Life Insurance for Estate Planning

With the changes Congress has made to the Internal Revenue Code (IRC) as a result of the American Taxpayer Relief Act of 2012, some of the uncertainty concerning estate taxes has been eliminated.  Congress enacted significant changes to the IRC in 2001, with a "sunset provision" that would return everything back to where things were on January 1, 2001, unless a future session of Congress made some or all of the changes permanent before December 31, 2010. 

For the better part of the next ten years, Congress largely ignored this.  Along the way, they did manage to make permanent the retirement plan provisions that increased contributions to all of the various types of individual and company-sponsored retirement plans.  But that's all they did in ten years.  Until the closing hours of 2010, when the impending sunset was about to occur.  Strangely, there was no real talk of a "fiscal cliff" in the days and weeks leading to December 31, 2010.

As a result of the mid-term Congressional elections in 2010,  the Republican party would once again have the majority of votes in the House of Representatives.  The spectre of any automatic reversions still loomed, but now it was going to be up to Congress to either do nothing and raise taxes (on income, dividends, capital gains, and gifts & estates) for all Americans, or do something.  Unwilling to work out a real solution, in true bipartisan fashion, Congress merely "kicked the can down the road two years."  To December 31, 2012. 

Suddenly, after two years of partisan sniping at one another, Democrats accusing Republicans of deliberately stalling, Republicans accusing Democrats of not wanting to compromise, Congress was once again faced with having to make some decisions they could have made at any time between 2001 and 2010.  Except for the "poison pill" that was inserted into the legislation in the wee hours of a late-December morning in 2010 . . . massive spending cuts virtually across the spectrum of US Budget expenditure line items.  As December 31, 2012 neared, the President petitioned Congress to pass his proposed changes, centered largely on an increase in the top marginal tax rate to 39.6% for persons with adjusted gross incomes of $250,001 or more.  Republican House Majority Leader John Boehner stood his ground, taking shots from all quarters, and refused to do anything before the Senate acted on the House Budget resolution.

The two sides stood around with their hands in their pockets, accusing each other of holding America and Americans hostage.  Politics as usual.  Senate Majority Leader Harry Reed decided he was giving up on the whole thing . . . let the law expire and blame the Republicans for the mess.  So Boehner and Senate Minority Leader Mitch McConnell bypassed Reed and went to VP Joseph Biden (the President of the Senate) and began negotiating, coming closer to a working solution as each day passed. 

There was still a lot of posturing taking place, but in the end, somewhat cooler heads prevailed, and each side made some concessions to each other.  And, as usual, each side was excoriated for having caved in to the other.  The nation did not run headlong over any precipice.

The top marginal income tax rate was increased to 39.6%, but for married persons with AGIs of more than $450,000 ($400,000 for single persons, and $425,000 for heads of household filers), while the other six "Bush Era" tax rates were made permanent, long term capital gains tax rates would increase from 15% to 20% for most taxpayers, and the estate tax was also made "permanent", with an increase in the top tax rate from 35% to 40%, for estates valued at more than $5,000,000 after December 31, 2012 (in reality, $5,325,000, thanks to indexing for inflation).  The Alternative Minimum Tax is still with us, with only some minor revisions to the income triggers.

The one change that has the most import for taxpayers is the estate tax.  At $5,000,000, the tax will not affect all taxpayers.  But it will have an impact nevertheless.  Congress just couldn't bring itself to make the "unlimited" exemption permanent.  In fact, they retroactively rolled back the "unlimited exemption" in late 2010, after George Steinbrenner and a few other wealthy Americans chose the perfect year in which to die.  The estates that were not supposed to pay any estate tax at all got clobbered by a Congress looking for every last cent of tax revenue they could, and even that wasn't enough. 

The estate tax could have reverted to the $1,000,000 level it was scheduled to reach in 2007.  So at least there is good news in this.  But $5,000,000 is not beyond the reach of many families in America.  When you consider balances held in IRAs and Roth IRAs, 401(k)s and 403(b)s, the assorted other retirement plans, and then add the value of the family home, perhaps a second residence, business property of sole proprietors (or a partner's interest in a business), not to mention stocks, bonds, mutual funds and ETFs, and other securities, there are plenty of households that are now exposed to the estate tax when the surviving spouse dies.   

