Trieschmann, Hoyt & Sommer
Financial and Estate Planning
Chapter 21
©2005, Thomson/South-Western
Chapter Objectives
• Explain the differences between the goals of financial planning and
estate planning
• List three factors that may result in estate shrinkage
• Describe the nature of death taxes and explain the basic approach
for computing federal estate taxes
• Explain why a will is an important estate planning tool
• Provide an example illustrating how gifts can be used to achieve
estate planning goals
• List the basic elements of a trust and explain how trusts can be used
in estate planning
• Analyze a family situation and make recommendations to deal with
the risks of premature death and loss of health
• Explain the important factors in selecting an insurer, an insurance
policy, and appropriate ways to compare the costs of different
policies
2
Financial Planning
• The term financial planning achieved
widespread usage during the 1970s and 1980s
– Individuals sought ways to deal with the effects of
high interest, inflation, and taxation
• To some people, financial planning primarily
involved schemes to shelter income from taxes
– To others it was synonymous with investment
activities
– And to others it was merely another term for
insurance sales
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Financial Planning
• Agreement has emerged about some aspects of
the concept and about those who call
themselves financial planners
• Financial planning is defined as a process
involving
– The establishment of financial goals
– The development and implementation of a plan for
achieving those goals
– The periodic review and revision of the overall plan
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Financial Planning
• Many similarities exist between the financial planning
process and the risk management process
– But risk management is properly classified as a subset of
financial planning
• A complete financial plan also involves analysis of
elements not associated with pure risk
– Examples include cash flow management, income taxes,
investments, and estate transfer plans
• Recognition of the overall financial planning context
should lead to a better understanding of the ways in
which life and health insurance, annuities, and employee
benefits can best be used to solve personal risk
management problems
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Estate Planning
• An executor fund is one of the financial tools often
associated with death
• Estate planning
– Advance arrangements designed to ensure that assets are
preserved and distributed in the manner the owner intends
• Objectives of estate planning are
– Minimizing the cost of transferring property to heirs
– Providing liquid funds to pay transfer cost in the most
economical way possible
– Assuring that estate assets will be transferred to the desired
beneficiaries
– Planning for the most efficient use of estate assets
6
Estate Transfer Costs
• Several factors may cause a reduction in the
size of the estate distributed to the heirs
– Sometimes known as estate shrinkage
• The reduction is caused by one or more of the
following
– Debts
– Costs incurred by the person administering the estate
– Taxes
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Debts
• At death, existing debts must be paid
before remaining assets can be distributed
• Typical debts include
– Mortgages, charge accounts, income taxes
due, and installment obligations
• As a percentage of the estate’s size, debts
average from 4 to 8 percent of total assets
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Administrative Costs
• The executor of an estate is the person appointed to
carry out the terms of the deceased person’s will
• If a person dies without a will, he or she is said to have
died intestate
– Courts will appoint an administrator to handle the duties that
otherwise would have been performed by the estate executor
• Depending on the types of property owned and the
complexity of the plan for distributed estate assets
– Sizable administrative costs may be incurred by the estate
executor or administrator that usually must be paid in cash
• Examples include appraisal fees, brokerage fees, court costs, legal
fees, accounting charges, premiums for property and liability
insurance on estate assets, and fees to compensate the executor or
administrator for services rendered
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Death Taxes
• A major reason for estate shrinkage is taxes
• Federal law allows for an estate tax on the right
of a decedent to transfer property at death
• States may also levy estate taxes
• If the estate is not sufficiently liquid
– Assets may have to be sold in order to pay estate
taxes
• Some states levy an inheritance tax on those
who inherit property
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Death Taxes
• The first step in computing the federal estate tax is to
calculate the value of all property owned by the decedent
at the time of death
– If the property was jointly owned with others, only the decedent’s
interest in the property is counted
– From this total, the costs associated with the decedent’s funeral
and burial, debts, and estate administration are subtracted
– Two major categories of deductions are then considered
• If the decedent was married at the time of death, all the estate
assets left to the surviving spouse are deductible
– It may be possible to use the marital deduction to effectively eliminate
all estate taxes payable upon the death of the first spouse who dies
• A charitable deduction is also allowed if estate assets are left to
charitable organizations
• If the decedent made any gifts after 1976 that exceeded
the allowable gift tax exclusions
– The total of those gifts must be added back to the estate and
considered in computing the estate tax payable
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Death Taxes
• The Economic Growth and Tax Relief Reconciliation Act
(EGTRRA) of 2001 made massive changes in federal
estate tax rules
– Before its passage, the maximum estate tax rate was 55%
– After its passage the maximum rate is scheduled to gradually fall
to 45% by 2009
• Then to 0% in 2010, when all estate taxes will be repealed
– The unified transfer tax credit effectively eliminates all estate
taxes for taxable estates up to a certain dollar amount
• Prior to EGTRRA this exemption amount was $675,000
– Scheduled to gradually rise through 2009 and become irrelevant in
2010 once estate taxes are repealed
– See Tables 21-1 and 21-2
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Table 21-1: Unified Rate Schedule for
Estate and Gift Taxes, Pre-EGTRRA
13
Table 21-2: Estate Tax Rates and
Exemption Amount Under EGTRRA
