Mathematical Validation For Using Life Insurance In Estate Planning
A growing number of advisors have asserted that a large estate, if very liquid, need not consider life insurance as part of the estate planning arsenal. Their position states that clients can easily accomplish all of their liquidity-based objectives by simply using cash from the estate. While this may be true, it is mathematically demonstrable that this is generally not “good business.”
Certainly, the aspiration of any estate plan is to accomplish the clients goals while minimizing the impact of transfer costs and taxes through strategic planning. This is generally achieved through gifting, and/or creating specific trusts and named bequests in order to maximize the net transfer of assets.
In the following presentation we will demonstrate that merely “minimizing transfer costs” is not synonymous with “maximizing net transfer” in the field of estate planning. We will build a mathematical foundation for an assertion that life insurance is generally a much more efficient transfer technique than a straight “cash bequest” under most circumstances. We will consider several variables, including age, health, mortality costs, tax advantages and the time value of money.
Basic Estate Planning Issues–Current Law
With the passage of H.R. 1836, the Economic Growth and Tax Relief Reconciliation Act of 2001, we have very little real guidance on the position Congress will take on estate taxes in the future. The general consensus among industry tax advisors under these extraordinary planning conditions suggests that a prudent estate plan must presume the client will incur an estate tax of at least 45% on taxable assets above $1.5 million (unless the client knows, with certainty, that he or she will die during the year 2010).
If we proposed a plan based upon our best guess of what Congress may do in the future, there is a statistical probability approaching 100% that the presumptions would be wrong in some aspect. Consequently, our projections will be built on current law using the above assumptions. However, it should also be understood that the mathematical foundation underlying our premise remains valid regardless of the future level, or degree, of taxation.
Asset Growth–The Constancy of Change
If we were to assume a net average asset growth rate of 8%, we can show that an estate can be expected to double in value every nine years. For example, if a clients assets total $6 million today, and these assets are projected to grow at 8%, the estate can reasonably be expected to grow to $12 million in nine years, $24 million in 18 years, and $48 million in 27 years. Consequently, a client s age as well as his or her investing ability must be considered in the estate plan. If the return can be expected to be higher than 8%, then obviously the estate will double in a shorter period of time.
As mentioned previously, the creation of trusts can minimize tax costs to some degree. However, once the estate goes beyond $1.5 million in taxable assets, the federal estate tax requires significant funding in order to cover the anticipated 45% tax rate.
If we assume this tax rate of 45% on assets for large estates, we can derive that $1 million made available outside the estate in an irrevocable life insurance trust (ILIT) is equivalent to about $1,818,181 accumulated inside the estate. The true value of life insurance lies in its ability to explosively leverage premium dollars outside the taxable estate.
In order to address the impact of age on our proof, we must also look at the variance of life insurance premium costs based on age. The illustrated costs found in Table 1 are derived as a typical $1 million policy in a joint second-to-die contract from a competitive insurer. The illustrated contract will be funded to endow the face amount (accumulate $1 million cash value) at the joint equal age of 100 using a current fixed interest rate of 6.5%.
As you can see in Table 1, there is an 18% growth ($440) in annual premium cost in the five years from ages 35 to 40, but a 45% growth ($13,128) between ages 75 and 80 due to increasing mortality assumption costs.
If a younger couple could expect to consistently earn a significantly higher return on their money, it may appear to be advantageous to buy term coverage for a period of time. However, the prospect of “higher than market” returns over the long term is often not a prudent or realistic expectation as shown in Table 2.
Additionally, higher than market returns result in faster growth of the asset values in the taxable estate as mentioned previously. In other words, it is very difficult to cover the pure cost of term coverage and also expect to “outperform” the estate tax over the long term.