The Need for Life Insurance
Let’s examine some uses for life insurance, the only asset class that can ensure the completion of proper funding for a myriad of unique planning needs - regardless of the state of the federal estate tax.
Income Replacement ("How will my family eat if I die?")
Even if your estate is not subject to estate tax, life insurance can replace lost income if you die unexpectedly (more policies pay out for income replacement than for liquidity to pay estate tax). For example, people with young children might consider using life insurance to ensure that there are sufficient funds available to pay for child rearing or college and post-graduate expenses in the event of a parent's premature death. For these income replacement policies, the estate tax, including the possibility of estate tax repeal, has no significance.
Planning Tip: Consider life insurance to replace income from the premature death of a primary income-earning spouse or parent.
Wealth Creation ("What if I die before I build an estate for my family?")
Another need for life insurance unaffected by the estate tax is the use of life insurance to create wealth. Examples of this need are families who wish to add to their wealth for future generations, or to fund their philanthropic objectives.
Wealth Replacement ("How can my family receive the full value of my assets?")
At Hammond Iles Wealth advisors, we promote $0 estate taxes through philanthropic planning rather than use life insurance to pay taxes. However, without $0 estate tax planning, traditionally, life insurance is used to replace wealth lost to the federal or state estate tax. With an increasing federal estate tax exemption currently $5.34M per individual, $10.68M per married couple, fewer people are subject to federal estate tax. (The Connecticut estate tax rate is a progressive one that starts with 5.085% of the first $100,000 over the $2M threshold and rises to 16% for the amount above $10,100,000.) Yet, many people have significant other wealth replacement needs.
For example, many peoples' most significant assets are tax-qualified plans (such as IRAs, 401(k)s and pension plans). Because these assets are Income in Respect of a Decedent (IRD), they will be subject to ordinary income tax when distributed to beneficiaries. While we often discuss with clients maximum income tax deferral ("stretch out"), many beneficiaries will deplete these assets quickly, incurring significant income tax. Recognizing this, many individuals would benefit from life insurance designed to replace this lost wealth.
In addition to traditional wealth replacement needs, wealthier people may benefit from wealth replacement for assets transferred to a charitable remainder trust (CRT) or to a charitable lead trust (CLT), which is often used to eliminate estate tax. Download Double The Impact of Your Retirement Accountto see a wealth replacement case study. (PDF)
Planning Unrelated to the Federal Estate Tax ("I didn't know there were so many other situations where only life insurance will assure me my goals will be reached even if I die!")
People often use life insurance in planning that is wholly unrelated to the estate tax. There is a continuing need for life insurance as a funding vehicle in numerous situations, including:
Long-term care, where insurance is used to replace lost wealth due to a lengthy illness. For example, if someone needs nursing home care, the average cost in Connecticut is approximately $12,000 per month. Should they need prolonged care for 2 years before passing, the cost could add up to be $288,000 or more. Life insurance proceeds can be used to replace the money spent. If the insured never needs care, then the proceeds would increase what is left to heirs.
- Buy-sell planning
- Key employee coverage
- Nonqualified deferred compensation
- Death-benefit-only plans
- Liquidity to pay debts
- Liquidity for state death taxes
- Inheritance equalization
Income-Tax-Free Status of Death Benefits ("What a difference not paying taxes can make on the amount to which my premiums can grow.")
With increasing federal estate tax exemption amounts, there is now an increased emphasis on income tax planning, with a particular emphasis on assets that combine basis step-up with tax-free or tax-deferred growth. Life insurance proceeds paid upon the death of the insured, as well as proceeds attributable to investment appreciation on the cash value portion of the policy, are excluded from gross income. As a result, not only is the death benefit of a life insurance policy tremendous compared to the premiums paid if the insured dies prematurely, in a properly designed policy the death benefit remains quite ample even if the insured lives past life expectancy.
Irrevocable Life Insurance Trusts ("A little planning can provide enormous tax savings.")
Even though the insurance death benefit is not subject to income tax, the life insurance proceeds will likely be included in the client's gross estate and, therefore, be subject to federal and/or state estate tax absent a properly drafted and maintained Irrevocable Life Insurance Trust (ILIT). As a result, many clients create ILITs for the purpose of owning life insurance to avoid federal and state estate tax on the death proceeds.
Planning Tip: Use an Irrevocable Life Insurance Trust to purchase, own and be the beneficiary of life insurance to avoid having the death proceeds subject to estate tax. A good lawyer with prompt turnaround of a trust document is a critical component of the planning team.
Planning Flexibility ("How can I deal with the uncertainty of estate taxes?" "Will I need the extra cash at my death, or not?")
The uncertainty surrounding the federal estate tax and the exemption equivalent amount may suggest the use of the most flexible types of cash value policies, such as universal life policies. These policies permit the policy owner to vary the amount of premium payment, the level of death benefit, and the amount of cash value (in exchange for this flexibility, the client may give up the guarantees that the premium will provide a guaranteed death benefit for the life of the policy). No other single asset provides the same degree of planning flexibility. However, it is incumbent on the planning professional to ensure that the product selected fits the needs of the particular client.
Planning Tip: Permanent life insurance is a unique asset that provides the highest degree of flexibility for changes in the law or changes in a person’s circumstances. The quality of the life insurance agent and the life insurance company he or she selects are among the most important choices a person can make.
Life insurance is the only asset class (other than cash) that a client can remove from his or her gross estate, yet it still provides liquidity (e.g., for federal or state death tax or capital gain tax) or wealth replacement (e.g., to make beneficiaries "whole" for large IRD items like IRAs, 401(k)s, and pension plans) without itself incurring income tax. -Guest post by Scott Iles, VP, Hammond Iles Wealth Advisors
Scott works with individuals, families, closely‐held and family‐owned businesses, helping them grow and preserve wealth, plan for retirement and manage their long-term care and life insurance. He may be reached at 1-800-416-1655 or firstname.lastname@example.org for a Medicare Assessment or guidance on retirement.
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