Considerations in the Use of Life Insurance in the Estate Plan

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1 Considerations in the Use of Life Insurance in the Estate Plan There are few practitioners who would argue that life insurance doesn t belong in an estate plan or that life insurance shouldn t at least be considered as a possible source of liquidity to help defray the cost of transfer taxes. There are those, however, who are adamant in their belief that life insurance should never be used to fund estate tax liabilities and that it is a totally inappropriate tool for such a purpose. This article will examine the issue of life insurance in the estate plan from a macro economic or holistic perspective. The reader may be moved to rethink the use of life insurance and its positioning as well as the type of product that may have the most holistic effect on the estate plan. The starting point for the discussion of life insurance in the estate plan could begin with a period of time that I call the Golden Age of Estate Planning. This period began with the Economic Recovery Tax Act of This law gave us the Unlimited Marital Deduction which for the first time allowed a decedent spouse to leave assets to the survivor without the imposition of a transfer tax. For the first time, the embedded estate tax liability on the entire estate of the decedent could be deferred into the future. At the same time as this was happening, interest rates began to fall and the U.S. stock market began two decades of bull market. The domestic insurance industry introduced a new product called survivorship life, also known as joint and last to die or second to die life insurance. The need for this product was clear it seemed. There were ever increasing estate values, ever increasing embedded estate tax liabilities and a need to fund the liquidity required at the death of the second to die. Life insurance, especially insurance delivered at the second death seemed to work perfectly. There are some conditions that need to be examined here in order to fully assess this reasoning. A typical pattern for estate planning involves the use of gifting to an irrevocable trust. For this discussion, if we were to assume a couple in their fifties with a $10 million dollar estate and two children, there would be an estate tax on $6 million (after the sheltering effect of the two Applicable Credits of $2 million). For simplicity s sake, with a Federal and State Estate Tax bracket of 50% the tax burden is $3 million. The gifts to the trust would be $12,000 times 2 (children) times 2 (donors) or $48,000. As long as the premium for $3 million of death benefit is less than the $48,000 gift limit, there appears to be no issue with this planning mechanism. This death benefit could be delivered on a single life or joint and last to die basis if the only consideration was the payment of tax. If the surviving family had income replacement needs then single life would be a more appropriate purchase. For this estate and this fact pattern the traditional model for estate planning works. We will revisit this notion later in this article. For now, it is interesting to note when this thought process breaks down and cannot produce the desired results. If this client were worth more than $15 million, the premium needed to support the

2 necessary death benefit could not be gifted using the annual exclusion gifts. If the client had fewer children or was single, the available annual exclusions would not be sufficient to cover the premium for the needed death benefit. If the client was significantly older the premiums would be significantly greater making the purchase of life insurance even more difficult. This mechanism calls for thinking about life insurance from a defined benefit perspective. In other words, there is a defined amount of life insurance death benefit that is required to satisfy the estate liquidity need. The premium flow into the policy is what must be adjusted to satisfy gifting limits. This forces the thought process into one which causes life insurance to be considered a commodity. As such, the planner must choose products or design premiums to accommodate this. The products that one could consider defined benefit products are term insurance, universal life (UL), variable universal life (VUL), blended whole life, and guaranteed universal life. Term insurance is unique in that for a relatively low premium, a death benefit can be provided for a period of up to thirty years. The availability of term insurance of long durations will be contingent on the starting age of the insured. Generally though, the term period for any insured will typically end well within the life expectancy of that insured making term an unreliable and inappropriate for the payment of estate taxes. In the case of universal and variable universal life, a planner can anticipate a return in the policy to lower premiums. In the early 1980s, when interest rates were high relative to today, planners could dial down premiums in anticipation of good policy performance. This did not pan out as the interest rate decline required much more premium to support the policy as was typically anticipated in the original design. With the rising stock market that began with declining interest rates, variable universal life allowed for the same machinations. Unfortunately, life insurance illustrations do not demonstrate volatility and the period of 2000 though 2002 placed a damper on variable life sales. It is because of the black eyes that VUL and UL received from these product designs that guaranteed universal life came into being. GUL is purported to be THE product to use when a planner must have a death benefit guaranteed to age 100 or beyond and a low contractually guaranteed premium. The death benefit is guaranteed as long as the premiums are paid on time and the cash value, if any, is untouched by either borrowing or surrender. It is available on a single life or survivorship life basis. For the most part, there are a few basic truths about policies purchased on a defined benefit basis. The policy owner assumes more risk in acquiring policies in this manner and the death benefit will likely not rise during the insured s lifetime. The ramifications of these are not obvious until they are thought of in the context of mortality. The graph shows the mortality for a pair of 50 year olds in preferred health. A few notable features stand out. The first is that the 50% probability of death for a pair of healthy fifty year olds

