Why Life Insurance Needs to Be Part of Your Clients’ Estate Plans
As tax exemptions are targeted, life insurance policies could offer high-net-worth individuals a different means for protecting their estates.
By Daniel F. Rahill, CPA, JD, LL.M., CGMA | Digital Exclusive - 2021
A day after the Senate approved a $1 trillion bipartisan infrastructure bill, it completed action on a fiscal year 2022 budget resolution that reconciles up to $3.5 trillion in spending and tax relief provisions—a move that opens the door to tax increases on wealthy individuals and corporations. While the details still must be formed into actual legislation, the Senate committees responsible for doing so have been instructed to complete the bill by September 15, 2021—and CPAs and estate planners with high-net-worth clients should be watching.
I suspect we’ve been warned about what’s to come for our clients—and maybe even ourselves. While on the campaign trail, now Pres. Joe Biden proposed reducing the estate tax exemption to $3.5 million from the current $11.7 million per individual (indexed for inflation) and raising the top tax rate to 45 percent from the current 40 percent. This could suggest an accelerated sunsetting of the $11.7 million estate tax exemption, which is currently slated to revert to the pre-2018 exemption of approximately $5.8 million after 2025 unless it’s renewed by Congress. Sen. Bernie Sanders is also targeting estates in his For the 99.5 Percent Act, which goes even further by reducing the estate tax exemption to $3.5 million (not indexed for inflation), reducing the gift tax exemption from $11.7 million to just $1 million, and raising the estate and gift tax rates as high as 65 percent.
So, where can wealthy individuals and families turn to minimize their estate taxes? Life insurance.
Escaping Estate Tax
The benefits of a life insurance policy go far beyond the tax-free death benefit payable to a named beneficiary or paying for the insured’s final expenses. In many cases, life insurance proceeds are used to pay estate taxes to avoid the forced sale of assets or may be used to fund the buyout of the decedent’s interest in a closely held business. We also often see the proceeds being used to fund a trust to provide for minor or special needs children.
Although life insurance death benefits are generally exempt from income tax, they’re not generally exempt from estate tax. However, if the policy is owned by an irrevocable life insurance trust (ILIT), the proceeds upon death will pass outside of the estate, freeing them from federal estate tax. With a significant reduction to the federal estate tax exclusion looming, establishing an ILIT is becoming an increasingly important tax planning strategy for excluding life insurance proceeds from the taxable estate. (Note: A Spousal Lifetime Access Trust, or SLAT, discussed in “12 Reasons a SLAT Makes Sense,” can also be the life insurance policy owner.)
Inside the ILIT
As mentioned above, a life insurance policy can be held in an ILIT so that the life insurance proceeds escape the federal estate tax and don’t use part of the estate tax exemption, whatever that may end up being. Typically, the life insurance policy owner either transfers the policy to the ILIT or the trustee purchases the policy for the trust. Most ILITs are funded with the purchase of a new policy rather than the gift of an existing policy since the policy owner must survive for three years after the transfer of the assets to the trust for the proceeds to avoid estate tax inclusion.
Unless the policy is a contributed policy that has been paid up, funds need to be provided to the trust to pay the policy premiums. The insured may make gifts to the ILIT for this purpose, but the insured must ensure that the gifts are of “present interests” to minimize gift tax consequences.
If a couple sets up the trust jointly, the life insurance policy purchased is usually a second-to-die policy, which can qualify for a lower premium rate and/or higher coverage given the couple’s longer joint life expectancy. Upon the second spouse’s death, the ILIT can then lend money to, or purchase assets from, the estate to provide it with liquidity.
Pocketing the Premium
Thanks to our current low interest rate environment, financing life insurance policy premiums through banks or other third-party premium financing companies has become very popular. For high-premium life insurance policies, financing the premium at a low interest rate allows the policy owner to avoid paying for the premiums outright, leaving their assets either untouched—presumably avoiding an unfavorable taxable event—or available for other, higher yielding investments.
In short, the policy owner will borrow at a low interest rate to pay the policy premium, either as a lump-sum or over a set term, and repays the loan in manageable, regular installments until the debt is satisfied or the insured passes away, in which case the balance is typically paid off with insurance proceeds. The loan can also be paid before death out of cash values of the life insurance.
Let me illustrate:
A married couple, age 69, uses their ILIT to purchase a $50 million second-to-die life insurance policy with a single payment premium of $10 million. The ILIT borrows the $10 million from XYZ Life Finance with an annual interest rate of 3.25 percent to pay the policy’s premium. The couple gifts cash to the ILIT annually to make the $325,000 interest payment, filing gift tax returns and applying the gifts against their lifetime exemption. In 20 years, upon the death of the second spouse, the life insurance company pays the ILIT the $50 million death proceeds of which $10 million repays the bank loan, netting $40 million of tax-free cash to the ILIT. After deducting the $6.5 million of interest paid over the course of the loan, the family nets $33.5 million that’s free from both estate and income taxes for the trust’s beneficiaries—usually their children and/or grandchildren. If the estate needs liquidity for estate taxes, or if it needs to sell an illiquid asset like a family business, it can transact with the ILIT. Any outstanding debt would be settled when the estate is disbursed to the heirs.
Our Opportunity
As you can see, an ILIT and life insurance policy can play a critical role in protecting the value of one’s estate. And as increased tax rates and estate tax exemption reductions loom, we have an opportunity to prove our value to our clients by showing them this tax-savvy strategy for minimizing their—or their heirs’—tax burdens. After all, we are their most trusted and strategic advisors for a reason, and we can help them protect the wealth and liquidity of their estates before it’s too late.
Illinois CPA Society member Daniel F. Rahill, CPA, JD, LL.M., CGMA, is a managing director at Wintrust Wealth Management. He is also a former chair of the Illinois CPA Society Board of Director and is a current board member of the American Academy of Attorney-CPAs.
This information may answer some questions, but is not intended to be a comprehensive analysis of the topic. In addition, such information should not be relied upon as the only source of information; professional tax and legal advice should always be obtained. Securities, insurance products, financial planning, and investment management services are offered through Wintrust Investments, LLC (Member FINRA/SIPC), founded in 1931. Trust and asset management services offered by The Chicago Trust Company, N.A. and Great Lakes Advisors, LLC, respectively. © 2021 Wintrust Wealth Management Investment products such as stocks, bonds, and mutual funds are: NOT FDIC INSURED | NOT BANK GUARANTEED | MAY LOSE VALUE | NOT A DEPOSIT | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY