On Jan. 1, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012 (ATRA) which creates “permanency” in the estate planning area for the first time since the passage of the Economic Growth and Tax Relief Act of 2001 (EGTRRA).
ATRA provides a degree of certainty that had been missing, and it may be the impetus needed to motivate clients to update their estate plan in order to protect their family and to minimize taxes.
In the transfer tax area, ATRA permanently establishes the same high exemption amount for gift tax, estate tax and generation-skipping transfer tax purposes. It also indexes this amount for future inflation. ATRA permanently extends portability, one of the key features of the Tax Relief Act of 2010 and sets the highest marginal estate/gift tax rate at 40 percent.
So, under ATRA, each taxpayer has available a unified gift and estate tax exemption of $5.25 million in 2013. This exemption (also referred to as the applicable exclusion amount) is permanent, unified, indexed for inflation, and portable.
These changes should serve as an incentive for seasoned financial planners to readjust their strategy when it comes to providing life insurance solutions to clients. But what will those recommendations be? To answer that question, it’s important to examine the impact ATRA may have in two areas: life insurance funding and life insurance ownership in general.
ATRA and life insurance funding
In light of the increased estate tax exemption, life insurance funding will likely change over time. Traditionally, producers have made certain assumptions regarding the client’s projected estate settlement costs and then recommended the client purchase the maximum amount of death benefit to meet that projected need.
Often, the goal was to minimize the premiums paid for a set amount of life insurance, given that the policy was often placed in an irrevocable trust, outside the direct reach of the insureds. This emphasis on maximizing death benefit coverage for a given premium favored purchasing guaranteed products.
There are several shortcomings with this traditional approach. First, it will continue to be extremely difficult to accurately predict the amount of estate settlement costs. Given the uncertainty regarding future estate tax laws, the future growth in the estate, the year of death, and how effective estate tax planning techniques will be in reducing these projected costs, the initial amount of life insurance purchased will often be far more or far less than the client’s actual need. This uncertainty is even greater with younger clients.
A second disadvantage is that in funding for the maximum death benefit, the client is sacrificing cash value buildup and may be jeopardizing the underlying viability of the policy. This emphasis on death benefit will often result in underfunding of the policy and the policy’s early termination.
These policy lapses have led some prospective clients and their advisors to perceive life insurance as a poor investment. For instance, some attorneys are reluctant to allocate the client’s generation-skipping transfer tax (GST) exemption to contributions to a life insurance trust for fear that this GST amount will be wasted if the policy lapses.
The key to planning with life insurance will be flexibility. Even with so-called permanency, one cannot truly know what the estate tax exemption amount will be when he or she dies. While many of the same needs and objectives for clients will still apply regardless of the level of the exemption amount, some needs are clearly the result of the estate tax. Many clients may be reluctant to commit to funding for an uncertain estate tax need. However, a properly designed irrevocable life insurance trust can still serve as the cornerstone of an effective estate plan.
Clients should consider using single life products inside these trusts because the death benefit can help meet a myriad of needs, such as support for the surviving spouse, family protection, education funding, business continuity and estate equalization.
New law, new approach
Rather than minimally funding the policy, an alternative approach is to heavily fund the policy and enable the cash values to grow more quickly in the early years and permit the death benefit to grow in later years when compared to a guaranteed product. Even though it may counter traditional thinking, a life insurance policy with a lower face amount and higher living values may prove more attractive over the policy term.
The most efficient cash value policy, if there is a significant chance the insured will live beyond life expectancy, is generally one that provides the minimum initial death benefit but the maximum cash value. While this policy will provide a lower death benefit initially, it will ultimately provide a greater death benefit at older ages and a better return on investment. If the insured lives to his/her normal life expectancy, the policy’s death benefit will often return the premiums with an attractive, compounded tax-free return. This is especially true when compared to guaranteed products.
The higher cash value policy will also provide more flexibility to alter the amount of coverage, to make changes in the event the policy is no longer performing or to re-allocate resources if the insured’s needs change. This increased flexibility, of course, will need to be weighed against a lower death benefit in the event the insured should die prematurely.
