Shared Dollar Life Insurance: An inter-generational approach to retirement planning

Transcription

1 Shared Dollar Life Insurance: An inter-generational approach to retirement planning

2 What will retirement look like for our children? If you are like most working people, from time to time you think about retiring. You may wonder what your life will be like and what your standard of living will be. If you re already retired, you know this first hand. Sometimes you may try to look even further into the future and think about what retirement will look like for your children. Will they be able to retire 20, 30, or 40 years from now? What will their standard of living be? Retirement planning could be a lot different for our children possibly a lot harder. The world seems to be changing in profound ways. Competition is increasing. Technology is rapidly transforming many businesses and industries. Good-paying jobs are harder to come by and require more skills. The workers and entrepreneurs of the future will need to be intelligent, quick learners who are both skilled and flexible. A big part of the cash flow we will have for retirement will most likely come from Social Security and work-based retirement plans (e.g. pension, profit sharing, 401(k), 403(b), HR-10, IRA plans, etc.). Will the same be true for our children when they retire? When we stop to think about their futures, there may be reason to worry. Retiring could be harder for our children for several reasons, including: 1. On average they should live longer, so their savings may have to last longer. 2. Ongoing inflation means the cost of living should keep rising. 3. Retirement benefits from employers and Social Security payments may be smaller. To retire comfortably, our children will probably have to be more self-reliant. If they get less from Social Security and company retirement plans, they will need to provide a larger portion of their own retirement income through savings and investing. To have a secure retirement, they will need good financial habits, self-discipline and effective money management skills. A big inheritance is unlikely Because we love and care about them, we want to help. But we may not be able to leave them much of an inheritance to supplement their retirement savings. How much we ll be able to pass on will depend on many factors which are out of our control, including: ĀĀ How long we live. Ā Ā The inflation rate and how much our cost of living will increase from year to year. ĀĀ How well our own qualified and nonqualified assets perform over time. Ā Ā The cost of health care and how much of it we will need to use. Life insurance may help Two things we could potentially use to help are some cash and some of our unused life insurance capacity. It may be possible to combine them to create a different kind of inheritance to increase their retirement security. Life insurance death benefits have been used to create inheritances for many years. If we are healthy, it would be relatively straightforward to purchase either a single life or second to die policy, pay the premiums annually and name our children/grandchildren as beneficiaries. If federal estate taxes are a concern, then our children (or a trust for their benefit) could purchase the policy and we could supply the premium dollars through annual gifts. Anyone who is wealthy enough could implement such a strategy. But many of us aren t wealthy, and those who are may not want to use their money this way. If a time comes when we can no longer pay the premiums, the policy could lapse and our money would be wasted. The traditional approach in which we provide both the insurability and all the premiums may not be workable or appealing. Consider a Shared Dollar Life Insurance Arrangement Concerned parents want their children to be responsible adults. We want to encourage them to plan ahead and to be financially strong. We can give them some strong incentives to do that by helping them develop a retirement game plan today. One way to do so is to partner with them in a strategy designed to supplement their retirement savings Shared Dollar Life Insurance. Because gifts from parents are often taken for granted, the partnership will require them to contribute part of the funds needed to pay policy premiums. Contributing financially to a life insurance policy may increase both their retirement readiness and their appreciation for what we re passing on to them. As parents we can contribute some of our remaining insurability and part of the premium cost. Some possible alternatives for sharing the policy premiums include: 1. Share premium costs each year. 2. Provide funds to pay the premiums for a specified number of years (e.g years); the children pay the premiums thereafter. 3. Pay a declining percentage of the premiums over time (e.g. 75% years 1-3, 50% years 4-6, 25% years 7-10, and 0% thereafter). 4. We pay the term insurance portion, the children pay the balance. 2

