What Is Estate Liquidity?
Property is generally either liquid or nonliquid (also referred to as illiquid). Liquid property is generally cash and property such as securities that can easily be turned into cash. Estate liquidity refers to the ability of your estate to pay taxes and other costs that arise after your death using cash and cash alternatives. If your property is mostly nonliquid (e.g., real estate, business interests), your estate may be forced to sell assets to meet its obligations as they become due. This may result in an economic loss or the need for your family to sell assets that you intend for them to keep. Therefore, planning for estate liquidity should be one of your most important estate planning objectives.
Why the Need for Estate Liquidity?
You may be surprised to learn that the cost of dying can be very high. Most of these expenses can't be avoided and must be paid promptly; for example, estate taxes are generally due within nine months of a death. In fact, liquidity may be your estate's most urgent need. Sufficient liquidity, or the lack thereof, may mean the difference between your wishes being carried out or not. Here is a quick checklist of the expenses for which you may need to plan:
- Expenses of your last illness
- Funeral, cemetery monument, and burial plot expenses
- Executor or administrator's fees
- Attorney's fees
- Appraiser's fees
- Probate court costs
- Death and income taxes
Besides these expenses, you must consider the continued daily living expenses of your family and any other special needs that they may have, such as educational funds for children or care for a handicapped child.
What Are Your Available Options for Estate Liquidity?
Distribute Assets Other Than Cash
One source of immediate liquidity is the cash you have in CDs, savings, and checking accounts. Save this cash for estate obligations by distributing specific nonliquid assets in lieu of liquid assets to your beneficiaries in your will--John gets the cars and boat and Jill gets the house, for example.
Caution: Don't rely on the cash you normally have on hand to meet all your estate's liquidity needs. Practically speaking, you would need to build up these cash accounts to a level that does not make sense economically. Also, you might want to ensure that your executor can reach these funds fairly easily.
In some cases, the executor or administrator of your estate may encumber (borrow against) the assets in your estate. Practically speaking, however, this is not a good option, and certainly should not be relied upon to meet your estate's liquidity needs. Probate laws generally prohibit an executor from obtaining a loan without incurring personal liability for the debt, unless your will specifically provides that the executor may do so. This makes the availability of credit limited, even if your executor agrees to take on such a responsibility. In addition, borrowing only postpones the problem. The loan will eventually need to be paid back and with interest.
Sell Estate Assets
Although your objective is to avoid forced liquidation, the planned sale of some assets to meet estate liquidity needs may be desirable. You may own assets that no one else wants, such as a collection of antique spoons or a Maine hunting lodge. The sale of such assets provides liquidity to your estate and relieves your beneficiaries from the burden of receiving them. Be sure to give your executor permission to make the sale.
Under a Section 303 stock redemption provision, a corporation is allowed to distribute cash needed by a stockholder to pay for estate costs and taxes. Under this IRS provision, your estate is not subject to ordinary income taxes on the entire distribution as it would be for distributions of dividends. Instead, the redemption is treated as a capital transaction. This may result in significant tax savings to the corporation and thus provide liquidity to your estate. There are certain eligibility and other requirements that must be met to qualify for this tax treatment.
Undertake a Buy-Sell Agreement
A buy-sell agreement is a legal contract commonly used by an owner of a closely held business to transfer his or her interest to his or her successors. It is an agreement that you can enter into now to provide for the future sale of your business interest to family members or other parties. Under the terms of a buy-sell agreement, the buyer is legally obligated to buy your interest in the business from your estate, and your estate is legally obligated to sell your business interest at your death. One of the many advantages of a buy-sell agreement is that it provides the liquidity needed to pay estate taxes and administration expenses. There are many types of buy-sell agreements. Many factors must be considered when deciding which one may be best for you.
Purchase a Survivor Annuity
Some annuities end at your death. However, there are annuities that continue until the death of a second individual and are called joint and survivor annuities. A joint and survivor annuity provides an annuity for the life of the participant with a survivor annuity for the life of the survivor (e.g., a spouse or partner). Joint and survivor annuities can be either refund annuities that provide a lump-sum payment at death or period-certain annuities that provide installment payments only.
Either way, a survivor annuity can provide your estate with some liquidity to pay expenses incurred by your estate if you name your estate or your executor as the beneficiary. Or, if your sole intent is to provide income for your family, you may name a family member as beneficiary. Be aware that if the continuing payments are made to your estate, the entire value of the remaining payments is includable in your gross estate for estate tax purposes.
Take Retirement Benefits
If you do not receive all the retirement benefits to which you are entitled from your retirement plan before you die, they will be distributed to your estate or a beneficiary until they are all paid out. Therefore, retirement benefits can also provide a source of liquidity, though not directly to your estate in most cases.
Caution: Be careful if you name a nonspousal beneficiary. Some state laws require that estate taxes due on the portion of the estate attributable to the retirement benefits must be paid from the retirement benefits, therefore depriving the beneficiary of those funds. You may avoid this result by providing in your will that estate taxes be paid using certain assets; for example, from the residuary estate. You should also keep in mind that most retirement benefits will be subject to income tax when they are distributed from the plan, and this will decrease their net value.
Buy Life Insurance
Perhaps the most common method of providing liquidity is with life insurance. Life insurance, sometimes called liquidity insurance, is a contract that you make with a commercial provider. You agree to make installment payments to the provider and the provider agrees to pay a certain amount of the proceeds to a named beneficiary upon your death. For many, life insurance creates funding for an estate where otherwise there would not be any.
If you have correctly forecasted the liquidity needs of your estate, the necessary cash will be available precisely when it is needed. When buying life insurance, some of the things you should consider are how much life insurance you will need, what type of policy is right for you, and who your beneficiaries should be. You must also pick a settlement option; for example, whether the proceeds go outright to the beneficiary or to a trust. There are also tax consequences to buying life insurance that you should be aware of.
Although this is a highly technical area, here are some of the general rules:
- Proceeds payable to your estate, your executor, or to an individual or trust legally obligated to pay estate debts are includable in your gross estate for estate tax purposes
- Proceeds payable to anyone on a policy in which you retain any "incidents of ownership" at the time of your death or within three years of your death are includable in your gross estate for estate tax purposes
- If you own a policy on the life of someone else and you die before the insured, the cash value of the policy is includable in your gross estate for estate tax purposes
- Generally, proceeds are not subject to income tax, except for transfers for value and gain on the surrender of a policy
Technical Note: "Incidents of ownership" is a legal term and generally, it means any right to control or benefit economically from the policy (e.g., name the beneficiary, surrender the policy, or borrow on its cash value).
Defer Payment of Estate Taxes
If unable to make estate tax payments when they are due, your personal representative may (1) request an extension of time to pay or, if your estate consisted substantially of an interest in a closely held business, (2) elect to pay a portion of the tax in 10 or fewer annual installments.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.
The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.