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The Bright Side of the 2010 Tax Relief Act

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With its estate, gift, and generation skipping provisions, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act) has a bright side for life insurance professionals. Fewer near-term concerns about federal estate taxes mean life insurance professionals can focus on a host of other estate and financial planning needs that can be served by life insurance, including retirement income planning.

As a result of the Tax Relief Act, in many instances, an individual will be able to buy and own his or her life insurance policy and enjoy all of its benefits and flexibility.

Life insurance has historically played a significant role in providing the liquidity that’s often needed to pay federal estate taxes. Over the years, dealing with estate taxes has complicated life insurance sales and has driven insureds to use irrevocable trusts in ownership arrangements that keep the insurance proceeds from increasing the size of their estates. While this arrangement has very attractive benefits that have generally made the strategy worthwhile, it has sometimes be an obstacle to the sale of life insurance.

As most professionals know by now, the exemption, known formally as the applicable exclusion amount, is set at $5 million for estate, gift, and generation skipping purposes. You can read a full summary of the Act on the Senate Finance Committee’s Website. At first glance, it appears that few estate owners will have to worry about transfer taxes, but planning has certainly been complicated by the sunset provisions of the Act. Specifically, the exemption amount and other provisions of the Act are only in effect through the end of 2012, after which the $1 million exemption and top marginal rate of 55 percent are scheduled to return.

Predicting political events two years from now is probably foolhardy. Will the exemption stay at $5 million? Is there any chance that it will return to $1 million? Judging by the last two years, anything is possible, although there appears to be growing thought that the return to the $1 million amount is highly unlikely. Life and financial professionals will be challenged to discuss this issue with their clients in the next two years in an effort to come to some reasonable agreement on an estate or financial plan. Some will want to play it safe and assume a lower exemption, but others will probably not.

One pressing financial planning issue for many clients is retirement planning. According to the National Retirement Risk Index, measured by Boston College’s Center for Retirement Research, 51 percent of working age households are at risk of being unable to maintain their standard of living in retirement. Additionally, many clients are also underinsured, with only 44 percent of U.S. households owning individual life insurance, according to LIMRA’s September 2010 report. For these clients, life insurance can multi-task to address both needs, as it can offer some pretty attractive supplemental retirement benefits at the same time as death benefit coverage and this too is made easier without an estate tax concern.

The life insurance in retirement strategy can best be illustrated with an example. Ted, age 50, owns his own business and he and his wife have combined assets of $4 million. The business does not have a retirement plan, but it is now doing quite well and he now wants to focus his attention more on his approaching retirement. He is not interested in a qualified plan and believes that the IRA deduction limits will not allow him accumulate enough in an IRA.

His financial adviser has recommended that he buy a life insurance policy on his life that will fill his need for immediate coverage funded over the next 15 years using bonuses from the company. Now, it is very possible that Ted will not retire in 15 years, but this is a good target to shoot for. If Ted pays premiums of $30,000 a year into a typical universal life contract for 15 years he can reasonably be expected to take distributions, depending on policy design and other factors, of between $50,000 and $60,000 tax free from age 66 to 85. These distributions are tax free because they come first from withdrawals to cost basis, then policy loans (Note that contributions and distributions should be designed so that the policy never lapses to avoid income taxes consequences at the time of lapse). Naturally, if Ted decides not to retire at age 65, he can increase his supplemental benefits by either continuing to pay premiums or postponing distributions, or both.

If Ted is willing to take on some performance risk, he could consider an indexed product from any number of insurers. Such products usually have a floor that avoids investment losses, but also have a cap on upside growth. Nevertheless, an indexed product illustrated at a 7.25% rate could result in the owner’s withdrawals being in the $65,000 to $70,000 range for the 15 year period.

A key objective in the case of both kinds of policies is cash value growth, but both also pay a death benefit that will likely start at $550,000 and rise to $1 million, before falling as distributions are taken (death benefit need would typically be falling also). Is Ted worried about estate taxes? Perhaps not for a couple of reasons. First, this plan is designed for supplemental retirement income and will not pay a significant death benefit if Ted lives to normal life expectancy. Should he die prematurely, any estate tax consequences will depend on the future of the estate tax exemption. If the exemption is not expected to be lowered at all or not substantially, then Federal estate taxes will probably never be an issue.

Again, the bright side of this new legislation is renewed opportunities for wealthy estate owners to own their own life insurance. Using the cash accumulation potential of life insurance for supplemental retirement purposes should be one of those opportunities.

Brian K. Titus, JD, LLM, CLU, ChFC, is advanced marketing attorney at Saybrus Partners, Inc., a wholly owned subsidiary of The Phoenix Companies.