Tax-Optimize Trusts with Investment-Only VAs

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1 ADVISOR DREW J. BOTTARO ESQ., CFP, VP & SR FINANCIAL COUNSELOR WESTON FINANCIAL ADVANCED PLANNING TECHNIQUES: Tax-Optimize Trusts with Investment-Only VAs When asked about the benefits of financial planning with trusts, Drew J. Bottaro, Esq., CFP, Vice President & Senior Financial Counselor, Weston Financial (Weston) says Trusts are frequently used in the high net worth and ultra-high net worth space those with investable assets of $5 million to $10 million or more. It s not necessarily complicated to use annuities with trusts and there can be measurable benefits in certain scenarios. He goes on to say, Tax deferral is one of the primary benefits. And that s where a low-cost Investment- Only Variable Annuity with a broad choice of underlying funds provides the competitive advantage. To learn more, we had a conversation with Bottaro about Weston s approach to leveraging tax deferral when using annuities with trusts: Q: TO START, TELL ME IN YOUR OWN WORDS WHAT MAKES YOUR FIRM UNIQUE. WHAT DRIVES YOUR SUCCESS? A: What s different about Weston is our 35-year commitment to every aspect of the comprehensive planning process. That is not universal in the industry. Our firm was founded in 1979, several years before the CFP board was created, years before the six-step planning process was commonplace. So that gives you some idea how a strong and enduring commitment to doing financial planning is embedded into our firm s foundation. Q: WHO IS YOUR TYPICAL CLIENT, AND WHY DO THEY USE YOUR FIRM? A: We have no typical client. Our firm s service model works very well for the high net worth who have $5 million to $10 million in investable assets; and for the ultra-high net worth who have $10 million or more. Not surprisingly, the majority of assets under management come from those clients. However, our clients investment assets range from $0.5 million to over $40 million. The experience we ve gained over 35 years makes us able to deliver custom financial planning advice very efficiently for clients in the $1-$5 million range as well. CONTINUED>

2 We ve used annuities as funding mechanisms either inside or outside the trust. It s not necessarily complicated and there can be tremendous benefits in certain scenarios but there are nuances. Tax deferral is one of the primary benefits. Our clients choose us because they know they re not getting a generic plan. We treat all our clients with an individual commitment and the highest level of expertise. They re getting something that is highly individualized for their needs, by an advisor who is using sophisticated tools and is able to focus on the key issues that matter most. A trained and experienced planner offers a measure of objectivity, professional guidance, a disciplined process based on analysis. It goes far beyond what most clients have time or training to do themselves. Q: LET S DISCUSS ONE OF YOUR SPECIAL AREAS OF EXPERTISE THE TOPIC OF FINANCIAL PLANNING WITH TRUSTS. A: All right. Full disclosure: I do have a law degree. I ve taught estate taxation at the graduate level. You ll get a very detailed answer here. A trust, in and of itself, is a device, where the prior owner or the grantor usually has very limited control of the assets. The beneficiaries also have very limited control of the assets. Then someone in the middle called the trustee has the legal title. For income tax purposes, a trust allocates taxation between the beneficiaries and the trustee, depending upon its design and the nature of the income. At Weston, we recommend trusts for two main purposes. One is for controlling assets that one person owns or used to own, where someone else is the beneficiary. That s the classic purpose, the governance point of view. The second, which tends to drive the decision more often lately, is tax planning typically estate tax planning or income tax planning. Q: WHAT TYPE OF CLIENTS CAN BENEFIT MOST FROM USING TRUSTS FOR INCOME TAX PLANNING, AND WHAT TYPES OF TRUSTS DO YOU TYPICALLY RECOMMEND? A: Income tax planning with trusts is very situational. It s not something we recommend for everybody. But it usually does apply to many in the high net worth and ultra-high net worth space those with $5 million to $10 million or more. And it can often make sense for clients in the $1 million to $5 million range. We recommend trusts mostly in the estate planning context. This can include charitable planning, charitable life planning, lifetime gifting planning, revocable trusts, and the family and QTIP trusts that typically are created at estate time. If a client is charitably oriented, we can do a lot of magic with trusts, whether they re remainder trusts or lead trusts. Charitable planning can include charitable remainder trusts for someone with appreciated property. These are either annuity trusts (fixed payments) or unitrusts (fixed percentage of assets, recalculated annually). Each type has variations, but that s the essence. Q: WHEN IT COMES TO INCOME TAX PLANNING WITH TRUSTS, WHERE DO ANNUITIES MAKE SENSE? A: We ve used annuities as funding mechanisms either inside or outside the trust. It s not necessarily complicated and there can be tremendous benefits in certain scenarios but there are nuances. Tax deferral is one of the primary benefits. The general rule is that an annuity owned by a trust no longer defers taxation of income earned by the annuity. However, in those cases where a trust is acting as a representative or an agent of a natural person, an annuity held by the trust would likely qualify for tax deferral. So, we have two flavors of trusts those that remove the annuity s income tax protection, and those that keep it intact. The standard revocable trust that individuals use to hold assets while they re alive can own a variable annuity and typically benefit from tax deferral until a distribution occurs. In most cases, the trust doesn t cause a taxable event until it distributes assets from the annuity. Irrevocable trusts often do not qualify under the agent of a natural person test if there is even a remote contingency that a charity, which is not considered a natural person, can be a beneficiary. Such a trust removes the normal tax-protected accumulation feature of annuities. Q: SO WHY CONSIDER ANNUITIES FOR SUCH TRUSTS? A: Since the 90s Weston had been using a strategy involving annuities inside charitable remainder trusts, especially the NIMCRUT [Net Income Make-up Charitable Remainder Unitrust], where the trust instrument delays distribution to the beneficiaries until the trust has enough income to make the distribution.

