Dear Michael: We have a situation with our estate. Our son has been farming with us for the past 30-some years – we are in our late 70s – but my husband still actively farms as a 50-50 partner with our son. Over the years we have put plenty of savings into retirement plans such as Simplified Employee Pension (SEP) plans and we’ve built quite a tidy sum in savings as well. We have four other children.
Now that we have reached our 70s, we are required to take out our required minimum distribution from our SEP plans. In order to avoid income taxes on the income my husband earns and on the distributions, we have to continue to buy machinery. In my mind, this favors the farming child as he receives all the new machinery when we die. But my husband insists on doing this annually, and my son isn’t about to argue with him if he gets new machinery each year.
We had purchased a million-dollar term insurance policy to make up the difference with our other four children, but now the company says we need to convert it and it would be close to $60,000 per year in premiums. Does your planning help us in our situation? – Rebalancing Our Estate
Dear Rebalancing: You have a pretty common situation for most farmers as they get older and continue to farm – whether that’s full-time farming or share-cropping. Your husband has been trained since he was a child to always buy something for your farm operation that’s tax-deductible rather than pay income taxes. He is so focused on that one solution that he doesn’t realize there are better options.
I had a similar client – same situation. We set up a plan for him whereby rather than buying farm machinery each year, he could make a contribution to his defined benefit pension plan.
Unlike other tax-deductible plans, he could continue to make contributions to his plan past the age of 70 and in much higher amounts – in this case around $250,000 per year for five years.
In addition, the plan was insured with $890,000 of life insurance which would go tax free to the beneficiaries. The premiums to the life insurance were also deductible except for the annual pure cost of the insurance of about $6,000 per year.
With the contributions, within five years this insurance amount had grown to more than $1.1 million. He also had acquired almost $1.3 million in his pension fund. To his beneficiaries, when he died, he would leave more than $2.4 million.
Now this is an example of two different methods of dealing with income taxes as you get older. One, having to take required minimum distributions plus still paying income taxes on active earnings led your husband to continue to build on the farming son’s side of the estate ledger and, inadvertently, lowering the non-farming children’s share as he took the required minimum distributions out and bought machinery with it. One child was benefiting while the other children, unbeknownst to them for the time being, were losing value each and every year. Converting the term insurance will cost another $60,000 (after tax) to the plan.
The second farmer determined he wanted to rebalance his estate so he took the money and put it into the pension plan. He was able to get a higher tax deduction than if he continued to buy machinery. He was able to provide the other beneficiaries with a tax-free death benefit from the insurance as well as a growing fund of value in the pension plan. He was able to turn what would have been $1 million of taxable income to him into $2.4 million of which almost half was tax free to his non-farming children.
In essence, one farmer bought $1 million worth of machinery for his farming son which will be worth half that in three years, making the farm son very happy, but he was annually inadvertently lowering the amount his non-farming children would receive. The other farmer put a $1 million aside that turned into $2.4 million for his non-farm children and told his farming son he was old enough to start replacing the machinery as needed.
Which ledger do you think all of his children were the happiest with when each of these farmers died?