3 An alternative - insuring the children Insuring the parents isn t the only option. In some cases insuring the adult children may be a better alternative, especially when the parents are uninsurable or the premium cost is high. Sometimes children will be more interested in building tax-deferred growth through life insurance cash values. In this approach the child would own the policy and would share the premium costs with the parents. If the policy is designed with a minimum face amount to avoid becoming a modified endowment contract (MEC), it could potentially generate significant cash values for a child s supplemental retirement income. Insuring adult children rather than their parents could also help the children provide more financial security for their own families. Children who are married or have dependents may need death benefit protection of their own. When either or both parents are insured, the child must wait until the parent s death to receive any benefit. Cash value insurance on the children s lives could provide both death benefit protection and cash values for supplement retirement income. Cash values in a policy insuring the parents may not grow to a high enough level to make much of a difference in the child s retirement. Cash values in policies insuring the children should grow more quickly because the child s mortality costs are likely to be lower. Thus, the children could potentially realize significant benefits before the parents deaths. When the parents are insured and live past normal life expectancy, the children might well be retired for many years before death benefits would be paid. Alternatives to gifts: loans or Split Dollar The Shared Dollar strategy could be appealing to many parents. Many will like the idea of giving their children a direct incentive to save more for retirement. They should also like the fact that they won t have to pay all policy premiums themselves. Their children can elect to participate at a level that works for them. Still, some parents may not be comfortable making gifts. They may be worried that someday they may need to use the funds themselves. They may not want to take the chance that they won t have access to their contributions if their circumstances change. Fortunately, there are alternatives for parents who want to retain access to their money. Instead of using gifts, the parents can pay their share of the premiums through Intra-Family Loans or through a Split Dollar Arrangement. Loans are usually a more flexible option because they can be structured in different ways and thereby provide more options for customizing the partnership to meet their children s situations as well as their own. See Appendix I for additional information on Intra-Family Loans. Split Dollar Arrangements are usually more expensive and less flexible. Because they need to be in writing, an attorney will have to be hired to draft a formal agreement. Parents have the most security and control in an endorsement Split Dollar Arrangement in which they own the policy and the death benefit is split. The parent s estate receives death benefits equal to the greater of the policy cash values or the premiums the parents paid and the child receives the remaining death benefits. If the child is to own the policy, the collateral assignment method can be used, but then a new document a collateral assignment must be prepared and filed with the insurer to protect the parent s rights. What will retirement look like for our children? Shared Dollar Arrangements give parents an opportunity to help their children without decreasing their own retirement security. 3