3 The flat-fee structure is minimal only 20 dollars a month it lets us implement this strategy at basically our advisory fee, plus the cost of the funds. This structure can be used to accumulate assets, tax-deferred, inside the annuity and effectively time the distribution of income until later years. The amount of the future make-up distribution, which is based upon trust accounting income, not taxable income, can accumulate inside the annuity, sheltered from distribution and hence from taxation to the beneficiary. Remember, in this case, the trust is an agent for a non-natural person, namely the remainder charity. But because the trust itself is charitable, it pays no income tax. Instead the accounting income that s stored in the NIMCRUT is taxed only when distributed. It s a very useful device, in the right situation; a charitably inclined client with stock that is highly appreciated could use this to defer taxation and cash flow until normal retirement age. Q: AND WHAT MAKES JEFFERSON NATIONAL S INVESTMENT-ONLY VA A FIT FOR FUNDING A TRUST? A: That s a good question. Because the flat-fee structure is minimal only 20 dollars a month it lets us implement this strategy at basically our advisory fee, plus the cost of the funds the same as any other investment advisory service. Whenever we need an annuity, the fees have ceased to be an obstacle. The number and quality of funds available within the annuity appear to be excellent. The fund choices include many of the ones we re already using and in your lineup, we have found acceptable choices for every asset class, to match the investment options that we have previously approved. It s easy. Q: YOU MENTIONED THAT YOU ACTUALLY HAVE A CRUT CASE RIGHT NOW. WITHOUT DISCLOSING ANY- THING CONFIDENTIAL, COULD YOU DISCUSS THE CLIENT SCENARIO? A: The client has some very low-basis stocks, common stock in a recognized tech company early issue stock where they have more than 99 percent appreciation and the capital gains taxes make it just painful to diversify. They have a couple of other stocks that are in the 60 to 70 percent appreciation category. So we re considering putting slightly more than one million dollars into a CRUT [Charitable Remainder Unitrust] with provisions that delay distributions until age 68 or so, and in effect limit the distributions and their taxation [by the way accounting income is defined] to withdrawals from the annuity. When the client retires, this will become like a private pension. We are recommending the CRUT because all of that appreciated stock can be put into the trust. The Client would get a current write off for the contribution to the charity (the value of the remainder interest), and once it s in the trust, it can be sold with no immediate taxable gains. And IRS regulations prevent inclusion of those original gains from contributions in distributable net income. Instead, we would invest the proceeds into the annuity, which locks down the accounting income no accounting income comes out to the beneficiary and no taxes are paid until it does come out. That s how this type of CRUT works. Investing the proceeds in an annuity means all the income and earnings that occur each year will be deferred until either a pre-set date or event, or until you and the client recommend to the trustee, within his financial plan and the terms of the CRUT, to turn on the spigot and make a partial liquidation from the CRUT, which happens with the consent of a special independent trustee. Annual decisions can then be made to turn the spigot off or on, depending upon cash flow needs. These CRUTs have many variations, and many technical requirements that must be respected; and the detailed legal requirements change now and then. Please consult with legal counsel in establishing these trusts. The number and quality of funds available within the annuity appear to be excellent. The fund choices include many of the ones we re already using and in your lineup, we have found acceptable choices for every asset class, to match the investment options that we have previously approved. It s easy.

