Life Insurance in Estate Planning

For couples, properly planned estates can protect $1.2 million from the federal estate tax. Estate values over this amount will be subject to an estate tax that has a marginal tax rate range of 39% to 55% (55% marginal rate is applied to estate values in excess of $3.0 million). Under current estate tax laws, the estate tax is a generational tax because it is generally due at the second spouse's death.

The simplest methods to reduce unnecessary estate and gift taxes are for couples to use both estate and gift tax credits, and to take advantage of the provision allowing annual gifts of $10,000 per spouse per donee to be excluded from gift taxes. The principal way to facilitate the full use of the estate and gift tax credits is for each spouse to own, in their separate names or via revocable trusts, at least $600,000 of estate assets that are directed, either by will or revocable trust, to fund a so-called credit shelter trust upon the death of the first spouse.

In addition to the simpler methods, there are more complicated estate planning techniques that can be used to reduce the ultimate estate tax burdens. Among them are techniques that can be used in association with life insurance. However, it is important that in this process, estate and life insurance planning needs are properly coordinated.

COORDINATION CONCERNS

New life insurance purchased explicitly for estate planning purposes or existing policies should avoid being subject to the estate tax. Whether an asset, including life insurance, is subject to estate taxes depends on the ownership of the asset. That is, estate taxability of life insurance proceeds depends on who owns the policy, not who the insured or beneficiary is.

Another common misunderstanding is for estate owners to value their life insurance at its cash value. This is understandable because personal net worth statements generally ask for life insurance policies' cash values, not the death benefits. However, from an estate planning viewpoint, it is the death benefits that need to be considered.

As an example of some of the concerns a couple may face in coordinating life insurance and estate planning needs, let's take the case of Bob and Alice Smith, both age 62, who have a net worth of $4.0 million that includes cash values of $80,000, but doesn't include combined death benefits of policies insuring Bob. Bob is insured with a whole life policy for $250,000 and $250,000 of term, for total coverage of $500,000. Both policies are payable to their four children. Because Bob owns both policies insuring his life, the Smith estate would owe unnecessary estate taxes at the second death of $216,000, or 43% of the life insurance proceeds, making it very expensive life insurance indeed.

The Smiths had been contemplating the purchase of survivorship life insurance for estate planning purposes but hadn't even considered the policies insuring Bob's life. Before they decide what is the best course to take with life insurance, they need to also consider their estate planning needs.

Bob and Alice sold the family business several years ago, so their assets are primarily marketable securities; thus there is no estate liquidity problem. They have annual income from their investments and retirement pensions of approximately $250,000. The Smiths' estate and gift tax credits are intact. After being admonished not to give something away they may want back some day, or to commit to annual payments (premiums) that may interfere with their own enjoyment during retirement, Bob and Alice conclude they can comfortably budget $40,000 annually for estate planning using their annual gift tax exclusions (with four grown children, they can gift up to $80,000 annually without causing a gift tax to be paid). However, they decide against using any of their estate and gift tax credits at this time.

The next option the Smiths consider is whether these gifts will be made directly to their children for their immediate use, or to use the gifts to fund a trust for their eventual benefit. Because all of their children are well-educated and successfully pursuing professional careers, Bob and Alice decide to accumulate a fund with their gifts that will be distributed to their children at the second death. Life insurance is the ideal asset for such inter-generational wealth transfer because its death benefits are entirely income-tax-free. The life insurance policy design that maximizes wealth transfer (in contrast to a liquidity life insurance need) features the lowest possible initial death benefits relative to the highest annual premiums. Unlike level death benefit policies, wealth transfer (increasing death benefits) life insurance designs favor insured(s) living as long as possible because the benefits increase every year tax-free. Therefore, a wealth transfer life insurance purchase favors survivorship life insurance because it will predictably remain in force longer than an individual single-life policy.

EXISTING LIFE INSURANCE

At this point, Bob and Alice have decided to purchase a survivorship life insurance policy with increasing death benefits (wealth transfer design) making annual gifts of $40,000. But what about the two policies insuring Bob's life for $500,000? One is a $250,000 term policy. Term insurance is for temporary life insurance needs, which Bob and Alice don't have. Therefore, it is decided to let this policy lapse when the new life insurance is in place.

Bob's whole life policy is another matter. The annual premium is $1,675. The current death benefits are $250,000, with cash values of $80,000. Bob has let the dividends pay the premiums for the past 10 years. Although wealth transfer favors a survivorship policy, retaining this policy on Bob's life is appropriate since it is with an excellent mutual company and the Smiths like the idea of an early inheritance for their children in the event Bob predeceases Alice.

Because they are now interested in increasing death benefits for wealth transfer, they decide it would be worthwhile to start paying the premiums on this policy again, buying paid-up insurance with the dividends. Based on an illustration from the insurance company (that has been tested for its reasonableness), it appears that this single-life policy insuring Bob could grow to almost $450,000 within his life expectancy under current pricing conditions. This represents a rate-of-return of 6.4%, entirely income and estate tax-free. Because the Smiths now view their life insurance as a method of transferring wealth, projecting its rate of return at various intervals is the preferred method of measuring its economic value. Table 1 shows projected death benefits for the policy insuring Bob's life. Rate of return calculations are based on current value of policy ($80,000) and projected future premiums of $1,675 annually.