This alternative approach views life insurance cash values as a tax-advantaged sinking fund. With the increase in income tax rates and the new 3.8 percent Medicare tax, there will be a shift in focus to the income tax benefits of life insurance. Clients will be motivated to increase their exposure to a tax-deferred vehicle such as life insurance by transferring large deposits into such policies to help manage today’s high tax rates.
This is especially true for non-grantor trusts, as the threshold for application of the 39.6 percent rate and the Medicare surtax is only $11,950. The high gift tax exemption should assist with this strategy, as it will now be easier to fund insurance premiums by making larger gifts to an irrevocable trust.
ATRA and life insurance ownership
In addition to life insurance funding implications, ATRA will likely have an impact on life insurance ownership in several other ways:
- Individual ownership will become more attractive.
The higher exemptions will permit clients with less than $5.25 million to own their own life insurance policies. This will enable them to have ready access to the cash values and to rely on the higher exemptions instead of the irrevocable trust to shelter the death proceeds from estate tax. Clients should still consider naming their revocable trust the beneficiary of the policy to continue to obtain the benefits of a trust.
- The spousal lifetime access trust (SLAT) will remain popular.
Clients may also wish to consider creating and funding a life insurance trust with specially designed flexibility to distribute principal and income to the spouse during grantor’s life — a so-called spousal lifetime access trust. Large gifts of income-producing assets — which, depending on circumstances may possibly be discounted for both lack of control and lack of marketability — can now be made to fund these trusts. The trust income could then be used to (i) fund life insurance premiums, (ii) pay interest on an installment note under a sale to a defective trust, and (iii) distribute excess income to the spouse or children, if needed.
The substantial funding approach discussed earlier works well with a SLAT. The SLAT addresses two primary concerns. First, given the uncertainty of projecting future estate tax liabilities, SLATs exclude the death proceeds from both the insured’s and the insured’s spouse’s estates. In addition, given the uncertainty of whether the insured and his or her spouse during the insured’s life and the surviving spouse after the insured’s death will have sufficient income, SLATs permit the trustee to make distributions of trust principal and income to the insured’s spouse not only after the insured dies, but also while the insured is alive.
To this end, while the insured is alive, it is possible for the spouse — in his or her capacity as trustee — to access the cash values without tax by taking withdrawals up to the policy’s basis and/or policy loans from the life insurance policy and to then make distributions to himself/herself, subject to a standard.
A SLAT will also allow the spouse, as trustee, to increase or decrease insurance coverage or make other changes to the policy as new legislation alters tax law or as the couple’s circumstances change.
At the insured’s death, the proceeds are received income tax-free and can provide continuing spousal survivor income. The fact the proceeds are in a trust, rather than paid outright to the spouse, will be consistent with the objectives of many clients.
- Dynasty trusts will continue to generate interest
The ability to make taxable lifetime gifts and generation-skipping transfers of up to $5.25 million in 2013 ($10.5 million for a married couple) will make it easier and simpler to fund a dynasty trust. For example, a married couple can use their combined $10.5 million exemption to fund a generation-skipping trust. This amount can then be leveraged by using a portion of this gift to purchase a life insurance policy.
Clients with illiquid estates may now be able to solve their liquidity problem by making one substantial gift to an irrevocable trust, assuming the trustee then elects to purchase life insurance with the gift.
A new environment
The estate planning environment is dramatically different today than at any other time in our recent past. For the first time, there is a permanent, unified, historically high, inflation-adjusted and portable exemption amount that effectively excludes all but the wealthiest 1 percent from gift, estate and GST tax. Since the threat of the federal estate tax will no longer be the catalyst to motivate clients to take action, it’s important to educate clients on the continuing need to plan, as non-estate tax planning such as business continuation planning, retirement planning, asset protection planning and legacy planning move to the forefront.
As a result of this new environment, life insurance funding strategies will need to change. Planning will become more income tax-driven. The substantial funding of a life insurance policy — with a focus on having ready access to cash on a tax-favored basis — will prove attractive to many clients. In short, many of the reliable ownership techniques that worked well in the past need to be re-evaluated — an analysis all seasoned financial and estate planners would be well advised to undertake.
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