If you intend to benefit a favored charity upon your death, life insurance is a fertile area for research. If you have liquid assets set aside to meet estate obligations and are in good health, you might find this example interesting. If you are a charity, you might want to find some folks to participate with you.
Bill and Jean, both 70, have transferred their business to their children and have a frozen capital gain of $1.5 million. They estimate the taxes on that gain to be about $375,000 but not due until they are both gone. They have set aside $500,000 for their tax obligation and to leave $125,000 to their favorite charities. While either of them is alive, they will invest this money in liquid, interest bearing investments, like short term bonds and spend the income. (For convenience, we have assumed a tax rate of 50%. The actual maximum rate in Ontario at the time of writing is 48.4%.) They assume that they can earn 3% or $15,000 pretax and they will spend $7,500 after taxes are paid. A tidy plan that takes care of two estate issues and provides a bit of income in the interim.
When they visit with their accountant, they find that their charitable bequests will reduce their income taxes due at death by about 50 cents per dollar given away. On discovering this, they revise their plan. Instead of $125,000 for charity, they now allocate $250,000. The donation will save about $125,000 in income taxes and they will owe only $250,000 on their capital gain. Their $500,000 remains enough. $250,000 to the government and $250,000 to their charity.
Bill and Jean will likely never find out that there is a much better way to arrange their affairs. If they happen to meet the right person, they will find it is possible to give away their taxes while increasing their annual spending from $7,500 to $9,500. All guaranteed by major financial institutions.
Here’s what they need to notice. Now they invest to meet two goals with one investment. Retain liquidity against the cash need in the estate and accept whatever income a secure, liquid investment can provide. In their estate no net capital will remain from the $500,000 and in the interim there will be $7,500 per year of after tax income. Their $500,000 means $7,500 per year to spend and money in the estate to meet two obligations.
Here’s how they can get more money with the same meaning.
Instead of investing in liquid investments Bill and Joan recognize that the only time they need their capital to be liquid is when the second of them dies and the income in the interim is not crucial to their lifestyle. With those recognitions in mind, they arrange specialized products to meet their specialized needs. They do that instead of using general purpose investments. See the Swiss Army Knife Problem.
The first of these products is a joint life, second to die, life insurance policy for $750,000 with level cost of insurance. Once approved for insurance, they will use their $500,000 to buy a life annuity with payments due while either is alive.
The annuity will pay them about $30,000 annually the insurance cost will be $18,000. Taxes will be another $2,500. Their net cash flow while living is $9,500 annually – up from $7,500 before. (All numbers approximate)
On the second death, their estate will donate the $750,000 insurance proceeds to charity and get a tax credit of $375,000. Enough to eliminate their income tax liability.
The summary. Their spending money will be 30% greater while they are alive and their favorite charities will receive an extra $500,000 on their death.
The example here is about the simplest example possible. Given more information about their intentions, significantly different answers could appear. You might want to investigate.
Also, notice that not everyone is in “standard health” and rates change with age and from time to time. Your mileage may vary, so check with a professional.
A great portion of financial success is finding options. You will be looking to get the same meaning in a more efficient way. Reorganizing apparently disconnected aspects of an estate plan into specialized products sometimes can benefit everyone. Well, I suppose everyone but the government.
I’m okay with that.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. firstname.lastname@example.org