In the days before the current Bush Administration enacted its controversial plan to phase out and ultimately repeal the federal estate tax, it was a foregone conclusion for advisors working with high-net-worth clients to suggest some form of second-to-die (survivorship) life insurance as a means of protecting assets and generating liquidity to pay estate taxes.
Much has changed in estate planning circles as a result of the Economic Growth and Tax Relief Reconciliation Act of 2001, however. Because federal estate tax exemption levels have been rising while the highest federal estate tax rates have been falling, a perception has emerged that people no longer need a life insurance policy as a tax-advantaged estate planning tool because their overall federal estate tax liability will diminish or disappear altogether over time. And that will indeed be the case, at least for one year (2010), assuming Bush’s plan remains intact.
However, such a perception fails to account for the possibility – and according to many astute observers, the probability – that the current plan will be restructured or replaced sometime in the not-too-distant future. Nor does it account for recent changes in state estate tax policies prompted by EGTRRA. Where states once uniformly followed Uncle Sam’s lead with regard to estate tax policies, since 2001 many have opted to decouple their estate tax schemes from the federal plan. New Jersey, for example, froze its estate tax exemption at 2001 levels rather than follow Uncle Sam. Today, an estimated 15 to 20 states have moved to decouple their estate tax schemes.
Amid so much flux and uncertainty, life insurance is no less vital as an estate-planning instrument today than it was five years ago, according to advisors who specialize in wealth-transfer and asset-protection strategies for seniors. The advantages that life insurance offers to clients who want to preserve a financial legacy – the ability to protect assets from taxation when they pass from one generation to the next, plus the ability to invest discounted dollars to ensure beneficiaries (heirs) have enough liquidity to cover estate taxes, without depleting the estate – are as valid in 2006 as they were in 2001.
“You would be hard-pressed,” says Certified Financial Planner Randolph J. Shine of Shine Financial in Deerfield Beach, Fla., “to find a better investment than life insurance to preserve or increase family wealth on a tax-favored basis.”
Where there’s a need
Life insurance has obvious value as an estate planning tool for high-net-worth clients whose estates are so large they still carry potential tax exposure, despite year-to-year increases in the federal estate tax exemption. The decoupling of state and federal estate tax policies, and the additional estate tax liability clients in “decoupled” states potentially face, is another reason advisors like Scott L. Harris, CLTC, continue to steer clients toward life insurance in an estate planning context.
Harris, an insurance specialist for the Carta Group in Syracuse, N.Y., finds himself in just such a position, with his home state among those to have decoupled its estate tax scheme following implementation of the federal repeal plan. For some clients with sizable estates, the federal phase-out giveth and it taketh away. In states that reacted to the Bush plan by decoupling their estate tax schemes, clients now may face state estate tax liability, even though the higher federal exemption levels mean they have no such liability to Uncle Sam.
As a result, explains Harris, “We’re telling our clients not to ignore the estate tax on the state side. We are seeing more states decouple as they look for ways to generate revenue. That’s going to be a troublesome issue – and one that demands that we remain flexible. Flexibility is one of the strong points of life insurance used for estate planning.”
Today, as in the days before the current plan, among the most popular uses for a life insurance policy within an estate plan is to generate proceeds to cover estate tax liability. Investing in an insurance policy “buys the ability to conserve family assets in meeting tax liabilities,” Shine explains. As a rule of thumb, one purchases a policy with a death benefit that’s large enough to cover those liabilities, he says.
But covering an estate tax tab isn’t the only valid reason for a senior to buy life insurance as one component of an estate plan. Buying an insurance policy also can help clients reduce liabilities in other areas of their tax ledger, according to Certified Financial Planner Sally Jo Button, principal at Button Financial in Lakewood, Colo. For example, she says, clients who own an annuity as a nonqualified asset may face significant tax liability having that annuity as part of their estate, particularly if the annuity contract has performed well on an income basis and the client has had it for a long period of time.
Rather than wrapping the annuity into the estate along with the income tax liability linked to it, Button says, the annuity owner can rid his estate of that liability by exchanging the annuity for a life insurance policy (a single-premium policy in many cases). If done properly, the exchange should be tax-free. Thus it makes sense, especially for clients who are wealthy enough they won’t need the principal from the annuity and would prefer to reduce the income tax exposure of the estate they pass on to heirs.
Life insurance also can be valuable in generating supplemental income, Button says, particularly in situations where one partner in a senior couple is depending on income from the other partner, and the partner who has been serving as the sole income source dies.
Another general rule in purchasing life insurance in an estate-planning context is to buy it within the framework of a trust. Despite the flux in estate tax policies at the state and federal levels, trusts remain an integral component of many estate plans that incorporate life insurance.
Advisors and clients seeking to fully exploit the benefits life insurance offers in an estate planning context often turn to a vehicle known as an irrevocable life insurance trust, or ILIT, which functions as the owner and beneficiary of the life insurance policy. Using the ILIT framework, proceeds from the policy are exempt from estate and income taxes when they pass to beneficiaries.
“If you’re talking about insurance in an estate planning environment, it is pretty much automatic that you’re talking about an irrevocable life insurance trust,” Shine says.
Putting the insurance policy inside a trust means it is not a taxable asset inside the estate. Essentially, the trust is the policyholder and the policy’s beneficiary. It receives the death benefit from the insurance policy and uses that money to buy assets from the estate, then distributes those assets to the trust beneficiaries, Button explains.
For estate planning purposes, advisors agree, permanent survivorship life policies remain the preferred type of insurance product. Most advisors use some form of universal life, variable or otherwise, because of the flexibility it offers with regard to adjusting the death benefit and premiums.
For obvious reasons, neither term insurance (because it is not permanent) nor whole life (because it is relatively expensive and inflexible) is commonly used in an estate plan setting. However, there is a place for single-premium universal life insurance products in that setting, according to Button. In certain circumstances, such as when there is an opportunity to exchange a nonqualified annuity, single-premium products are worth considering as an estate planning or wealth transfer tool, with features such as lifetime money-back guarantees, minimum death and long term care benefit guarantees and residual death benefits.
Single-premium policies tend to build cash value faster than most other types of life insurance since the lump sum paid upfront begins earning immediately. Policy beneficiaries generally are not taxed on death proceeds. So if a client has enough liquidity to cover the first-year premium payment, a single-premium policy is a straightforward, tax-favored wealth-transfer tool, the proceeds from which can be used for such things as pre-funding a lifetime gift or bequest to a beneficiary.
From single-premium life to universal life, from ILITs to other new-fangled trust structures, advisors and their senior clients face increasingly complex choices regarding the use of insurance policies within a broader estate plan. Given the uncertainty shrouding the status of state and federal estate tax policies, it’s safe to assume those choices are only going to get more convoluted unless there’s a drastic shift in policy. Stay tuned.