High net worth individuals looking to
protect their assets from taxation are often faced with a variety of
challenging decisions. They know the end result they want to achieve, but the
processes and options at their disposal can often feel like they’re written in
a foreign language.
To give you some food for thought we’re
going to take a look at the issue of accumulation distribution: what it is, why
it occurs, and how to solve it. That way you’ll be able to make an informed
decision that will stand the test of time.
What is Accumulation?
High net worth individuals will
commonly set up Foreign Non-Grantor Trusts (FNGTs). These are legal tools that
allow a non-US citizen to transfer their income to a US beneficiary in a safe
and secure way. A common example of this would be a high net worth parent
looking to financially support a child or relative living in the US. Whilst
FGNTs have a number of attractive benefits, they can also have their downsides
if not structured correctly.
The wise approach is to pay out net
income each year to the beneficiary so as to minimize the impact of the US tax
system. Issues can arise when this is not always possible, resulting in some of
the income remaining in the trust. This is referred to as accumulation, and it
can result in large, unforeseen additional interest charges if proper planning
is not in place.
Why Might Accumulation Occur?
Accumulation could occur for a whole
host of reasons including: poor planning, a delay in payments, working to
reduce that year’s taxable income for the beneficiaries as well as a whole host
of things which will be specific to your personal circumstances.
The key take home point here is that
when the accumulated income is eventually paid out to the beneficiary, it will
be subject to what is often called a ‘throwback tax.’ This effectively taxes
the beneficiary at exactly the same rate as if the income had been fully
distributed by the end of each tax year.
The downside is that this can leave a large hole in annual budgeting and
completely strip capital gains of the favorable aspects that made them so
appealing in the first place. So, what can you do about it?
Solving the Accumulation Distribution
Problem: Private Placement Life Insurance (PPLI)
Before we get started, we should say
that PPLI cannot be used to solve the issues caused by existing accumulation
issues in a FNGT. It’s designed specifically to address future issues, making
it a wise choice to consider when you want to future proof your financial
arrangements in a way that legally protects them from the US tax system.
There are a variety of different ways
you could implement PPLI, one of the most common of which is investing in a
Non-Modified Endowment Contract (non-MEC). Whilst the technical details of such
an arrangement are beyond the scope of an introductory article, the key
benefits are clear for all to see. Here are 4 key channels which are not
treated as taxable income under a non-MEC arrangement:
-
Death benefit proceeds such as
inheritances and assets left to you in a will
-
Policy loans and other such
arrangements
-
Withdrawals all the way up to a
pre-stated premium
-
Any income or investment returns that
are housed inside the policy
The specific arrangements of a non-MEC
approach will depend on your individual circumstances, and will hinge on issues
such as the level of your assets, residency status and immigration status. As
with every aspect of complex financial planning, it is always recommended to
start planning as early as possible, and to always seek the advice, guidance
and expertise of an experienced legal professional.
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