Estate Planning Often Fails to Protect Your Family
Creating a Will or Trust Does Not Solve Many Key Problems
What is Estate Planning?
Insurance companies, banks, financial advisors, and many attorneys all advertise that they will help you with your estate plan. However, when financial advisors talk about estate planning, unless you are using the proper disclosures, many people can be confused as whether you are providing financial and/or legal advice.
The Answer
An effective estate plan is one that protects and provides, for you and your loved ones, now and in the future. Then, this plan distributes your property the way you want, when you want, and how you want, while paying the minimum of taxes and expenses and causing the smallest possibility of a family feud. The reality is the only way this effective plan can happen is when two things occur:
1. You take advantage of utilizing the skills of lawyers, accountants, financial planners, insurance professionals and/or trust officers.
2. Each of these financial professionals involved work together to coordinate and integrate this estate plan so that it works in harmony with the rest of this client’s comprehensive financial plan.
Example: Sam and Sally
Sam and Sally meet with a seasoned estate planning attorney to develop an estate plan. During the interview the estate planning attorney discovers that Sam has several old life insurance policies which would provide $300,000 to Sally if Sam died, and the total cash value of the policies are $280,000. The cash value is what the insurance company would pay Sam today if Sam turned in (surrendered) the insurance policies while Sam is still alive.
Like many seniors and baby boomers, Sam draws income from a pension plan which has a 50% Survivor Benefit. Therefore, after Sam dies, Sally will receive only half of his pension income, which creates a significant decrease in not only Sally’s income and standard of living, but also her ability to maintain the payments and upkeep of their house.
Like most seniors and baby boomers (and homeowners for the most part), Sally’s home is her pride and joy. She has spent thousands of hours on activities and improvements such as landscaping, building beautiful flower beds, decorating her kitchen, adding a wonderful deck and patio, and so on. Sally enjoyed making her home a very pleasing and comfortable place, and this special home is filled with many wonderful memories of family gatherings.
What is the Central Problem?
As mentioned earlier, the lawyers can create the Wills, Trusts, Powers of Attorney and property transfers to make their estate plan perform as they believe to be effective. But, the reality in most cases is that these documents do not save Sally’s house. The central problem in Sam and Sally’s estate is not the legal documents.
Their original intention was to prepare the proper legal documents and estate plan that would ensure their property goes to whom they want, when they want, and how they want, with the minimum of taxes and expenses. However, in this case, this does not accomplish some of key goals which have been overlooked or ignored.
The problem here is that Sally, who statistically is likely to survive Sam, will not receive enough life insurance proceeds to replace the income she needs in order to stay in her beloved home after Sam dies. As with most cases, the children of Sam and Sally have their own families, are well established and don’t need (or are not depending on) Sam and Sally’s money to live on. And now at Sally age and place in life, the so-called “golden years”, she does not have the stamina, skills, or desire to go back into the workplace.
Providing For the Surviving Spouse
In this case, the proper solution to this central problem would have been for Sam, or a qualified financial advisor, to identify this potential problem, and exchange his insurance policies for a new insurance policy that will provide enough money for Sally to live on after Sam dies.
Not only is this something financial advisors are trained to protect retirees agains, but they are also likely to know that the tax code under Section 1035 allows Sam to exchange his old policies for a new policy with a higher death benefit and lower cash value. The best part is this life insurance policy can exchange without paying any taxes at the time of the exchange, even though Sam is using his untaxed earnings (capital gains, dividends, interest, etc.) in his insurance policy to buy something of greater value to him.
The Main Purpose of Life Insurance
There are many reasons people or families choose to buy permanent life insurance, since it can serve many purposes. For example, some purchase these policies as an investment due to the upside growth potential of the cash value. Others purchase these permanent policies as a tax-saving or tax-deferral vehicle, since the cash value grows without being tax, and if managed properly, can be withdrawn without paying taxes or penalties. One other common use of permanent insurance is to replace the income or estate taxes which could be due at the death of the surviving spouse.
However, the basic definition of insurance is the transfer of risk. Therefore, the most common reason people own life insurance is to replace the income lost in the event a spouse were to unexpected die, transferring the risk of a premature death to the insurance company. In this case, with $280,000 of cash value and a death benefit of $300,000, Sam has nearly all of the risk of his death on his shoulders and his insurance is providing him virtually no leverage.
This is the type of information that should be discovered by a financial advisor or insurance agent in the initial stages of the planning process, or discovered and brought to Sam and Sally’s attention during a review of their estate plan. By simply asking questions regarding the amount of income Sally will have to live on should Sam die, how much life insurance Sam has, what kind of life insurance Sam owns, and what the cash value amount is, this potential problem could have been easily avoided.
Solving the Central Problem.
The best possible solution is for Sam and Sally to have a qualified estate planning attorney and trustworthy financial and/or insurance professional working together. The insurance professional’s role would be to “shop around” and locate an insurance company that would be willing to offer Sam the best and most appropriate policy, with the goal being the largest death benefit and the longest duration. Sam and Sally would then pay for this life insurance policy by using the cash value from Sam’s existing insurance policies.
The Features and Benefits
This aforementioned life insurance policy exchange, known as a 1035 exchange, does not require Sam and Sally to write a check, there are no tax consequences when they “trade the cash value” for this new policy, and they will not be required to pay any future insurance payments because they used the entire cash value to pay for this new policy in a lump-sum.
So if Sam owns a permanent policy, this is better in every way. If Sam owns a policy where the life insurance protection only lasts for a certain number of years (commonly referred to as either Term Insurance or Universal Life Insurance), Sally will likely receive a much high amount of life insurance proceeds, and when combine with some of their other assets and income sources, this will likely be enough for Sally to stay in her beloved home.
Of course, Sam had the alternative of taking the $280,000 out of the policy and investing it in hopes that he could grow this $280,000 to a much higher amount, there are two major problems with this strategy. First, there is risk. For example, in 1966, the DJIA reached 1000 for the first time. However, approximately 8 years later the DJIA plummeted to 570 at the Watergate Bottom, losing nearly 50% of its value during this 8-year period. Another example is back in 1999 when the Nasdaq surged to approximately 5000. However, 10 years later, the Nasdaq was below 1000, losing 80% of its value over this 10-year period. The second problem is, even in a rising stock market trend such as 1990 to 1999, there are no guarantees Sam will live to a certain age. Remember, the main goal of using this strategy is to transfer Sally’s risks to an insurance company.
How Can this Fail?
This happens very frequently because Sam’s prior insurance agent failed to discuss the possibility of this future problem with Sam and Sally. However, if Sam had consulted with a qualified insurance agent or financial advisor, he or she would have likely recognized this problem and either suggested a solution or recommended that Sam and Sally perform annual reviews to monitor this problem in the years ahead. This happens far too often in the financial professional industry, and the most common reasons are:
1. Some financial professionals tend to focus solely on products or strategies where they are compensated
2. Others fail to recognize the importance and necessity to coordinate with the other key financial professionals who are directly or indirectly involved
3. Some financial professionals simply fail to lack the training and expertise to understand these issues and options.
Key to Creating an Effective Estate Plan
Arguably the key ingredient in creating an effective estate plan is working together with a team of financial professionals who are looking out for the clients best interest from a “big picture standpoint”. By working with a team that includes key financial professionals like a CPA, estate planning attorney, insurance professional, financial advisor, or personal banker, each of them can make an important contribution in helping to protect and preserve an sound estate plan.
Questions or Concerns?
Please contact our Estate Planning Expert Roger McClure at (571)-633-0330 or www.wealthcounsellors.com
