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Estate Planning Financial Planning

The Right Type of Life Insurance for Your Estate Planning Needs

Life insurance works well for estate planning because of when benefits are paid and the ability to create wealth for heirs outside of the estate.

by Peter Katt | July 2014

Life insurance has been associated with estate planning for decades.

It is believed that the estate tax has settled down to an individual credit equivalent of $5.34 million per individual in 2014. (The amount will adjust each year for inflation.) The estate and gift tax laws allow for “portability.” Portability allows a surviving spouse to preserve a deceased spouse’s unused estate tax credit by filing a federal estate tax return. This expands the amount that can pass free of estate taxes per couple to $10.68 million.

Life insurance works for estate taxes because they are due when death occurs, the same trigger that that pays life insurance death benefits.

But one life insurance size doesn’t fit all estate planning situations. Let’s go over the common situations.

Pure Estate Tax Liquidity

Paula, now 64, came to me six years ago. She is single with a son. She owns a fraction of a large apartment complex. It was decided that approximately $5 million was a good life insurance amount to cover her estate tax. She also decided to purchase a current assumption universal life policy to be protected against inflation and to have a decent cash values.

Each year, we review her policy and change premiums to keep up with changing interest rates and in case her health changes (it hasn’t). She has her estate protected for her son. She could have opted for guaranteed universal life with guaranteed premiums, but knew she wouldn’t be protected against inflation. Plus, the policy would have low-to-zero cash values in case she ended up selling her real estate interest.

Relatively Large Liquid Estate

Dan and Rita have a large estate with mostly marketable assets. They don’t have a estate liquidity issue, but they may want to consider life insurance as a wealth transfer asset.

Ideally they could use a participating whole life policy with increasing death benefits. The premiums could be set based on the annual gift tax exclusions, and they could even throw some of their gift tax credits into the policy. Life insurance benefits are income tax free, so they provide excellent income tax planning, and when held within an irrevocable trust they aren’t included in the estate. Under current financial conditions, the premiums to death benefit yields at life expectancy are in the 4.5% range.

Dan and Rita don’t need life insurance, but it is usually a worthwhile tax-advantaged asset to use.

Significantly Large Liquid Estate

Bob and Lois have the same issues as Dan and Rita, but a much larger estate, so they should certainly be moving their estate and gift tax equivalent amounts ($5.25 million) out of their estates, either to children directly or to an irrevocable trust.

If a trust is used, life insurance is a good choice as an investment due to the tax advantages. Participating whole life with increasing death benefits is the way to go.

For some reason clients and many advisers believe it is a good idea to save the gift tax credits. NO! Use them as soon as feasible because it is the growth outside the estate that counts. That is, if $5 million is gifted (purchasing life insurance with premiums over a period of years, let’s say) with a value of $8 million at the time of death, it is the $3 million that is out of the estate. The original gift amount of $5 million is brought back into the estate for final accounting.

Also, keep in mind that if the $5 million goes down in value, the $5 million is still the value of the gift—so be careful with what type of assets are gifted.

Can Term Insurance Be Used?

Yes, if the need is for a specific period. As an example, let’s say our first client, Paula, has a buyout on her real estate investment in 10 years. Using term insurance works just fine for this situation. It provides estate tax liquidity in the event she passes within 10 years and it is fully liquid when the property is sold and the term policy is terminated.

Second Marriage With Older Children From First Marriage

This is a people-planning need. It might be good to have a separate life insurance policy for the older children so they don’t have to wait around until the second wife passes.

Guaranteed Universal Life

This has been very popular with agents and buyers for some time. It guarantees the premiums and death benefits usually to age 120. Usually there is low-to-zero cash value.

The potential problems are if cash values might be needed or if there is a heavy bout of inflation, since guaranteed pricing is set. Current assumption universal life policies are protected from inflation because their crediting rates would likely go up.

Periodic Reviews for Policies Is a Must

All policies should be looked at every few years to test the continued creditworthiness of the company, to make sure the policy is properly funded and to reassess the insureds’ health.