3 is actually about age 95 (green line). The 10% probability comes in at roughly 84. The most notable feature of the graph is that it takes more than twenty years for the probability of death to reach 1%. The blue line is the probability of a least one of the pair dying and the 50% probability of that comes in around age 83. Of those that die first there is a 60 to 75% probability that it will be the male. A long joint life has a consequence. The estate that might have been perfectly planned by positioning life insurance out of the estate using available credits is likely to grow and outstrip the ability of the life insurance to handle the liquidity need. Business interests, real estate, and other assets, would be expected to perform at a higher level over time than the long term ROI of premiums to death benefit of a life insurance policy. The illusion that the estate tax is due now, and must be planned for as if it were due now under prepares clients for the likely outcome of a long life. This is not to say, however, that a planner positioning life insurance in this way has done anything wrong or improper. It does suggest that there are other questions that need to be answered besides the obvious one of how to handle the estate tax liability on an estate if both deaths were to occur in a manner that triggered a tax in the short term. What role then can life insurance play in the estate planning process? In order to see life insurance in a new role we can turn to the defined contribution purchase of life insurance. Consider that life insurance can be thought of as an asset instead of an expense. As an asset, a policy of life insurance can be compared to other assets that an estate holder might own. After June 20, 1988, amounts put into a life insurance contract were limited (Modified Endowment Contract (MEC) limits) so as to prevent funding abuses of these tax efficient vehicles. Cash values of life insurance grow tax deferred and, assuming a policy is not a MEC, withdrawals are taxed on a first in/first out basis. Loans can be taken on a taxfree basis and the death benefit is income tax free. Whether life insurance is bought on a universal life or a variable universal life chassis, deposits in excess of the target premium are not exposed to the same level of charges and costs that a policy funded on a defined benefit basis are. In other words, once the funding of the policy has overcome the internal hurdles, the policy performs disproportionately better with higher funding. A new player comes on the scene when life insurance is considered this way. That player is whole life. Whole life is unique in that the endowment of the policy (the point at which the cash values and the death benefit meet) is contractually guaranteed. A consequence of this is that as long as the premium is considered paid the cash values continue to rise until the policy endows (age 100 for older policies; age 121 for newer policies). The cash values cannot go down; the only consideration is the slope of the upward rising curve. Participating whole life policies which pay dividends can have an internal rate of return of premiums to cash values in the 4 to 5% range after about 20 years depending on the amount of funding in the policy. Life insurance might be considered as an asset that could compete favorably with a municipal bond return.

