthier partner’s Last Will and Testament or Revocable Living Trust at his or her death. Under the terms of the CLT, an income stream is paid to charity for either a term of years or for the life of a designated individual. There are rules to take into consideration regarding permissible measuring lives when a CLT is established for the life of one or more individuals. When the charity’s interest ends, the remaining assets in the CLT pass to the non-charitable beneficiary, such as the surviving partner. Regardless of whether the trust is a CLAT or a CLUT, the client’s estate will receive an estate tax charitable deduction based on the present value of the charity’s lead interest. While the present value of the non-charitable beneficiary’s remainder interest will be included in the gross estate, it may be possible to “zero out” the CLT so that the estate-tax calculation of the remainder interest is zero. How can life insurance enhance this planning tool? Remember that, with a CLT, the surviving partner does not receive any portion of the trust estate until after the charity’s interest ends. By purchasing life insurance inside of a WRT, your insured client can assure that her or his partner receives assets immediately at the client’s death, in addition to the “delayed inheritance” she or he will receive upon the charity’s interest terminating. In addition, this strategy allows the client to retain full control over assets during her or his lifetime without sacrificing the goal of making a significant charitable impact. While it’s true that non-traditional couples face estate planning challenges that married couples of the opposite sex do not, as this article shows, a thoughtful financial professional can help his or her clients overcome most of these with proper planning – and life insurance can play a critical role in the process.
by Cynthia L. Hearing, JD, CLU, ChFC, CLTCMs. Hearing, JD, CLU, ChFC, CLTC, is a consultant with the Business Resource Center for Advanced Sales at The Guardian Life Insurance Company of America. Prior to joining Guardian, she held positions with MassMutual, New England Financial and Prudential Securities.