4 Motivating the children So far we ve assumed that because Shared Dollar Arrangements are designed for the exclusive benefit of adult children, they will jump at the opportunity to participate. This may not be the case. In reality, some may be hesitant to participate. This could be the case for a variety of reasons, including: ĀĀ Fear of not having enough discretionary income to pay their share of the premium now or in the future. Ā Ā Uncertainty that paying part of the premiums is a good use of their own money. ĀĀ Familiarity with other retirement vehicles, but not with life insurance. Because of concerns like these, it is important that the Shared Dollar strategy is presented to the children carefully. Critical parts of the presentation include (1) why the parents want to do this, (2) why they ve chosen to use life insurance, (3) the details of the arrangement and (4) how the child, his/her spouse and children stand to benefit. In particular, they need to understand exactly what their risks are and why this strategy is a good deal for them. One of the best ways to show how they might benefit is to show them an internal rate of return (IRR) analysis on their share of the premiums. Flexible premium payment options Each year a new policy premium is due, the parents have the flexibility to choose how much to pay and the form in which they will make the payment. From year to year their contribution can vary in amount and in form. The strategy can potentially be revised to fit their own financial circumstances and those of participating children. Each year they do contribute, they can choose whether to make a gift, a loan, or a combination of the two. Policy ownership When we are the insureds and pay part of the premiums, we get to decide how the policy will be owned. Normally there are two alternatives. If we want to control and manage the policy, we can own it and name the child as the beneficiary. Then we can be certain that our child is paying his/her share of the premiums and not withdrawing cash values for short term needs. If we want to control how the death benefits are used, we can go to the expense of creating a trust and name it as the beneficiary. The trustee will distribute the death benefits according to the directions we put into the trust. However, if we don t need control, the child can own the policy and be the beneficiary. Implementing the arrangement Families that are interested in this concept often wonder what they need to do to make it a reality. There are several possible ways to structure a Shared Dollar Arrangement ranging from formal agreements to informal understandings and it can be customized to fit the goals of those participating. Here are some of the options for putting the partnership in place: A formal agreement - A written agreement is drawn up and signed by the parent and the child. The contract addresses all issues, including ownership, premium payments, policy beneficiaries, assignments, cash value access, etc. Parental ownership - The parent owns the policy and pays his/her share of the premiums as agreed. Each child pays his/her premiums either by making gifts to the parent, from parental loans or a combination of the two. When a child is the insured, he/she is the contingent owner of the policy and takes over ownership at the parent s death. This approach allows the parents to control the policy and lets them be sure the child is paying his/her share of the premiums. Child ownership - The child could be the policy owner and pay his/her share of the premiums directly. The parent s share could be provided by gifts or loans to the child; the child s share of the premiums could be added to the parent s contributions and the child could pay the total combined amount to the insurer. If the parent is making loans to the child, the parent could receive a collateral assignment to protect that interest. The trust approach - Parent establishes an irrevocable life insurance trust (ILIT) to own and manage the policy. The parent pays part of the premiums as gifts or loans to the trust and the child s portion of the premiums is gifted to the parent who then contributes it to the trust. Having all contributions come to the trust through the parent may prevent the child from being considered a grantor of the trust for income tax purposes. The trustee manages the policy under the terms of the trust and makes distributions as needed to accomplish the trust s objectives. By using an ILIT, the terms of the trust control distributions after the parent s death and protect the death benefits from potential claims from the child s creditors A Shared Dollar Arrangement in action Suppose Jane and Joe Smith are both 63 years old and want to give their two children some strong incentives to save for their retirements. They are open to using a Shared Dollar Arrangement. Assuming Jane and Joe are insurable and have enough unused life insurance capacity, they will arrange for each child to purchase and own a $500,000 survivorship policy insuring their lives. Jane and Joe will make gifts of one half of the premium payment annually to each child; each child will match that gift with personal funds and forward the combined total to the insurance company. Jane and Joe expect to pay their share of the premiums through gifts. If a child is unable to pay his/ her share of the premiums in any year, Jane and Joe have the flexibility to lend that child his/her share of the premium. Suppose the total annual premium on each level death benefit $500,000 policy is $10,000; Jane & Joe make $5,000 gifts to each child and each child matches that gift with $5,000 of their own personal funds. Because Jane and Joe are paying half the premiums, they are effectively giving their children the equivalent of a 50% discount on the premium payments. Assuming Jane and Joe are in standard health, the child s rate of return on the $500,000 death benefit is summarized in Table 2. 4

5 Potential Disadvantages A Shared Dollar Life Insurance Arrangement using a policy insuring either or both parents has several potential disadvantages, including: Ā Ā The life insurance policy may not perform as anticipated or as illustrated. Ā Ā The parents may not be able to contribute to the premiums as long as expected. Ā Ā If premiums can t be paid in any year prior to the insured s death, the policy could lapse or the policy death benefit may have to be reduced. Ā Ā If an insured parent lives beyond his/her life expectancy, the child may have to pay more premiums than expected. Ā Ā Some children may not be able to pay their share because of personal circumstances; there needs to be an understanding of what will happen in those situations. To avoid this problem it can make sense to have separate arrangements (and separate policies) for each child; this safeguard prevents the financial problems of one child from impacting the others. Potential Advantages There are also several potential advantages, including: Ā Ā At the insured s death the policy death benefits may create a potential inheritance. Ā Ā Death benefits paid out to the children can supplement other retirement savings. Ā Ā Death benefits paid to the children should be federal income tax free under IRC section 101. Ā Ā When parents pay part of the premiums, the child s potential internal rate of return on his/her portion of the premiums will be higher. Ā Ā By participating in the partnership and paying part of the cost, the child should have a greater appreciation for the benefits that are being provided. Conclusion Shared Dollar Arrangements give parents an opportunity to help their children without decreasing their own retirement security. It offers them a flexible way to work together to create a unique inheritance. From year to year parents have the flexibility to change how they structure their share of the funding and they can even position their money so they can get it back if needed. Sharing premium contributions gives children strong incentives to participate and potentially realize good internal rates of return on the funds they contribute. Shared Dollar Life Insurance Arrangements give us the potential to improve our children s quality of life when they retire. 5