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Death Taxes
• Two other credits are available to reduce
the actual estate tax that must be paid
– If any gift taxes have been paid in the past
• They are subtracted from the estate tax payable
– The amount of state death taxes payable is
credited against the federal tax due
• Subject to specified maximums
15
Wills
• A will is one way to transfer ownership of property at
death
• To be valid a will must usually be in writing and
witnessed by two or more persons
• Because each state has specific laws regarding wills
– Each time an individual moves from one state to another, his or
her will should be reviewed for changes that may be necessary
or desirable
• When a person with a will dies, the will’s validity is
established through process called probate
– In a special court called probate court
• Which also oversees the work of the estate executor throughout the
estate settlement process
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Wills
• The existence of a valid will is important for
ensuring that a decedent's property is distributed
in the way desired
– Rather than in the arbitrary manner that might
otherwise be dictated by state intestacy laws
• However, not all property owned at the time of
death necessarily is governed by the terms of a
person’s will
– For example, when property is owned jointly with the
right of survivorship, ownership automatically
transfers to the surviving owners when one of the
owners dies
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Wills
• Policy proceeds that are payable to a named
beneficiary are not part of the decedent’s
probate estate
– The simple act of naming a beneficiary in a life
insurance policy may result in administrative savings
during the estate settlement process
• A valid will is considered to be an essential part
of most effective estate plans
• Wills provide security about the distribution of
estate assets and facilitate some cost-reducing
estate planning tools
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Life Insurance
• Unless sufficient liquidity exists within an estate
– Other assets will need to be sold to pay estate taxes
and other transfer costs
– If these assets are not readily convertible into cash,
forced sales may result in unnecessary losses for the
heirs
• However, if life insurance proceeds are payable
in an amount approximately equal to the transfer
costs
– The estate will have liquid resources available
precisely at the time that they are needed
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Life Insurance
• The unlimited marital deduction for federal estate tax
purposes is helpful to most couples’ financial and estate
plans
– But it may lead to a very large estate tax liability after the second
spouse dies
• Sometimes the payment of estate taxes will require the
liquidation of family businesses or other assets that the
couple would have preferred to keep in the family
– To overcome this problem, insurers offer survivorship life
insurance
• Sometimes referred to as second-to-die life insurance
• They insure two lives but pay only after both insureds have died
• Coverage is generally less expensive than either an equivalent
amount of insurance on one spouse’s life or half the amount on both
spouses
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Life Insurance
• Life insurance can also be used as a risk
management tool to safeguard the
continuation of a business
– Small businesses face loss exposures arising
out of the death of a sole proprietor, partner,
or major stockholder
• One method of addressing this problem is for the
owners to enter into buy-sell agreements while all
of them are still alive and well
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Life Insurance
• Buy-sell agreements state that a deceased
owner’s share in a firm is to be purchased by
one or more specified individuals during the
estate settlement process
– The buyer agrees to buy and the seller agrees to sell
• With the sale price or the method for determining the price
specified in the agreement
– Even with such agreements in place, a remaining
element needed to ensure business continuation is a
way to fund the sale
• This need is often met through the purchase of life insurance
22
Gifts
• Reducing an estate through gifts while the
owner is still alive is another way to reduce
estate transfer costs
• Federal gift taxes may apply to living transfers
• Individuals can give up to $11,000 per donee per
year without incurring any gift taxes
• Gifts from one spouse to another and to
charitable organizations are fully excluded from
gift taxes
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Gifts
• Gifts of life insurance policies can be
especially effective for estate planning
purposes
– Because such gifts are valued at their predeath values
– In most cases, that amount approximately
equals the policy’s cash value at the time the
gift is made and is considerably less than the
face amount that might otherwise be included
in the decedent's estate for tax purposes
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Trusts
• Involves the transfer of property from a donor to
a trustee for the benefit of one or more of
beneficiaries
• Trustees have legal ownership of the trust
property
– But they are required by law to manage and distribute
in accordance with the instructions specified in the
trust agreement
• If the trust is set up while the donor is still alive
– It is called an inter vivos or living trust
• If the trust is created at the donor’s death
through a will
– It is known as a testamentary trust
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Trusts
• Life insurance trust
– Will collect, invest, and distribute the policy proceeds
when the insured dies
– An individual, a bank, or another financial institution is
specified as the trustee
– The trustee is the beneficiary of the life insurance
policy
• The trust agreement specifies how the proceeds should be
used
• The donor can specify how the proceeds are to
be invested by the trustee
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Trusts
• Credit shelter trust
– Possible to decrease taxes while still retaining most of the same
advantages for a surviving spouse
– To implement this arrangement, both spouses can insert
provisions into their wills that would establish a credit shelter
trust when the first of them dies
– Instead of transferring ownership of all assets directly to the
surviving spouse
• Some of the assets owned by the first of them to die would be
placed into the trust
– With the remaining assets given to the survivor
• The amount placed in trust should equal the amount exempted from
estate taxes
