The Windsor decision, the IRS’ and DOL's rulings and ATRA have eased ownership and use of cash value policies.

2013 and 2014 are proving to be landmark years for many same-sex spouses, ones they’ll likely remember for years to come. 

In United States v. Windsor the United States Supreme Court ruled that the portion of the federal Defense of Marriage Act that allowed the federal government to discriminate against same-sex married couples was unconstitutional. The IRS issued Revenue Ruling 2013-17 announcing that it would apply the nation’s tax laws equally to legally married same-sex and heterosexual married spouses. 

The Department of Labor issued Technical Release 2013-04 requiring ERISA retirement plans to treat all married spouses equally regardless of gender or state of residence.  And, the number of states that recognize same-sex marriages continues to increase.1 In February the Justice Department extended to same-sex spouses the same rights heterosexual spouses have had in bankruptcy applications, federal prison visits and exemptions from testifying.

These events combined to give same-sex spouses rights and opportunities they’ve never had before.  When the American Taxpayer Relief Act of 2012 (ATRA) was signed into law in January, 2013, same-sex spouses could not enjoy all its benefits.  The Windsor decision and Rev. Ruling 2013-17 changed that. They now have “tax parity” with heterosexual spouses and can take advantage of the more than 1,000 tax benefits the Internal Revenue Code gives to spouses.  Among these valuable benefits are:

Spousal IRA rollovers

The gift tax marital deduction

Spousal annuity rollovers

The estate tax marital deduction

Split gifts

Portability of the estate tax exemption    

Life insurance will be easier to use

These changes may have a big impact on how same-sex spouses purchase and use life insurance.  For many years life insurance policies have helped people accomplish a number of financial goals.  Cash value life insurance policies can provide both income tax-free death benefits and potential supplemental retirement income. In previous years, many same-sex spouses had to consider federal estate taxes in deciding how to own and manage their life insurance policies.  Before the ATRA and IRS Revenue Ruling 2013-17, there was always a possibility same-sex spouses would have to pay estate taxes when either of their estates was worth more than $1,000,000, including life insurance death benefits.  

The inability to use the estate tax marital deduction meant that many shouldn’t own their own life insurance policies. Consequently, many created Irrevocable Life Insurance Trusts (ILITs) to own them.  This made life insurance decisions more complex and more costly to implement.

The ATRA raised the federal estate tax exemption to $5,000,000 and indexed it for annual inflation (the exemption has increased to $5,340,000 for 2014).  The new opportunity to use the estate tax marital deduction, “portability” of a deceased spouse’s estate tax exemption and the increase in the amount of the exemption make life insurance planning for many same-sex spouses much simpler and less expensive.

Now same-sex spouses are unlikely to have a federal estate tax problem until the combined value of their estates exceeds $10.8 million.  If the total of their life insurance death benefits plus the value of their other assets doesn’t exceed $10.7 million, it may make sense for them to own their policies personally.  This wasn’t the case in the past when policies had to be owned by third parties or by ILITs.   Now many same-sex spouses will be able to:

avoid the costs of establishing and administering an ILIT

retain full privacy about the details of their policies

control paying premiums and taking cash value withdrawals/distributions2   

manage the amount of death benefit coverage and beneficiary designations2

The Chris Johnson and Pat Jones Example

A case study makes it easy to see the new flexibility same-sex spouses now have with life insurance. Chris and Pat are married same-sex partners.  Chris has two minor children and Pat has three adult children.  Chris’ net worth is $200,000 while Pat’s is $3,000,000.  In the event of her death, Pat is concerned that Chris will need money, but Pat wants to pass on the bulk of her $3 million to her adult children.  To protect both Chris and her own children, Pat decides to purchase a cash value policy insuring her own life with a face amount of $1,000,000.  Pat will name Chris as the primary beneficiary and Pat’s children will be the contingent beneficiaries.  The policy will give Pat benefits like these:

  1. If Pat dies, the $1,000,000 death benefit will be estate tax-free to Chris under the federal unlimited estate tax marital deduction. 
  2. If Pat wants a measure of asset protection for the death benefits or wants to control how they are distributed after her death, she can create a testamentary trust in her will and name it the policy beneficiary. After her death the trustee will receive the death benefits and distribute them according to the terms Pat puts in the trust.  She can revise the trust whenever she wishes during her lifetime.
  3. If they divorce or Chris dies first, the sum of the life insurance death benefit and the rest of Pat’s net worth is still likely to be below the federal estate tax exemption; consequently, even if Pat is the survivor, her estate is unlikely to pay federal estate taxes.  
  4. Pat can purchase the coverage with full privacy; she does not have to disclose its existence to Chris or any family member.  Only the financial professional helping her obtain the policy needs to be aware of it.  This means Pat can revise or terminate the policy without explanation.
  5. Pat will have complete access to all cash values during her lifetime* and may use them as she sees fit to supplement her own retirement income or fund gifts to Chris, her children or grandchildren. 
  6. If Chris dies first, Pat has the freedom to change her plans and use cash values to supplement her own retirement income or to make gifts or intra-family loans.
  7. If Pat becomes terminally ill, she may be able to access policy death benefits while she is alive to help pay approved medical costs* 

These potential benefits weren’t available to Pat and Chris in 2012.  Personal ownership of the policy would have been more difficult and expensive.  To avoid estate taxes Pat would probably have needed to hire an attorney to draft an ILIT to own the policy and then give the trust cash to pay the annual premiums.  In that case, she would not have been able to personally manage the policy or benefit from it. 

Conclusion

2014 is the beginning of a new life insurance planning era for same-sex spouses.  The Windsor decision, the IRS’ and Department of Labor’s rulings and the American Taxpayer Relief Act of 2012 have combined to make it much easier for them to own and use cash value life insurance.  As a result, they will probably want to use it more often.      

1 These states allow same-sex couples to marry:  CA, CT, DE, IA, HA, MA, MD, ME, MN, NH, NJ, NM, NY, NV, RI, VT, WA, and the District of Columbia. (IL will permit these marriages beginning on 6/1/2014). 

2 within the terms of the policy