A particularly disturbing issue has been coming up in my practice: Many policies sold in the 1980s and 1990s mature at age 100 and agents haven’t explained this problem well. If an insured lives to 100, the policy pays out the cash value. However, some companies are taking it on their own to continue the policy until the insured passes and pay the cash value as a death benefit. If the insured is in good health with a reasonable chance of making it to 100, either the policy’s premiums need to be changed so the policy’s cash value will equal the death benefit at 100 or a new policy should be looked at.

On the other end of the spectrum are insureds in poor health who will certainly not come close to living to age 100. They can probably stop paying any further premiums.

But regardless of the specific situations, policies need an independent and professional review every few years.

Premium Financing

Do not be talked into premium financing (borrowing money to cover the cost of the policy). When insureds live to their life expectancy, financing of premiums and interest will almost always fall apart with an unhappy and expensive termination of the policy. If you can’t afford the premiums, buy less life insurance. While split dollar (a payment strategy where some or most of the policy premiums are paid by a third party that retains a collateral interest in the policy) has become mostly obsolete, it should not be used to finance premiums.

Conclusion

Life insurance can be a valuable estate planning asset. Use the right type and use it wisely.

Discussion

sasi madisetty from texas posted over 12 years ago:

I got a universal life insurance in 1980 at age 33. A crook advised my husband to cancel my policy and sold a new policy with premium payments through loan.Now I am 66 yrs old, had to cancel that policy and lost lot of money and had to pay taxes on unrealized gains. I have a professional degree and a son. I just bought a term life policy now.I can not even share this story with my son to teach him through my mistake.


John Kazlauskas from VA posted over 12 years ago:

I bought a Universal Life insurance policy with flexible premiums in 1986. The aim was to have funds available for college tuition for my two kids. This was prior to 401ks/529s/IRAs (with $2,000 max. per year). The policy had a death benefit of $100,000 with premiums applied to the benefit. I now have $72,000 in cash value, so the policy would pay my beneficiary $172,000 tax free. The cost of the policy has gone from about $150/year back then to $1,500 today with more raises coming in the future, which I don't like. My agent recommends I convert the policy and use the cash value to buy an immediate annuity. Is this the best option I have?


Charles Rotblut from IL posted over 12 years ago:

John, We cannot give personalized advice. You may want to consider getting a second opinion from a different adviser, however. -Charles


Mark Schmidt from CA posted over 12 years ago:

down to an individual credit equivalent of $5.34 million per individual in 2014. (The amount will adjust each year for inflatio If this statement is true can I assume any one with an estate less than this amount WON'T have to pay an estate tax and if so you should include this in your article . Thank you Mark S


DCG from OR posted over 12 years ago:

True for the federal estate tax, which is what most planners talk about. What seldom seems to be addressed is that most state level inheritance tax triggers are considerably lower; eg OR at $1,000,000.


Mary from WI posted over 11 years ago:

Please explain the role of cash value in a policy. * If I have a policy with a death benefit of 100,000 and a cash value of 17,000, what amount is paid out at my death? Do I 'lose' the 17,000? *If I borrow the 17,000, then die, what amount is paid out, and must the borrowed 17,000 be repaid? *I've read that I can ask my agent to add the 17,000 to the death value so I would have a death value of 117,000 and no cash value. Is it accurate that that can be done?


Charles Rotblut from IL posted over 11 years ago:

Hi Mary, Here is the response from Peter Katt. * If I have a policy with a death benefit of 100,000 and a cash value of 17,000, what amount is paid out at my death? Do I 'lose' the 17,000? If the DB is level at $100k - DB is $100k - if it is $100k plus CV - amount paid is $117k - this is an option on ULs *If I borrow the 17,000, then die, what amount is paid out, and must the borrowed 17,000 be repaid? You can borrow less than $17k, if you borrow all CV, the policy will terminate *I've read that I can ask my agent to add the 17,000 to the death value so I would have a death value of 117,000 and no cash value. Is it accurate that that can be done? Yes and no - if health is good you may be able to change a level $100k to $100k plus CV - if this is done the CV will remain at $17k, but the overall cost of policy will increase because there are more DBs -Charles Rotblut