– The marital deduction eliminates all taxes on the assets transferred
immediately to the surviving spouse
» The unified transfer tax credit exactly offsets the estate tax that
would otherwise be due on the amount placed in trust
– See Table 21-3
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Table 21-3: Illustration of Estate Transfer
with and without Credit Shelter Trust
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Considerations in Buying Life and
Health Insurance
• Many individuals conclude that insurance is an
appropriate risk management tool for their
particular situations
• That conclusion must be implemented with the
selection of a particular insurance company and
a specific insurance contract
• Assumptions that all insurance companies and
policies are the same may lead to inefficient
purchases and unnecessary future problems
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Coverage Needed
• Some people mistakenly assume that all
insurers offer the same coverages
• However, some insurers write only very
basic forms of insurance while others offer
many innovative variations of the basic
policy forms
• Some insurers have developed expertise
in specialized niches
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Evaluating Financial Strength
• An insurance policy is of little use if the insurer
selling it does not have the financial strength to
pay losses when they occur
• Two important factors in assessing an insurer’s
financial condition are
– The quality of its investments and the relative size of
its surplus
– All states regulate both of these factors
• But concern does exist about the ability of states to
adequately regulate the solvency of large insurers
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Evaluating Financial Strength
• Most insurance purchasers are ill-equipped to
analyze the financial strength of insurers directly
• Several secondary sources of information are
available
– Best’s Insurance Reports
• Reports financial and operating information about many
insurers along with a rating of the financial strength for most
insurers that have been in business at least five years and
have annual net premiums of at least $1.5 million
– Standard and Poor’s Corporation
– Moody’s Investors Service, Inc.
– Duff and Phelps, Inc.
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Evaluating Service
• The element of service in the selection of an
insurer may have two aspects
– The service provided by the agent
• Sometimes agents act merely as order takers while at the
other extreme they may develop and maintain
comprehensive plans of insurance designed to meet
changing client needs for a lifetime
• Agents may sell policies that come closest to meeting the
real needs of their insureds or they may sell policies that
provide themselves with the highest commissions regardless
of whether the policies are appropriate
– Service provided by the insurer’s home office
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Evaluating service
• Perspective insureds should ask questions about the
degree of service that can be expected of an agent
• In judging the quality of service that may be received
from an agent, some factors to consider are
–
–
–
–
The methods employed in selling the coverage
The length of time the agent has been in business
References from impartial sources
Evidence of professional accomplishments, such as possession
of CLU or ChFc designations
• Life and health insurance policies often are long term
contracts involving 30 or 40 years of premium payments
to the insurer and 20 or 30 years of benefit payments to
the insured or to beneficiaries
– Thus, service from the insurer’s home office is also important
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Selecting a Contract
• Two important considerations in buying life and
health insurance are
– A good understanding of the goals and purposes the
buyer wants to achieve
• For example, if the goal is to increase the estate’s liquidity for
the payment of estate taxes, some form of permanent life
insurance might be an appropriate choice
– A general idea as to how much can be spent on
premiums
• If premium dollars are scarce and the primary goal is to
provide additional income for survivors until children are old
enough to support themselves
– Decreasing term insurance would probably be the best decision
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Contractual Provisions
• Relatively few basic types of life and health insurance
exist
– Literally hundreds of different arrangements of these basic types
are sold
• Before comparing the cost of two whole life insurance
policies, for example
– One must make certain that each has the same waiver of
premium provision, settlement options, policy loan clause, and
nonforfeiture and dividend options
• Before comparing prices for disability income policies,
one must ensure that the following components are
comparable
– Elimination period, definition of disability, maximum period for the
payment of benefits
• Comparing health care policies can be even more
complicated
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Cost Factors
• If two health insurance contracts are
sufficiently alike to warrant comparison the
next step is to compare their premiums
• Some policies may be participating
– Dividends are payable periodically if
experience warrants
– Such policies usually have higher gross
premiums than comparable nonparticipating
contracts
• But may be less expensive after dividends
37
Cost Factors
• Comparisons of life insurance costs are
more complex
– One cost comparison method that has
achieved some acceptance within the industry
is the net payment index
• This method computes the level annual payment
that, if invested at a stated interest rate for a
specified time period, will accumulate to the same
total as would the policy’s net premiums if invested
in the same way
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Cost Factors
• Another life insurance cost comparison method is the
surrender cost index
– Incorporates consideration of a policy’s cash value at of a
particular point in time
– Most appropriately used to compare policy costs when an
individual plans to keep a policy in force until a specified time
• After which it will be surrendered for its cash value
• A drawback of this method is that it can be manipulated by insurers
through the judicious specification of their cash values at intervals
most likely to be selected by buyers for surrender cost index
comparisons
• It is used because of its relative simplicity
– If an insured intends to keep their coverage in force until death
• The net payment index is a more appropriate method to use
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