In an uncertain economic climate, there are two financial matters that are abundantly clear. There will be a federal estate tax that will be levied on wealthy individuals and life insurance will be an effective way to minimize the financial sting of that tax.
Many excuses can be offered for delaying the life insurance buying decision, but the uncertain fate of estate taxes is no longer a credible one. It is time for agents, professional advisors and wealthy clients to recognize the estate tax issue and consider how
life insurance can be a solution.
A mistake to delay
At the time of this article, Congress has not finalized an estate tax bill. Yet there is no reason to delay performing an estate tax and funding review. There is significant support for continuing the estate tax at the current $3.5 million exemption and 45% marginal tax bracket.
There is very little support for raising the exemption or lowering the tax rate. The more likely contingency is that Congress deadlocks on the issue and no estate tax bill is passed in 2009. That would mean there would be a temporary repeal in 2010 and then a reversion to a $1 million
exemption and 55% top rate in 2011. Unlikely as this may be, it is not a reason for delay.
First, if a person expects to die for medical reasons in 2010, he or she is unlikely to be insurable, making the life insurance decision moot. Second, if the concern is dying for some other reason in 2010, this is all the more reason to purchase life insurance. Finally, even if the one year repeal goes into effect, the law would institute a "carry over basis" rule which could generate the need for life insurance to defray additional income taxes. The financial risk of dying without life insurance trumps the minor uncertainty of the exact provisions of the estate tax.
Insurance companies have long anticipated changes in the estate tax law. For example, many offered an estate tax repeal rider. Any qualified insurance advisor knows how to structure an insurance plan to deal with contingencies such as changed tax rates.
A strategy relevant to the upcoming changes in estate tax law would be to purchase the permanent insurance on the assumption that the exemption will be $3.5 million. An additional amount of term insurance could then be purchased as a hedge against the law reverting to the $1 million exemption level. Some life insurance companies will even allow two term policies on husband and wife to be converted to one survivorship policy.
Life insurance uses in estate tax planning
Life insurance obviously provides a death benefit available to pay estate taxes after the insured's death. But clients and their professional advisors may not fully appreciate all life insurance can accomplish when doing estate tax planning. Some of the many advantages include the following:
Life insurance as an asset: Because of the large estate tax exemption, the federal estate tax only applies to wealthy individuals and families. For this reason, the planning objective is often more focused on wealth preservation than wealth creation. In many cases, the specific preservation objective is to create a family dynasty.
Life insurance as an asset is a complement to this strategy. First, it provides a defined amount exactly when it is needed, at death. Further, it is an asset that is not correlated to the investment market. The owner of the insurance knows that irrespective of the investment market, a defined value will be paid. Assuming the continued viability of the insurer, the only unknown is the date of death.
Life insurance as a hedge: With larger estates, there are typically a number of assets in play. There may be substantial business interests, real estate holdings and an investment portfolio. Death can occur at an inopportune moment and severely harm the value and viability of these assets. The life insurance purchase is a financial hedge designed to provide liquidity at a known event, mitigating the potential loss to these assets.
For either a single or ongoing premium, the family can lock in a known amount that will be paid at an unknown time, such as death. In some ways, this can be analogized to a call option with the call being upon the occurrence of an event rather at a particular time. If the life insurance is permanent, it may also offer a partial refund feature.
Life insurance as a sponge: Although there are many planning opportunities that can help mitigate estate taxes, many wealthy families must still pay an estate tax. Life insurance is the financial sponge that can absorb what taxes haven't been eliminated through planning. Especially because the insurance can be placed outside of the estate in an irrevocable life insurance trust (ILIT), this product is the ideal tool to provide the amount needed at the time needed.
Life insurance as a liquidity source: Especially when the source of wealth is a family owned business, liquidity and cash flow are crucial to the estate planning process. A common strain on the liquidity of many small businesses is the death of a founder or owner. The estate tax is often one of the primary demands for cash that follows the owner's death. Life insurance not only represents a handy asset at an unfortunate time, it also represents a flood of liquidity at a time where the very survival of the business is at issue.
Life insurance as a tax planning tool: There is a significant planning flexibility in the estate tax arena. Most advisors agree life insurance is one of the most important funding tools for leveraging this flexibility and it offers numerous tax advantages. Between the ILIT, grantor trusts, Crummey provisions and other insurance-based planning tools, life insurance offers a number of tax-related advantages. In the right circumstances, this product can be structured to have premiums gifted without gift taxes, the death benefit received income tax-free, available to pay estate taxes, and without the death benefit being subject to estate taxes. Tax flexibility begets tax savings.
Conclusion
A continued federal estate tax appears to be inevitable. Advisors and their clients are focused on ways to combat the negative consequences of this tax and minimize its effect on families and businesses. Fortunately, the government allows tools and products to be used that mitigate the sting of transfer taxes. Life insurance has long been one of those products utilized in creating liquidity and minimizing taxes.
As the federal estate tax firms up in the coming months, a clear planning tool available to provide relief is life insurance.
Steve Parrish, JD*, CLU, ChFC, RHU, is national advanced solutions consultant with the Principal Financial Group.
*JD is an educational degree and the holder does not provide legal services on behalf of the companies of the Principal Financial Group.