Steve Woodson from MO posted over 8 years ago:

all the above would have benefited from term life and disregard all other types of insurance. But term and invest the difference still works


Joe Remmers from MO posted over 8 years ago:

I agree with Steve Woodson. Agents seem to do a very good job of explaining vanishing premiums and flexible payments but seldom ever advise their clients (or provide a schedule) of the actual mortality charges for the pure life insurance. As we age, the cost of life insurance goes up. It doesn't matter what type of policy we have. These mortality charges have to be paid. If premiums are low or non-existent, where are the funds coming from to pay these charges? From the so-called savings account, of course. As the account becomes depleted, the insurance company will bill you to keep your policy in effect. If you borrowed money on your policy and you elect to just walk away, our favorite uncle steps in and might tax you on a "forgiven" loan. I suggest you Google the Book "What's Wrong With Your Life Insurance" by Norman Dacey and read it. He doesn't say many nice things nice about cash value programs.


James Shindler from PA posted over 8 years ago:

Please pardon a biast from the past from an 87 year old retired insurance agent who does not agree with the “buy term and invest the difference” concept rather than time-proven participating Whole Life insurance with disability waiver of premium benefits. I do believe in term insurance for temporary short term needs and have owned large amounts of guaranteed convertible term as both riders and individual policies which have long since been changed to WL. As for disappearing premIums, my premiums could have disappeared many years ago but I eagerly look forward to paying those low annual premiums while I watch the regular dividends and the dividends on my additional paid up whole life accumulate tax free. My current cash values approach $235,000 and are just slightly less than the $250,000 death benefit and all without paying income taxes. Yes, pure insurance costs do increase each year and this is calculated into the higher initial premiums for whole life at younger ages when compared to pure term with increasing annual premiums as the insured’s age increases. In reality WL is an Endowment at Age 100 and should I live to age 100 (unlikely) the policy will endow and the IRS will calculate the gains that are taxable.


Richard Sammons from Ohio posted over 7 years ago:

What about a term insurance that provides coverage until age 100?


Tim C from NE posted over 7 years ago:

To Richard S from Ohio -- I'm not aware of a term policy that will provide coverage to age 100. Northwestern Mutual has a Term to age 80 policy, and many other companies will allow a 70 year old individual to purchase a 15 or 20 year term policy. They aren't cheap but it can be done. But if you want to make sure you have life insurance in force until age 100, you are looking at a permanent policy -- either whole life or universal life. Universal life as a general rule will be cheaper, and can be used as a "permanent term", as long as your premiums and the credited interest rate cover the cost of the insurance inside the policy. With interest rates at historic lows,and to make sure you can afford the premiums, only get a quote based on the minimum guaranteed interest rate the company is paying into the policy, rather than a hypothetical interest rate that is unrealistic. A bad agent can illustrate a policy that "pays" 8%, but you only end up getting 2.5% credited to the policy. Don't get fooled by that trick. This is especially important because inside the policy, universal life is term insurance PLUS an interest rate. And the cost of that term insurance goes UP each year as you age. So if the credited interest isn't covering the cost of the insurance, you'll get a notice from the company saying you owe more money into the policy -- and no one likes that. So Universal Life, while not my favorite option, can be effective when used properly. Get it from a mutual company and go with the guaranteed interest rate (not the assumed or current rate, as they change every year). Best thing would be to purchase an appropriately sized 100% whole life contract when you are young and forget about it. It's not an investment -- it's a life insurance contract -- but over a lifetime it should accumulate a fair amount of cash should you need it. And it's always there as life insurance if you decide to keep it for a death benefit.


Don from ND posted over 7 years ago:

Be sure the information in the article reflects the latest in tax law. The current estate value (until tax year 2025 or 2026) that passes tax free is $11 million from spouse, not the $5.25 million in the article. Personally, I am so far from even the old threshold that I usually ignore these articles.


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