4 Armed with this new information, it is possible to place life insurance in the estate of a high net worth individual. Many high net worth estates include municipal, government, and corporate bonds. As such, clients are comfortable substituting life insurance for a portion of or all of their bond portfolio. The decision to do so will be dependent on the need to produce cash flow in the short term. In the optimal situation, the amount of life insurance that should be positioned in this manner is a face amount that roughly equals the entire estate less applicable credits. As an example, if a couple were worth $20 million, then it would be optimal to embed no less than$16 million in the estate. In order to appreciate this as a solution for the estate planning client we will look at three different circumstances: husband and wife die early, husband dies first and wife survives, both husband and wife live a long life. Husband and Wife Die Early In this case, at the death of the second to die, the total estate is $36,000,000. This is because the life insurance is included in the estate of the husband and as his wife is dying soon after or simultaneously, the effect is as if we have grossed up the estate. The estate tax due on this total sum is roughly $16 million leaving a net estate of $20 million. Therefore, in the circumstance that the traditional estate model works in, the new alternate plan works as well. Husband Dies Early/Spouse Survives In this case, when the husband dies the policy on his life endows as a death benefit and is cash in the hands of the surviving wife. The death benefit is delivered estate tax free as are the other estate assets due to the unlimited marital deduction. The basis of the assets is stepped up to full fair market value. The wife can now make a gift of a portion of the assets she inherited to her children in trust or outright and use the cash from the policy to pay a gift tax instead. Ignoring the applicable gift tax credit, if the spouse were to give $10 million to the children or children s trusts, she would pay a $5 million gift tax. This would leave her with $21 million to live on. The $15 million is then out of the estate to grow free of estate tax. This produced a superior result to the traditional plan. Husband and Wife Live a Long Life In this case, neither the traditional estate plan nor the new life insurance thinking works to absorb the ever increasing estate growth. It is important to use other estate planning tools to solve the future growth problems. Note sales to Intentionally Defective Grantor Trusts (IDGTs), zero remainder interest Grantor Remainder Annuity Trusts (GRATs) are critically important to wealth shift large amounts of wealth to the next generation. Distinct from the traditional planning model, where gifts are used to buy life insurance, the thought process here is to use either the annual gift tax exclusions or the applicable credit to seed trusts for these other gift strategies. In this manner, higher valued opportunities, higher returning assets, and higher cash flowing assets are removed from the estate. The nature of these

5 strategies and the details associated with them are beyond the scope of this article. The key is that the trusts used are intentionally income tax defective. Life Insurance End Game A by product of wealth shifting is the trading of one tax bracket for another. Planners shift wealth to avoid a 45% estate tax bracket. When assets are moved out of the estate and into trusts for the benefit of the estate owner s descendants, assets are moved with a carry over basis. Additional growth is expected to occur outside of the estate. The heirs may choose to liquidate the property they inherit after the senior generation dies. This will trigger a capital gain tax and possibly recapture taxes on depreciated assets. Depending on the state, the total tax could be anywhere from 15 to 25%. A common practice among estate planning attorneys is the use of a power of substitution to exchange high basis assets that are in the estate with low basis assets that already outside of the estate in intentionally income tax defective trusts. The life insurance policy that has been maturing inside of the estate is now the perfect property to swap for low basis assets. As the trust is intentionally defective, neither the trust nor the grantor will experience the recognition of gain, and the transfer for value rule, which can subject death benefits to income tax, does not apply. In addition, as long as the swap is for fair and adequate consideration in money or money s worth, no gift will have been made to the trust, and the three year rule does not apply, so the policy is out of the estate. For a whole life insurance policy that had been purchased on a male age 50, the death benefit would be roughly 60% more than the cash value at the age of 75. As the policy proceeds would be fully income and estate tax free after the swap with the trust, one could say that the basis for the life insurance is 160% of its transfer cost. Summary Life insurance is a valuable tool in the estate planning process. It is the only asset that has the certainty of liquidity when it is needed to solve the liquidity crisis that other assets might face. The traditional model of estate planning does work to pay estate and inheritance taxes at the second death and yet it can be seen that solving for the current estate s taxes may not be sufficient. Long life and estate growth combine to reduce the effectiveness of the standard use of life insurance bought in an irrevocable trust. Well funded life insurance can behave in a bond like manner. When thought of as an asset, clients are inclined to acquire more life insurance than they would need to satisfy the current tax bill. When positioned in the estate, life insurance doesn t crowd out the ability to give gifts of estate assets or to engage in planning strategies like Note Sales to IDGTs and GRATs. Later in life the insurance policies can be sold to the trusts for their fair market value and the death benefit can be removed from the estate while helping heirs avoid embedded capital gains.

6 Educating clients to the ramifications of long life and estate growth may have both the client and the planner rethink the use, positioning and type of life insurance. The objective of total tax avoidance as opposed to handling the current estate tax bill alone will enable planners and attorneys to provide more valuable services and to assure more long lasting relationships with clients. Registered Representative and Financial Advisor of Park Avenue Securities, LLC (PAS). Securities products/services and advisory services offered through PAS, a registered broker-dealer and investment advisor, Financial Representative, The Guardian Life Insurance Company of America (Guardian),New York, NY. PAS is an indirect, wholly-owned subsidiary of Guardian. Strategies for Wealth is not an affiliate or subsidiary of PAS or Guardian. PAS is a member of FINRA, SIPC