Life insurance trusts have long been hailed as a smart way to provide financial protection for loved ones while simultaneously avoiding any adverse estate tax consequences—but the question that most often arises today in the context of life insurance trust is, do I really need it?
The 2017 tax reform law doubled the estate tax exemption, to $11.4 million per person ($22.8 million per married couple) in 2019, meaning that, for all but the fortunate few clients, the estate tax itself may seem irrelevant. For some clients, dismantling existing life insurance trusts may be the smartest move—but not without considering both the repercussions of that approach and carefully planning for any continuing life insurance needs, where a tax-free replacement strategy may be key to safeguarding future financial protection.
Look Before You Leap: Reasons to Keep the Trust Intact
First and foremost, one reason that clients may wish to keep their life insurance trusts intact is the possibility that the exemption level will change going forward—in fact, it’s already scheduled to revert back to between $5 million and $6 million in 2026. The tax law is never permanent, even if the tax code says it is, so clients should remember that a change in the political winds could mean that the exemption will decrease and/or the estate tax rate could increase.
For other clients, state-level estate and inheritance taxes could be a consideration in favor of keeping the life insurance trust intact. States that do have estate and inheritance taxes have overwhelmingly chosen to keep their transfer tax exemptions at pre-reform levels, meaning that if state taxes were an issue for the client pre-reform, they continue to present the same issues now.
Clients with liability concerns, whether relating to a business, malpractice possibility or otherwise, might want to consider the asset protection value of the life insurance trust before choosing to dismantle it.
Dismantling an Existing Life Insurance Trust
If the client chooses to dismantle the trust, that process is actually fairly straightforward. The client could choose to give the policy to his or her spouse, and if there are no other assets held in the trust, that would be the end of the story—with no assets, the trust would essentially be dismantled.
In some cases, the client should obtain the consent of any remainder beneficiaries to the trust—for example, adult children. Often, obtaining this consent is not a problem. If the client is concerned about future issues, he or she could execute a non-judicial settlement agreement that would essentially provide a formal agreement to dismantle the trust and distribute the policy.
A more pressing concern for most clients will be deciding what to do with the life insurance policy after the trust itself has been eliminated. For some clients, exchanging the existing policy for another policy or financial product might provide an attractive option.
The 1035 Life Insurance Replacement Strategy
Some clients may choose to dismantle their life insurance trusts, but recognize that they continue to have ongoing life insurance needs—whether to provide financial protection for loved ones or establish a tax-free source of income during retirement from a cash value insurance policy. These clients might be interested in executing a 1035 exchange, and get rid of the old insurance policy in favor of a policy or financial product that better suits the client’s current needs—including the client’s long-term care needs.
The IRC Section 1035 exchange rules allow the owner of a financial product, such as a life insurance or annuity contract, to exchange one product for another without treating the transaction as a sale. This means that no gain is recognized when the first contract is disposed of, and there is no intervening tax liability. A life insurance policy may be exchanged for another life insurance policy, an annuity or endowment contract with long-term care benefits. An annuity contract may be exchanged for another annuity contract with long-term care benefits.
The owner of the policy or contract must not change in the exchange—i.e., the insured individual under the exchanged life insurance policy must be the same insured under the long-term care component of the hybrid product received in the exchange. As an exception to this general rule, the IRS has allowed 1035 treatment where a change in insured individuals occurred because a policy insuring two lives in a second-to-die policy was exchanged for a single life policy after the death of one of the original insured individuals.
Clients must complete the 1035 exchange in what is essentially similar to a trustee-to-trustee transfer in order to avoid adverse tax consequences. This means that the client never receives the proceeds from sale of the first policy—instead, the proceeds are transferred directly by the original insurance carrier to a new carrier that issues the replacement product. An original annuity must also be non-qualified for like-kind exchange treatment to apply, meaning that it was purchased with after-tax dollars.
Life insurance trusts can continue to be useful for clients for a variety of reasons even post-tax reform, but for a client who has decided the trust is no longer worthwhile, a Section 1035 tax-free exchange can provide a tax-preferred way to obtain a life insurance policy, annuity or even long-term care protection for the future.
- Read previous coverage of estate planning strategies in Advisor’s Journal.
- For in-depth analysis of the general rules governing estate taxation of life insurance, see Advisor’s Main Library.
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