Today’s Planning Opportunities with Life Insurance
For many, the onging global health crisis and political turmoil in Washington, DC have caused a significant amount of uncertainty regarding both our everyday lives and the future. While we work to adjust to the “new normal” of the present, it is important to be prepared for potential changes that could arise.
No matter how much wealth you have accumulated, life insurance can be an important part of your estate and financial plan. For families of modest wealth, life insurance can provide cash when your family needs it most.
Upon the death of a parent or spouse, life insurance proceeds can help pay debts, fund children’s college tuition, or provide the family with additional funds to maintain its lifestyle. For families with considerable wealth, life insurance can be used to replace wealth lost to estate tax, inheritance tax, and income tax; prevent illiquid assets from being sold at “fire sale” prices; or to provide a family business with sufficient cash to carry on after the loss of its leader.
Changing times may require a change in plans. Gazing over today’s horizon at an uncertain future, perhaps now is an appropriate time to review your and your family’s goals and objectives and the plan to achieve them. As part of your overall wealth planning assessment, you should periodically review your life insurance policies. As described in this article, now may be the perfect time to do so.
For families with considerable wealth, it is still a good time to plan. Although interest rates have risen from the historic lows of last year, they remain low when viewed historically. Also, the currently large exclusion amounts available from the federal gift, estate, and GST taxes, sometimes referred to individually or collectively as wealth transfer taxes, allow for a significant amount of wealth to be transferred at an historically reduced cost. Taking advantage of these circumstances can allow wealthy families to implement new life insurance strategies or strengthen existing life insurance programs.
The Tax Cuts and Jobs Act of 2017 (TCJA) created a significant opportunity to transfer wealth to future generations in a tax-efficient manner. The current exclusion from the estate and gift tax allows an individual to transfer during lifetime or at death $12.06 million (essentially, $24.12 million for a married couple) in 2022 without the imposition of a wealth transfer tax.
The exclusion amount is indexed for inflation. Additionally, there is a similar exclusion amount for the GST tax (also indexed for inflation) that can exempt transfers from such tax and the estate and gift tax for many generations. For individuals and families willing and able to make significant gifts, this represents an unprecedented opportunity to transfer assets to younger generations at a much-reduced wealth transfer tax cost.
These very large exclusion amounts are currently set to expire on December 31, 2025, and, beginning on January 1, 2026, be decreased to 2017 amounts (indexed for inflation from 2010 to an estimated $6.4 million per person in 2026). However, the outcomes of federal general elections in 2022 and 2024 could cause these exclusion amounts to change before 2026.
Reducing the Transfer Tax Exclusion Amount
Whether a Congress between now and 2026 sunsets the current estate and gift tax exclusion amounts early, or they sunset in 2026, a reduction in the exclusion amounts for estate and gift taxes will mean more people will be subject to that tax. “About 4,100 [federal] estate tax returns will be filed for people who die in 2020, of which only about 1,900 will be taxable—less than 0.1 percent of the 2.8 million people expected to die in that year.” Although it is not possible to predict legislation that the 117th or a future Congress might enact, history may illustrate the impact of a decreased estate tax exclusion amount. If, for example, the federal estate tax exclusion amount were to be reduced to 2009 levels ($3.5 million per person), one would expect more taxpayers to pay federal estate tax. Filing statistics show for decedents who died in 2009, about 12,900 federal estate tax returns were filed, of which 5,700 were taxable. Even without adjusting values for inflation from 2009, this is a three-fold increase in the number of taxable estates.
Using Your Exclusion Now
Making gifts during life would allow you to use your exclusion from the gift and estate tax, and if allocated, your exemption from the GST tax. Of course, any gifting strategy (including the amount of the gift and recipients thereof) will depend upon your unique goals and your plan to achieve them.
For taxpayers with very large estates, and who will not need access to the gifted funds (or the income therefrom), gifts equal in value to their exclusion amounts to trusts for their descendants may be appropriate. However, for many taxpayers the loss of access to such a large amount of wealth may not be palatable or, in some cases, financially feasible. In those cases, married taxpayers could consider creating non-reciprocal spousal lifetime access trusts (SLATs), which may allow them to use their exclusions from federal wealth transfer taxes while retaining indirect access to transferred assets.
Leveraging Gifts with Life Insurance
One important attribute of life insurance is the ability to leverage premium dollars paid into a larger amount of death benefit.
