IMC White Paper Life Insurance Planning Under the American Taxpayer Relief Act (H.R. 8)

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1 1 IMC White Paper Life Insurance Planning Under the American Taxpayer Relief Act (H.R. 8) Synopsis: On the verge of the fiscal cliff, the president signed into law the American Taxpayer Relief Act of 2012 (ATRA). ATRA initiated changes in the tax system that directly correlate with life insurance planning. The purpose of this white paper is to outline some of these changes, and provide some thought and consideration as to planning strategies in this revised tax environment. Introduction History of Life Insurance & Taxes The concept of life insurance has been around for almost two centuries, however, its uses and structure have changed over time. What used to be considered as a vehicle to pay for funeral expenses or family protection, life insurance has become a powerful tool for wealth preservation/accumulation, business succession, financial planning, and income replacement. These uses have largely resulted from changes to the tax system. In 1913, income tax became a permanent fixture in the U.S. tax system. Shortly after, the Revenue Act of 1916 established the estate tax as a permanent source of federal revenue (Exhibit A). As the tax system developed, and as rates have increased over time, families and financial advisors have been looking for ways to reduce the tax burden. Life insurance has tax advantages that make it a useful tool for tax planning. The death proceeds are income tax-free and cash value is tax deferred. The death benefit creates tax-free liquidity at death, which can be used for estate taxes, unfunded liabilities, buysell agreements, and much more. The tax-deferred nature of life insurance cash value makes it a valuable alternative asset class for income and capital gains tax planning. We expect life insurance to continue to be an important component in estate and financial tax planning, especially as tax increases will likely continue for the foreseeable future as the government looks for ways to reduce the country s debt.

2 2 The American Taxpayer Relief Act (ATRA) Highlights Related to the Life Insurance Industry On the verge of the fiscal cliff, the president signed into law the American Taxpayer Relief Act of 2012 (ATRA). ATRA permanently unifies the federal gift and estate tax transfer systems. For 2013, the exemption amount will be $5.25 million, increased from $5.12 million in 2012, indexed annually for inflation. The inflation rate, as measured by the Consumer Price Index (CPI), was 2.5% for This rate is consistent with the 20-year average (Exhibit B) 1. In addition to the increased transfer amounts, the highest estate tax bracket has increased to 40%. The permanency of ATRA creates a level of certainty in estate planning that was not available in the past. In recent years, estimations for estate tax liabilities varied by millions of dollars due to the uncertainty in long-term tax rates and unknown exemption amounts. A permanent estate tax should help with this issue and stabilize planning discussions. This directly affects life insurance planning, as many affluent families utilize life insurance for estate tax funding and capital preservation strategies. ATRA also made some notable changes that will affect the amount of taxes individuals and trusts pay on income, capital gains, and dividends. A new income tax rate of 39.6% was introduced for the top bracket, and capital gains rates for high income earners also increased to 20%, with dividends taxed at the same rates as long-term capital gains. Coupled with restricted exclusions and deductions, this will increase the amount of taxes high income / high net worth individuals will pay. The tax-free build-up of life insurance makes it an attractive vehicle for sheltering taxes and gains. Life Insurance and ATRA Planning Considerations Above and Below the Threshold A good method of evaluating life insurance planning is to separate into two groups, Above the Threshold and Below the Threshold. Classified as above the threshold are those subject to estate taxes. These are people who have estates greater than $10.5M ($5.25M for individuals). A net worth that does not exceed $10.5M, falls below the threshold. Above the Threshold Utilizing the Indexed Exemption Many families above the threshold took advantage of the $10.24M lifetime gift exemption last year. Due to indexing for inflation, these families have an additional $260,000 available to gift, resulting in a new exemption total of $10.5M. We see some valuable uses for this $260,000 as it relates to life insurance. First, as interest rates have been historically low for many years now. This has caused life insurance carriers to reduce crediting and dividend rates. These reduced rates have 1 Data provided by the Federal Reserve Bank of St. Louis;