So what happens?  Is there a way to avoid this?  What are my options?

Estate tax returns must be filed within 9 months of the date of death. Taxes must be paid, or severe penalties and interest will be imposed.  Where will the money to pay the tax come from? 

The heirs of small business owners, farmers, and others often have to take over management of estate assets, and may be forced to sell off estate assets to amass the proceeds needed to pay the tax due.  The so-called "estate sale" becomes a means to the end.  Homes are sometimes sold and below market value because the housing market is cyclical, and yesterday might have been a better day to sell.  Bank accounts are liquidated or otherwise looted to pay taxes.  Things can get ugly quickly. 

Life insurance is commonly used to pay the estate tax due upon death as a means to avoid selling estate assets.  But it can be both a blessing and a headache.  The life insurance proceeds are normally payable tax-fee (in most instances), but if the decedent were also the policyowner, then the value of the death benefit in excess of the premiums paid must be included in the value of the estate.  It doesn't matter to whom the life insurance proceeds were paid.

In the coming months, there is going to be a large amount of advertising by both insurance companies and agents directed at consumers concerning the estate tax and life insurance.  Consumers may be disturbed by their lack of understanding about this subject and end up purchasing life insurance they do not need, or possibly the wrong kind of life insurance to meet their need.  Most agents do not intentionally mislead their clients when it comes to providing products and services, but many agents fail to fully understand the products they are marketing, and this frequently results in persons purchasing a product based on a faulty explanation and a misunderstanding of the product they subsequently own and pay premiums for. 

The most heavily marketed type of life insurance today, and for the foreseeable future, is called Universal Life Insurance, sometimes referred to a Flexible Premium Adjustable Life Insurance.  And the most commonly marketed products in this category are called Indexed Universal Life Insurance, or "IUL", and Guaranteed or Secondary Guarantee Universal Life Insurance, or "SGUL" for short, and also Variable Universal Life Insurance, or "VUL", as it is known in the industry (which is also a securities product regulated by both the state Department of Insurance and the Securities and Exchange Commission).. 

These products are frequently presented by agents as equivalent to "Buy Term and Invest the Difference" -- a combination of term life insurance and a savings or investment account.  But that's not entirely accurate, because the cash accumulation in Universal Life insurance is wrapped up inside the insurance contract, not sitting separately inside a bank or mutual fund company and apart from the life insurance company (the cash value in a VUL policy is held in a "separate account" owned by the insurance company, but it is not independent of the insurance contract). 

Agents will point to the tax-deferred growth of principal in life insurance, which is accurate, but sometimes mislead folks by changing the words to "tax-free" and also describe a way to have "tax-free income" from the insurance policy in retirement. At the same time, they may fail to mention that the income is actually a loan from the insurance company based on using the life insurance cash value as collateral.

Such discussions should not occur when the purpose of the life insurance is to pay the estate tax due in the future.  A policy intended to pay taxes or other expenses at death should not be "tinkered" with along the way.  The SGUL policies may be a very good choice for covering the estate tax needs.  They are designed with minimum premiums, thus conserving current capital.  The hard part might be one's ability to pay the premiums at some point in the future.  Missing just one premium payment in some contracts is all it takes to lose the no-lapse guarantee, and cause the owner to have to pay significantly higher premiums to keep the policy in force or risk losing the policy altogether. 

I don't want this to happen to you, your parents, or anyone else.  If you have been sold any form of UL policy, you would probably benefit from a policy analysis -- to find out if your policy is on track or not -- and especially so if you've had your policy more than 5 to 7 years.  If it is not on track, I can show you how to correct for that now in order to avoid the risk of unaffordable premiums in the future.  And I can teach you how to monitor your policy's performance going forward so that you can stay on top of any changes that need to be made as you get older.

Use the Contact page to get more information about a policy analysis.  Or give me a call.  We'll get together and I'll take a look at your situation.  If changes need to be made, I'll show you how to make them.  If everything is on course, I'll tell you that, too..