For families of modest wealth, funding an irrevocable life insurance trust (ILIT) with unused annual exclusion amounts is a tax-efficient way to create and maintain a life insurance plan. In most cases, the death benefit payable from a life insurance policy held in a properly constructed and administered ILIT will not be subject to income tax or estate tax. To enable gifts to the ILIT to qualify for the annual exclusion from gift tax, often the terms of the ILIT allow the beneficiaries to withdraw those gifts (up to the annual exclusion amount) for some period of time. Funding policies of insurance in an ILIT with annual exclusion gifts can leverage gifts of modest amounts into significant wealth when the death benefit from the policy is paid. Moreover, by holding life insurance in trust, you can prevent the death benefit from being subject to wealth transfer taxes on your death, provide for your family, and preserve the funds received from the death benefit for your family and, perhaps, future generations of your descendants.
If you have more substantial wealth and you have used some or all of your exclusion from the estate and gift tax (and possibly GST tax) to fund a trust, some of the income from the trust’s income-producing assets can be used to purchase policies of life insurance that insures the lives of the creator(s) of the trust. Upon the death of the insured the death benefit will be added to the principal of the trust, potentially increasing the benefits provided by the trust to its beneficiaries.
This type of planning can also be reversed. If you have already created an ILIT that holds only a policy of life insurance, and if you plan to use your exclusion from the estate and gift tax (and perhaps GST tax) by making large gifts, you could make some of those gifts to the ILIT. The amount given to the ILIT could generate sufficient income to carry the premiums on the policy of insurance owned by the ILIT or if the income is insufficient, some of the gift itself could be used.
Using funded trusts to purchase life insurance could alleviate the need for you to continue making annual gifts to the trust so that the ILIT property can pay the annual policy premiums.
It is important to remember that in most circumstances a trust that owns a policy of life insurance on the life of the trust’s grantor or the grantor’s spouse is a so-called “grantor trust” for income tax purposes. As such, for federal income tax purposes, the grantor of the trust will be deemed to own the assets in the trust. The income from those assets will be included on the grantor’s personal income tax return. The grantor should be prepared to continue paying income tax on the assets in the trust, even though the grantor will not receive that income.
Also, it is important to remember that the insured cannot be a beneficiary or trustee of a trust that holds life insurance on such person’s life as it may cause the value of the death benefit to be included in the grantor’s gross estate and potentially subjected to the federal estate tax.
Taking Advantage of Low Interest Rates
Perhaps you have already used your exclusion from the gift and estate tax, or you are not able (or do not desire) to part with so much of your wealth. Using the currently low interest rates, it may be possible to start a new, or to “firm up” an existing, life insurance plan through borrowing.
Low Interest Rates
In general, to avoid certain adverse income and gift tax consequences, the Internal Revenue Code requires that loans earn a minimum rate of interest. The required minimum interest rate is known as the applicable federal rate (AFR) and varies depending on the length of the debt obligation. A variation on the mid-term AFR is used as a discount rate to determine the actuarial present value of annuities and income interests (Section 7520 Rate).
Accessing wealth to pay premiums is necessary to establishing or continuing a life insurance program. Sometimes a family’s wealth is held in trust, is invested in illiquid assets (e.g., real estate), or forms the underlying capital of a family business and cannot be transferred to a trust to support annual premiums. Alternatively, some members of a family that should be insured may not have wealth sufficient to support an appropriate amount of insurance. In each of these cases, borrowing funds from sources within the family could provide access to the cash needed to pay premiums.
Applying Low Interest Rates
Imagine the following scenario: Assume that Spouse 1 created a SLAT for Spouse 2 fully funding it with Spouse 1’s exclusion from the estate and gift tax, and allocating all of Spouse 1’s GST exemption to the trust. Further assume that Spouse 1 and Spouse 2 own other assets but are not comfortable funding another SLAT. Nevertheless, Spouse 1 and Spouse 2 would like to augment the amount passing to their heirs, and if the estate tax exclusion amount is decreased, replace wealth lost to wealth transfer taxes by purchasing a joint and survivor life insurance policy insuring both of their lives that pays a death benefit when the second of them dies. Because Spouse 2 is the beneficiary of the SLAT, the policy should not be owned by the SLAT. In this case, the spouses could create a separate ILIT to hold the life insurance policy. The ILIT, if written to permit the trustee to do so, could borrow funds to pay the premiums from the SLAT. Neither the assets of the SLAT nor of the ILIT would be included in either spouse’s gross estate and subjected to estate tax. Accordingly, when both spouses have died and the loan is repaid to the SLAT, nothing is returned to either spouse’s estate and the two trusts can continue for their beneficiaries. This transaction can take advantage of the currently low interest rates by having the ILIT borrow from the SLAT an amount sufficient to pay the entire premium obligation for the life of the policy. The loan amount could be invested inside the ILIT allowing it to potentially grow, which growth could be used to pay future premiums. The terms of the debt could provide for a long-term interest-only period with principal being paid at the end of the term (with no prepayment penalty). This type of loan allows for repayment flexibility while locking in today’s low interest rates for many years.
