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Mathematical Validation For Using Life Insurance In Estate Planning

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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.

Leverage Effect

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.

Impact of Leveraged Growth in an Irrevocable Trust–”The Assertion”

We cannot consider costs without also considering the impact of the premium on the estate value through use of an irrevocable trust. By implementing a plan that includes life insurance in an irrevocable trust, we accomplish two goals simultaneously.

First, we reduce net asset growth by moving dollars systematically out of the taxable estate and into a non-taxable trust, and then we use those dollars to buy coverage that leverages this tax advantage for the benefit of the estate.

Consequently, we can make an assertion that the true cost of plan implementation is actually negative, until such time that the net value of the premium dollars invested inside the estate would grow to equal the leveraged value of the insurance coverage outside the taxable estate. (Stated another way, how long must we invest the premium dollars inside the estate to equal the net value of the non-taxed insurance coverage?)

Mathematical Assessment of the Assertion

In our assessment comparison of this assertion, we must invest the premium dollars for some period of time until they reach $1,818,181 (45% tax-rate equivalent of $1,000,000 inside the non-taxable trust) at an assumed interest rate. Let us assume our client can reasonably expect to earn 15% on his money over the long term in his own business. In a 39% tax bracket, this means the client can net about 9% by investing the premium dollars in his own business. (Actually, we should use the clients least attractive investment earnings, but lets use the higher rate for the sake of the demonstration).

Therefore, if our clients are joint age 65, we can derive that it will take 29.25 years investing the premium of $14,308 to grow to $1.8 million after taxes. In other words, one of them must live to age 94 and earn an average return of 9% after tax in order to equal the value of the insurance. Most advisors would agree this is not a prudent risk to assume. See Table 2 for similar calculations at various ages.

We can raise the assumed interest rate if the client wishes to presume extraordinary growth, or we can reduce the tax rate if the client wishes to presume Congress will extend the law or go even further. Yet, no matter how we try to stretch the limits in our example to maximize the potential growth of cash inside the estate, it just does not make sense to ignore the simple and extraordinary efficiency of life insurance due to the inherent tax advantages.

Clearly, this study strongly supports our original assertion that funding any anticipated bequest or need with cash from the estate is far less efficient than utilizing life insurance to fund that need. This model remains valid whether the purpose is for estate taxes, or for any other specific cash bequest. It is not a question of whether the estate can fund the need from cash assets, but rather a question of the advisability of planning to do so.

It simply does not make good business sense to pay estate taxes or make any other bequest with 100% cash rather than funding it at a cost of 1.4% on the dollar each year for a 65-year-old couple ($14,308 /$1 million) or even at a cost of 2.9% each year for a 75-year-old couple ($29,135 / $1 million).

Other Considerations–Single Life & Rated Coverage Options

It should be noted that single life contracts have a significantly higher premium than joint second-to-die contracts due to higher single life mortality costs. Nevertheless, our premise remains intact. Although it may take less time to equal the non-taxed trust amount, it is still not prudent business to presume the client can live for the requisite amount of time in order to simply equal the life insurance (especially if that client already has significant health problems). See sidebar for a single insured life example.

Charitable Planning

In addition to all the arguments in favor of life insurance planning to fund anticipated estate costs, we should also point out that charitable bequests are especially well treated using such techniques. Life insurance purchased for a charitable bequest, and owned in the name of the charity, is currently income tax deductible to the extent of premiums paid. In other words, a 65-year-old couple can fund a $1 million bequest to their church, alma mater, family foundation, or other charity for a net cost of $9,300 per year ($14,308 – 35% federal tax deduction = $9,300).

Rather than a cash bequest, the client would be much better off putting the $1 million in a fixed-rate CD, paying the tax-deductible premium from interest, and then letting the remaining interest continue to grow. Our clients could fund the “John and Jane Doe Chair for Entrepreneurial Research” at “State U” for very little net cost.


It is clear that life insurance should never be discounted as a primary estateplanning tool regardless of the client s level of wealth and liquidity. Simply because the client has the available cash to fund an anticipated need or desire does not mean the client should fund that need with 100% cash from his or her estate. Life insurance, at a small fraction of the cost, is generally a far more efficient use of those dollars.

Thomas V Robertson, CLU is president & CEO of Z-Quote, Inc., Tulsa, Okla. He may be reached via e-mail at [email protected]

Reproduced from National Underwriter Life & Health/Financial Services Edition, June 24, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.