PROBLEM PRESENTED:

In 1993, the maximum estate tax rates were 55% and the lifetime estate and gift tax exemption amount was only $600,000. To save potential estate taxes, a couple with two children bought a $784,000 joint and survivor policy on themselves jointly as a legacy benefit for their children. Had they died while these tax laws in effect, their heirs would have needed the funds to pay the high estate taxes on the value of the couple’s respective estates.

With estate tax rates so high, it made perfect sense to reduce the size of the couple’s potential estate, given the value of the father’s business, and leverage the legacy gift for his children to cover the high estate tax rates.

Fast forward to 2019. The father’s business had closed long ago, and the couple had to live on far lower asset values than expected for over 20 years. Now, as the couple entered their retirement years, they needed supplemental retirement income, but the policy was tied up in the Irrevocable Trust for the benefit of the children.

The paid-up policy carried a cash value of nearly $229,000, and a death benefit of nearly $784,000.

The policy at this point is not marketable to outside parties. The Life Settlements market typically requires the youngest on the joint policy to be over 65 and the cash value to be less than 10% of the death benefit amount—both conditions not present here. Plus, there was too much cash value inside the policy for the Life Settlements market to pay up for.

SEVERAL PROBLEMS SOLVED:

Both children have above average incomes and low debt levels (as a result of prior gifts to them to buy their first homes). They wish to help out their parents in retirement without impinging on their current lifestyle.

One option is for the trust to merely cash in the policy for $229,000 and pay out the proceeds to the children. In turn, the children could gift back the proceeds to their parents, using up some of their respective lifetime gift and estate tax exemptions.

The parents then will be faced with a decision as to how to invest these proceeds with the least risk and still earn a reasonable return on funds that need to remain fairly liquid–quite difficult in today’s low interest rate environment.

ALTERNATE STRATEGY PROPOSED:

The Trust could sell the policy to the two children over 15 years, with interest at 3%, slightly above the 20-year US Treasury rates (which was 2.92% at the time of review).

This gives the Trust decent safe income, as their children are, essentially, paying the Trust what the Trustee could get in safe fixed income investments, and the children would be unlikely to default in paying for the policy, as their parents are the intended beneficiaries.

Nevertheless, the Trust would maintain the policy as collateral, until fully paid by the children. That way, the Trust owns a lien on the policy.

Once the mom turned 65, the Trust could strip out the cash surrender value from the policy, which would be higher than it is now, and then sell the lower value policy (death benefit less the cash value stripped from the policy), to the Life Settlements market.

The combined stripped out cash value plus the payment from the Life Settlements market would significantly exceed what the parents could get from simply cashing out the policy today and investing the proceeds in the market. The reason is because an in-force policy has a valuable $784,000 death benefit attached to it. Once the policy is cashed in, that death benefit disappears.

The children, assuming they pay the 180 monthly payments, would own an asset that will ultimately pay them over $784,000 in death benefit, for a total investment of only $284,409 paid over 180 months. That’s 2.7 times more than what they will have paid for the asset.

If the parents pass away earlier, the death benefit could greatly exceed the accumulated payments they made into the policy. If the parents pass away past their life expectancies, the children receive the greater benefit of having their parents alive longer, but will still ultimately get back their investment plus growth of 2.7 times what they invested into the policy as a death benefit.

Since both children have discretionary income to afford the policy purchase, they get the side benefit of adding half the value of the policy to their personal net worth statements.

It’s a win-win situation for all:

–Mom and Dad get supplemental retirement income over 15 years, without worrying about market crashes.

–The children can get tax-sheltered growth of an asset paid out to them as cash at some
point, worth 2.7 times what they paid for it.

–At the end of 15 years, the children own the policy free and clear of the Trust’s lien.

–At that point, they could borrow against the cash value for whatever needs come up.

–They can choose to pay the loan back on their terms, with interest, into the policy for a
full restoration of death benefit.

–Thus, the policy itself can serve as the equivalent of a “private bank account” for the children, with a growing cash value they can tap as needed. Any loans and accrued interest outstanding at the death of the last parent, would simply be subtracted from the ultimate $784,000 death benefit paid out to them.