GREG ROBERTS’ ON THE MONEY: Life insurance can enhance estate planning strategies
Life insurance can play a prominent role in many sophisticated estate planning strategies. Under current tax law an estate of less than $5 million in value will pay zero estate taxes. For larger estates, there are three options: sell your assets, using some sort of discounting technique, gift them to charity or pay the estate taxes. In all of these scenarios, life insurance can provide valuable financial leverage.
Consider the case of a 60-year-old prominent business man, Dan, who recently sold part of his business for $1 million. Over the years, his estate has grown substantially, and he will not need this additional income to supplement his retirement. Dan also is very interested in making a substantial gift to his college but does not want to disadvantage his children. The strategy in question involves establishing an irrevocable charitable trust and making a $1 million gift to the trust. The trustee, in turn, acting on Dan’s directives, purchases $100,000 in municipal bonds with a 4 percent coupon rate. The $4,000 annual income is directed to Dan’s college each year. The trustee then purchases a single premium life insurance policy on Dan’s life with the remaining $900,000, and this premium generates a $3.8 million life insurance policy, guaranteed for life.
This strategy will generate an immediate $950,000 charitable income tax deduction for Dan when he donates the money to the trust, and he will have made a gift of $1,000,000, but by the use of his annual and lifetime gifting limits, no gift taxes will be due.
Upon Dan’s death, the trust will make a final gift of $2.275 million to the charity, and the municipal bonds are then left to Dan’s children, along with $1.425 million from the life insurance policy. Using life insurance, in this instance, significantly leveraged the value of the gift for the charity and for Dan’s children.
Another oft-employed estate planning strategy is the use of an irrevocable life insurance trust to purchase what is known as second-to-die life insurance on the lives of a prominent couple, who will have an estate tax liability at the death of the second spouse. Policies of this ilk were developed by the life insurance industry when estate taxation rules were changed to allow all of a deceased spouse’s assets to pass to a surviving spouse estate-tax free. At the subsequent death of the second spouse, however, estate taxes might be levied, depending on the size of the estate and the then-current estate tax exemption amounts.
As an example, John and Linda Evans, both 60, are facing a potential estate tax liability since their taxable estate is greater than $5 million. They have two grown children, and John and Linda elect to establish an irrevocable life insurance trust with their children as trust beneficiaries. John and Linda may “gift-split” and make annual gifts to this trust of $28,000 for each child, or $56,000 in total. Since John and Linda’s annual gifts are within the amounts set forth by the IRS, there would be no gift taxes due on their gifts to this trust. They will make this gift each year, and the trustee will use that gift to purchase a second-to-die life insurance policy with a face amount of $5.6 million.
At the death of the second spouse, the life insurance company will pay the death benefit to the trustee, and the trustee may, in turn, purchase assets from John and Linda’s estate for cash, which can then be used to pay any estate taxes due. The purchased assets are then in the trust and can be distributed to the children. There is no other financial vehicle available to provide this sort of leverage to fund future estate taxes.
Another compelling use of life insurance arises when the primary asset in a person’s estate is a closely held business and one child is involved in the business, while the other is not. If the business is left outright to the child that is active in the family business, the other child might be disinherited. A solution would be, again, to establish an irrevocable life insurance trust, and purchase enough life insurance to cover any estate taxes and also provide the non-involved child with a death benefit equal to the value of the business.
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Greg Roberts is a certified financial planner with 35 years of financial and estate planning experience.