3 3 significantly impacted the performance of many life insurance policies issued in the last years. The additional gifting amounts, whether used in part or in whole, can help strengthen non-performing policies as initially illustrated or desired. In essence, fixing distressed policies. Second, using the increased gifts for new life insurance can create substantial leverage (Exhibit C). While we consider life insurance as a hedge for mortality, it more often than not produces a positive internal rate of return at life expectancy. Below the Threshold Uses for Unnecessary Life Insurance Policies The permanency of the new estate tax at historically high exemptions may lead many consumers to reconsider existing life insurance purchased for estate planning. Someone who acquired a life insurance policy for estate tax funding in the early 2000 s with a $1 million exemption, may no longer need that insurance for estate tax funding liquidity. These clients should revisit those policies to see if they can serve other needs. These policies could be exchanged for annuities to create a source of retirement income, or for long-term care policies to help preserve assets in the event of needing advanced health care. If some of these retirement needs have already been met, restructuring these policies so they can be maintained with no further premiums may be of interest. Reducing coverage duration or death benefit coverage can accomplish this goal. Altering the purpose of the insurance by donating the policy to a charity is also an option to consider. This creates an income tax deduction in the year gifted, and also helps meet charitable endeavors. Above the Threshold Life Insurance as an Asset Class As mentioned previously in this article, increased capital gains and income rates magnify the tax benefits of life insurance cash values. Tax-deferred growth of cash values make life insurance an attractive supplement to investment accounts, which get taxed annually on realized gains or dividends. It can also be an attractive supplement to retirement accounts, as cash values can be accessed through tax-favored policy loans and withdrawals. The new law raised the estate tax rate to 40%, which suggests large estates be reviewed for the increased tax exposure. Also, the return on estate assets may outpace the CPI, so forecasting future tax exposure may be warranted depending on projected growth of estate assets. Qualified investors may also consider private placement life insurance as well. This solution has the same tax-favored qualities of life insurance, but includes benefits not available in retail products. One of the primary benefits is the ability to invest in alternative investments.

4 4 Conclusion As described throughout this paper, insurance has become a prominent tool for estate and wealth transfer planning. Due to recent changes created through ATRA, revisiting current insurance coverage and wealth transfer plans may be warranted. Whether above or below the threshold, the current tax environment will cause our clients to reevaluate their existing coverage. For nearly four decades, IMC has been working with many of the country s wealthiest families and top advisory teams. Through a unique process of Inspired by Why, IMC is able to create a vested outcome of various alternatives under ATRA as it relates to life insurance planning. This information has been taken from sources, which we believe to be reliable, but there is no guarantee as to its accuracy. This material is not intended to present an opinion on legal or tax matters. Please consult with your attorney or tax advisor, as applicable.

5 5 Exhibits for IMC White Paper Exhibit A: 100+ Years of The Transfer Tax System 1906 Theodore Roosevelt proposes a graduated inheritance tax to Congress 1916 Estate taxes become permanent source of federal revenue with the Revenue Act of 1916 ($50,000 exemption) 1924 Federal gift tax enacted to prevent avoidance of estate tax 1926 Repeal of gift tax and lowering of estate tax 1932 Gift tax reinstated and estate tax rates raised to fund federal programs dealing with the Great Depression 1948 First marital deduction (50% of adjusted gross income) 1976 Unification of estate and gift tax systems in Tax Reform Act of 1976 ($120,667 exemption) 1981 Economic Recovery Act of 1981 raises exemption to $225,000 and creates unlimited marital deduction 1986 Tax Reform Act of 1986 raises exemption to $600, Taxpayer Relief Act of 1997 raises exemption to $1,000,000 (phased in between 1998 and 2006) 2001 EGTRAA increases exemption over the next 8 years with planned phase-out of estate tax for 2010 only (Step-up in basis rescinded for 2010) 2011 EGTRAA sunsets with estate and gift tax rules returning to 1997 legislation 2013 Exemption unified for Estate and Gift Tax at $5M per spouse indexed for inflation ($5,250,000 as of 1/1/13) and tax rate of 40% Exhibit B: Consumer Price Index for All Urban Consumers: All Items (CPIAUCNS), Percent Change from Year Ago, Annual, Not Seasonally Adjusted Observation Date CPI Percent Change Observation Date CPI Percent Change YEAR AVERAGE: 2.50% Data provided by the Federal Reserve Bank of St. Louis; Exhibit C: Leveraged Life Insurance with $260,000 Annual Premium Ages 50/50 Ages 60/60 Ages 70/70 $55,000,000 $30,000,000 $14,000, % LE 6.89 % LE 6.57% LE Life expectancies are based on the Society of Actuaries 2008 Valuation Basic Table, assuming standard mortality risk. Other tables may generate different life expectancies. Life expectancies were calculated as 41 years for ages 50/50, 32 years for ages 60/60, and 23 years for ages 70/70. Life insurance pricing assumes standard rate classes, specified ages, and current pricing available through an M Financial proprietary product. This information was prepared for summary and estimation purposes only; there is no guarantee these results can be achieved.

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