Life insurance and your estate plan

Life insurance and your estate plan

As tax exemptions are targeted, life insurance can potentially serve as an effective wealth transfer asset.
November 25, 2021

Life insurance and your estate plan

Life insurance and your estate plan

As tax exemptions are targeted, life insurance can potentially serve as an effective wealth transfer asset.
November 25, 2021


Written by:

Daniel F. Rahill, CPA, JD, LL.M., CGMA
Managing Director
Wintrust Wealth Management

On November 5, 2021, Congress passed a $1.2 trillion bipartisan infrastructure bill, which now heads to the President's desk to be signed into law. The second pillar of President Joe Biden's domestic agenda, the Build Back Better (BBB) reconciliation bill (H.R. 5376)  was stalled in the House as Democrats tried to negotiate a deal on the separate $1.9 trillion economic package.

The BBB proposal opens the door to tax increases on wealthy individuals and corporations. While the details must still be formed into actual legislation, negotiations In Congress are moving forward and high net worth individuals should be watching.

I suspect we have been warned about what is to come for our clients—and maybe even ourselves. While on the campaign trail, President Joe Biden proposed 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. There will be many changes to the current House proposals before they vote on them and send the bill later in 2021; however, one theme remains abundantly clear: higher income and net worth Individuals could very likely face higher taxes and a lower estate tax exemption in the future.

So, where can 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 are 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 (SLAT), discussed in our summer Guidance newsletter “2021 Financial Planning, The Increasing Popularity of SLATs,” can also be the life insurance policy owner.)

Inside the ILIT
A life insurance policy can be held in an ILIT so 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. Some additional upfront collateral may be needed to cover initial costs. This money can be lent to the trust by the grantor and taken back as the policy cash surrender value grows over time.

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 will repay 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.

An illustration
A married couple, both 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% 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 is 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
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, this is a tax-savvy strategy for minimizing their—or their heirs’—tax burdens.

Please note: The information above is provided solely for informational purposes and is not meant to serve as tax advice. We encourage you to consult with your legal, tax, accounting, or financial advisors, as necessary.

The opinions presented are those of Dan Rahill of Wintrust Investments and not by any affiliated or contracted research department. Observations and views may change at any time without notice. Information and opinions presented have been obtained or derived from sources believed to be reliable, however, there is no guarantee as to their accuracy or completeness. Wintrust accepts no liability for loss arising from the use of this information. While this information may answer some questions, it 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, competent tax and legal advice should always be obtained.

Securities, insurance products, financial planning, and investment management services 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.

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