Although the previous example describes a new life insurance arrangement, low interest rate loans of the type described above can be used to fully fund an existing life insurance program, locking in low interest rates, and protecting against interest rates drifting higher over the coming years (and even decades). For example, assume that the shareholders of a business have a cross purchase buy-sell agreement funded by life insurance. Each shareholder would own policies of life insurance on the lives of the other shareholders. In this case, the shareholders could take advantage of low interest rates by borrowing funds from the company or from other sources creating a fund to pay future premiums or even to prepay all premiums. Interest (and amortization) on the loan could be paid by future distributions from the company.
Don’t Wait — Review Your Current Plan; Recent Law Changes May Help
As described above, should exemptions from the federal wealth transfer taxes be reduced, more people will be subjected to those taxes. Preparing for this possibility makes sense. Even basic life insurance planning can replace wealth lost to federal gift, estate and GST taxes. As mentioned throughout this article, life insurance provides a way to replace wealth lost to taxes. Buying life insurance can provide financial protection for your family should you die prematurely and, if you may be subject to estate tax, a possible way to replace wealth lost to such tax when you die.
The law of averages applies to insurance underwriting and (as a general rule) policies of life insurance purchased later in life are more expensive than comparable policies purchased at a younger age. Additionally, as one ages, health considerations become more of a concern and can impact the cost of life insurance. Starting now can help you to “lock in” your underwriting status at your current age and health, so as to possibly avoid cost increases as you age, or large cost increases due to an adverse health incident.
The general thoughts of the immediately preceding paragraph are particularly relevant today. We really don’t know what the lasting effects of a COVID-19 infection will be. Perhaps it will cause long-term “preexisting conditions” that will hamper or prohibit your ability to obtain life insurance in the future. Why not consider locking in your underwriting status by purchasing convertible term insurance today? By purchasing a convertible term policy, should your health condition change and you are within the conversion period, you can convert the term policy to a policy of permanent insurance without additional underwriting (that is, no physical exam requirement) and at the same rate class you had when you originally purchased the policy. Of course, following the conversion, you will pay premiums based on a permanent policy at your attained age, but even if you had become uninsurable, you will be able to protect your family.
As with any financial asset, you should periodically review your life insurance coverage. Many policies purchased when interest rates were higher are not performing as anticipated and may expire before you do.
Replacing an under performing policy may be a solution, and an unheralded change to the IRC made at the end of 2020 may help. IRC § 7702 sets forth requirements for an arrangement to be considered a life insurance contract for federal tax purposes. Some of these tests are mathematical and require complicated actuarial calculations using certain minimum interest rates set by that statute. The statutory interest rates were established in 1984. Market interest rates have declined significantly since then, and today remain relatively low.
Although market interest rates have fallen over time, the statutory rates applied when testing a life insurance contract remained the same (and were much higher than market interest rates). This disparity in rates has made it challenging for life insurance carriers to qualify new products as life insurance and to remain profitable, while also hindering policy owners from adequately funding their policies, due statutory funding limitations. IRC § 7702 was amended to allow insurance carriers to use lower interest rates (driven by the market) for internal policy actuarial calculations on new life insurance contracts (issued after December 31, 2020). This means that a new policy may be less expensive than your current policy and that you may be able to keep more cash value in a new policy accumulating returns tax deferred (or even tax free). Given this change in the law, perhaps now is the time to review your existing policies to determine if replacing them with a new policy could maintain coverage, save you premium dollars or permit you to increase death benefit at equivalent cost.
Also, over the last few years a number of insurance companies have raised some of their policies’ internal mortality costs, again with the result that your policy may not be performing as expected. You may want to obtain an “in force ledger” for each of your policies to determine if they will be there when your family needs them. If a policy is not performing as expected, consider adding more cash or exchanging it for a new policy.
A PNC insurance specialist can help you analyze your current policies and determine if replacing them with a new policy or policies is right for you.
What to Do Now?
The possibilities with respect to life insurance structures are as varied as the circumstances in which life insurance can be used.
Now is a good time to review your existing life insurance policies or consider beginning a new life insurance program.
Your PNC team can introduce you to an insurance professional, such as PNC’s local insurance strategist, who, along with your personal tax and financial advisors, can help you accomplish your family’s goals and objectives as part of your overall wealth planning strategy.
For more information, please contact your PNC Private Bank advisor.