4 For that part of a client s portfolio that needs to be taxsheltered, or for a client who needs to build up long-term wealth, a low-cost Investment-Only VA is an automatic fit. For high net worth clients, who don t need immediate liquidity, it s often an essential piece of the portfolio. Q: CAN YOU DESCRIBE HOW A FLAT- FEE AND BROAD CHOICE OF FUNDS MIGHT BENEFIT THIS STRATEGY? A: That s a great question. Let me explain how this works. Say a client puts $1 million of very low basis stock into a NIMCRUT. The distribution required by the trust document is set to roughly 5 percent of the trust s assets, not to exceed accumulated accounting income. The client and planner identify a year, say seven years out, when the trust s cash flow would be desired, possibly because the client/ grantor may be in a lower bracket. We can totally liquidate the stock right after it s contributed to the CRUT, without taxation. We then invest the proceeds in the annuity, to let the account grow taxdeferred and create accounting income waiting to be released, and all the while it s invested appropriately and diversified. This is key: you are generating accounting income from a diversified portfolio, which otherwise would be creating capital gains. The annuity lets you create accounting income from all parts of a well-diversified portfolio. Let s be more specific and start with the taxes avoided, were we to liquidate brute force outside the trust. Because of the client s tax bracket, let s say we re looking at avoiding a capital gains rate of 20 percent federal, percent in Massachusetts so we re talking maybe more than 25 percent. That works out to more than $250,000 in tax savings that can be re-invested into the annuity, to accumulate tax-deferred for as long as the client lives. That could be another 30 years for a healthy 62-year-old. The Client puts in $1 million of zerobasis stock. She gets the deduction up front of approximately $400,000, worth $160,000 in tax savings (outside the CRUT). And she gets the $250,000 tax benefit inside the trust, instead of liquidating the stock and reducing it to $750,000. In other words, she gets $1,160,000 of assets working for her versus $750,000. Simple, instantaneous math. That s huge. Going forward, the only thing that will be subject to tax is the 5 percent that comes out in retirement. It s likely to be ordinary income, because that s what comes out first. But with the deduction and tax savings up front, and the taxdeferred compounding going forward, let s say it doubles in eight years. It s $2 million and it pays out $100,000 a year, which goes a long way towards covering her living expenses. That s the homerun. Much of the benefit comes from portfolio growth, growing in a diversified portfolio, reducing the risks, at low cost. Q: WHAT ARE OTHER WAYS THAT YOU CAN USE AN INVESTMENT-ONLY VA AS A TAX-ADVANTAGED INVESTING SOLUTION? A: Typical annuities are not the right fit for most investment management models, as they re not advisor-friendly in many ways. The layers of assetbased fees. The limited selection of funds. The back-end deferred sales charge [redemption fee]. However, in certain circumstances they are appropriate based on the individual needs and objectives of the client. When it comes to annuities, tax deferral is one of the primary benefits. Low fees, and a robust selection of high-quality funds, are important. Using Jefferson National s annuity vehicle, with a flat-fee and nearly 400 funds, we can execute the investment strategy almost exactly as we do on the taxable side. We can use it for managing investments with unlimited tax deferral wrapped around it. Using the annuity for asset location is a great way to increase returns without increasing risk. It s good for the alternative asset class, fixed-income, assets that generate a lot of non-qualified dividends, ordinary income or short term capital gains. The way it s created, in my mind, it s like an unlimited nondeductible IRA. For that part of a client s portfolio that needs to be tax-sheltered, or for a client who needs to build up long-term wealth, a low-cost Investment-Only VA is an automatic fit. For high net worth clients, who don t need immediate liquidity, it s often an essential piece of the portfolio.

5 ABOUT WESTON FINANCIAL Founded in 1979, Weston Financial serves clients throughout the country, with approximately $2.0 billion in assets under management. Offering an open platform of best-in-breed investment managers and highly credentialed professionals, Weston Financial is a division of Washington Trust Wealth Management. Bottaro joined Weston Financial in 2011 with over 25 years experience as a financial planning professional. A graduate of the Massachusetts Institute of Technology, he received a law degree from Boston University School of Law. He serves as a board member for the Town of Winchester s Planning Board and serves as clerk and board member for Sustainable Winchester. To learn more, please visit: ABOUT JEFFERSON NATIONAL Jefferson National is a leading innovator of tax-advantaged investing solutions for RIAs, fee-based advisors and the clients they serve. Named the industry Gold Standard, one of Barron s Top 50 Annuities for two consecutive years, and winner of more than 45 industry awards, including the DMA 2010 Financial Services Company of the Year. Trusted partner to a network of 3,000 advisors nationwide, the Company is based in Louisville, Ky., with authority in 49 states and the District of Columbia. To reach our advisor support desk, please call WHY-FLAT ( ). To learn more, please visit An investor should carefully consider the investment objectives, risks, charges and expenses of the investment before investing or sending money. The contract prospectus and underlying fund prospectuses contain this information. For a prospectus containing this and additional information, please contact your financial professional. Read it carefully before investing. The summary of product features is not intended to be all-inclusive. Restrictions may apply. The contracts have exclusions and limitations, and may not be available in all states or at all times. Variable annuities are investments subject to market fluctuation and risk, including possible loss of principal. Your units, when you make a withdrawal or surrender, may be worth more or less than your original investment. Variable annuities are long-term investments to help you meet retirement and other long-range goals. Withdrawal of tax-deferred accumulations are subject to ordinary income tax. Withdrawals made prior to age 59 ½ may incur a 10% IRS tax penalty. Jefferson National does not offer tax advice. Annuities are not deposits or obligations of, or guaranteed by any bank, nor are they FDIC insured. Monument Advisor is issued by Jefferson National Life Insurance Company (Dallas, TX) and distributed by Jefferson National Securities Corporation, FINRA member. Policy series JNL , JNL , JNL