=========================================

TABLE 1. BOB SMITH'S POLICY

(Purchased at Age 35)

Projected Projected

Age Death Benefits Rate of Return

($) (%)

----------------------------------------

65 268,970 34.0

70 306,634 15.0

75 351,506 10.0

80 400,247 7.8

84 442,499 6.4

90 470,797 5.3

95 468,216 4.4

Bob's life expectancy at age 62 (excellent health) is 22 years, or age 84

=========================================

Since the total annual wealth transfer gifts are to be $40,000 and $1,675 annually will be used for Bob's existing single-life policy, the budget for the new survivorship policy is $38,325 annually. To maximize wealth transfer the lowest initial death benefit of $410,000 (that increases with the increase in the cash value) is selected. Based on current (and reasonable) pricing assumptions, the projected long-term rate of return range is 8.2% to 6.2%. Table 2 shows the projected death benefits and rate of return at selected intervals for an increasing death benefit survivorship policy.

These long-term rate of return levels for the survivorship policy will remain within a narrow range even if Bob and Alice live well into their nineties and would increase if interest rates and inflation surged (conversely, they would decline if interest rates fell and remained lower). Wealth transfer life insurance is well protected from inflation.

This wealth transfer design is in contrast to a level death benefit design. Using the same annual premium ($38,325) and pricing assumptions, a $2.85 million level death benefit could be purchased. The decision to select a wealth transfer design rather than a level death benefit design depends on whether the estate assets are primarily marketable securities (Bob's and Alice's are) and whether the estate owners want to "bet" long (Bob and Alice do, since they both have longevity in their families). Table 2 shows that the crossover point is policy year 26 when the wealth transfer design equals a level death benefit design; however, their joint life expectancy is 29 years.

=========================================

TABLE 2. THE SMITHS' SURVIVORSHIP POLICY

Policy Projected Projected

Year Death Benefit Rate of Return

($) (%)

-----------------------------------------

5 632,554 42.0

10 937,211 15.0

15 1,367,385 10.0

20 1,937,742 8.2

26 2,850,908 7.1

29 3,380,752 6.7

30 3,582,125 6.6

33 4,243,134 6.3

35 4,734,044 6.2

Bob and Alice's joint life expectancy is 29 years

=========================================

WHO SHOULD OWN THE POLICIES?

Now we must deal with the ownership issue for these policies. In order to keep the policies' proceeds from being included in Bob and Alice's estate, and taxed at marginal rates of 43% to 55%, neither Bob nor Alice can own these policies.

There are two basic ownership choices. The Smiths' children could own these policies, or Bob and Alice could create an irrevocable trust to own the policies.

If the children are to own the policies, they should create a revocable trust to act as owner and beneficiary. This is important in order to handle a myriad of possible occurrences that could cause problems if the children jointly owned the policies directly. For example, if one or more of Bob and Alice's children predeceased them, the deceased child's interest in the policy can be better protected in a revocable trust. The revocable trust can provide that a deceased child's interest in the policies would be retained for that deceased child's surviving children (if any).

Having the children own life insurance insuring one or both parents, via a revocable trust, allows for more flexibility than if Bob and Alice themselves create an irrevocable trust. A possible disadvantage of having the children directly involved in the life insurance on their parents' lives is their active participation in their future inheritance. Some parents don't care for this, and prefer to be more discreet with their inheritance plans. Parents who desire more privacy about their estate plans can execute an irrevocable trust to own life insurance. This would be more desirable because using an irrevocable trust executed by the parents will require much less involvement of the children.

Bob and Alice, however, aren't concerned with estate planning privacy. Therefore, they decide to have their four children create and execute a revocable trust for the purpose of owning the single-life policy on their dad's life and the new survivorship policy.

The existing single-life policy will be transferred to this trust. Under current law, if Bob dies within three years of this transfer, the proceeds will be included in his estate as if it hadn't been transferred. Since estate liquidity isn't a concern in this case, the three-year rule isn't a significant problem. However, in cases where estate liquidity is critical (where, for instance, estate assets are primarily a closely held business and/or difficult to sell real estate) this three-year rule is a problem. If the estate owner is in good health, it can be handled by having the trust purchase term insurance in the amount of the potential estate taxes that would be generated by the transferred life insurance policy if death occurs in three years. That is, if the transferred policy is for $1.0 million, term insurance of $550,000 would be purchased by the trust, and held for three years to cover this contingency. After three years, there is no risk of the transferred policy being included in the insured's estate. Or, if the combined cost of the existing policy and the new term policy is more than the cost of a new policy (preferably low-load) originally owned by a trust and outside the estate (therefore, not subject to the three-year rule), this would be the way to go.

Smiths' new survivorship policy won't be subject to the three-year rule because the original applicant and owner of the policy will be the revocable trust created by their children. The policy will never be owned by Bob and Alice. Care should be taken to avoid applying for a new policy before the relevant trust(s) have been executed so the IRS won't have any reason to claim a policy transfer occurred, bringing in the three-year rule.

Bob and Alice will make annual gifts to their four children (or directly to the revocable trust) for the payment of premiums. The gifts will be subject to the annual gift tax exclusion because they are gifts of a present interest.

THE BOTTOM LINE DECISION

Bob and Alice have earned more assets than they could reasonably be expected to need during their lifetimes and have therefore decided on a systematic pattern of wealth transfer for their children.

[ Home ] [ Up ]

Copyright © 1998 Auerbach & Gussin