6 Appendix one intra-family loans Demand loans can be very flexible. With these loans the parents retain the right to demand repayment at any time. If their personal goals, finances, the economy or the tax laws change in an unfavorable way, they have the right to demand repayment. Term loans are different. Term loans last for a specified time and can t be terminated early without the consent of all the parties. Because they last for a specified time, they generally have a fixed interest rate which is determined by how long the loan will last. If the loan will last less than three years, it is measured by the current IRS short-term interest rate. If it will last at least three years, but less than nine years, it will use the mid-term rate. If the term is nine years or longer, it will use the long-term rate. Term loans have the advantage of an interest rate that is locked in for the duration of the loan. With demand loans, the interest rate changes yearly and could go up in future years. Loans are most attractive when interest rates are low. Low interest rates mean that the interest payment due from the children or a trust for their benefit will be lower and thus more affordable. At present, current interest rates are extremely low. The interest rate summary in Table I shows the history of interest rates in recent years. Loan interest must be accounted for annually. How the loan interest will be handled is important. Fortunately, the loan interest can be handled in several different ways. The simplest way is for the child to pay the interest back to the parent. However, if the parent doesn t need the interest, the loans can be structured with no interest payment (an interest-free loan). In these cases, the fair market interest amount is treated a gift to the child. A third alternative is to accrue the interest by adding it annually to the loan principal. If all or part of the loan remains outstanding at the parent s death, he/she can have a provision in their will directing the executor to distribute the note(s) back to the child. This has the effect of forgiving repayment of the loan balance. When parents decide to make some or all of their contributions through loans, they want to be sure money is available to pay them back should the need arise. This is one of the reasons it makes sense to use cash value life insurance rather than term insurance. Cash value policies may give the parents some margin of safety if they actually do need to recover all or part of their contributions. At any time under a demand loan and at the end of the term with a term loan, the parent (as the lender) has a right to recover the premium contributions they have lent. In order for this right of recovery to be real, policy cash values must exceed the loan balance and the cash values should be formally assigned to the parent. This should not be a problem if policy cash values are reasonably managed and if the children are contributing their shares. It often makes sense for policy cash values to be collaterally assigned to the parents; this allows them to control the cash values while they are alive. Two types of cash value life insurance policies with the potential to build sufficient enough cash value to protect the parents investment are variable universal life and indexed universal life insurance. Table 1 Yearly interest rate summary * Year Short Term Mid-Term Long Term % 4.79% 5.09% % 3.46% 4.58% % 2.87% 4.32% % 1.94% 3.66% % 1.19% 2.95% %.95% 2.40% % 1.65% 3.32% % 1.72% 2.74% % 1.68% 2.61% *IRS Index of Applicable Federal Rate (AFR) Rulings 6

7 Table 2 IRR analysis on $500,000 death benefit Death at End of Year Policy Death Benefit Rate of Return on Total $10,000 Premium Rate of Return on Child s $5,000 Premium 5 $500, % 123.9% , % 40.4% , % 21.5% , % 13.7% , % 9.5% , % 6.9% , % 5.2% , % 4.1% , % 3.4% Decision checklist for a Shared Dollar Arrangement 1. Who will be the insured(s)? 2. What type of life insurance policy should be used? 3. How should it be implemented? (formal contract, parent ownership, child ownership, ILIT ownership, informal, etc.) 4. How large should the policy death benefit be? 5. How much will the annual premiums be? 6. How should the premium sharing arrangement be structured? 7. From year to year, how should the parents pay their share of the premiums gifts, loans or a combination? 8. Each year a loan is used, should it be structured as a demand loan or term loan? 9. When loans are used, what should the interest rate on the loan be? 10. How should the annual loan interest be handled? 7

8 These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor. The Voya Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone. You should seek advice from your tax and legal advisors regarding your individual situation. Life insurance products are issued by ReliaStar Life Insurance Company (Minneapolis, MN), ReliaStar Life Insurance Company of New York (Woodbury, NY) and Security Life of Denver Insurance Company (Denver, CO). Within the state of New York, only ReliaStar Life Insurance Company of New York is admitted and its products issued. All are members of the Voya family of companies. Not FDIC/NCUA Insured Not A Deposit Of A Bank Not Bank Guaranteed May Lose Value Not Insured By Any Federal Government Agency 2016 Voya Services Company. All rights reserved. CN /15/2016 Voya.com