Universal and whole life insurance policies seem to be slipping out of favor with estate planners and financial advisors.
They rate the benefits as oversold, and indeed, for the average punter, they likely are. For a young professional with a mortgage and young children, term insurance is the best way to go, they counsel. The premiums are low, the coverage substantial and the peace of mind inestimable.
Term life lacks the flexible features of permanent life: there’s no cash value component or guaranteed death benefit, for starters. If a term policyholder reaches the end of said term and has somehow failed to meet an early demise, they get nothing from the insurer. While this doesn’t dim the celebrations, cerebral or real, of beating the reaper and his actuarial tables, it suggests that something better might have been done with the premium money, now gone with nothing tangible to show.
This last notion is something of a myth, planners tell clients. Permanent life insurance – whole life, which pays a fixed rate, and universal, linked to money market rates or a benchmark yield – sounds better, but the yields are usually limited compared to the heady rates offered by other investments, equities first in line. Borrowing on the cash value can be dangerous and drawing it down has tax implications, to say nothing of shrinking the death benefit, when it comes due.
For most customers, specialists recommend forming a six-month emergency fund first, purchasing an economical term life policy second, and then investing any cash surplus in high-yielding investments – higher than what’s offered by insurers, at any rate. We think this strategy makes sense. But what if you don’t fall into the confines of the average, bread-and-butter case?
High net worth clients may be sitting on what looks like easy street, but they have plenty of problems, particularly in an unsteady tax environment. The coronavirus crisis is costing federal and local governments staggering sums: for Washington alone, it will easily top $3 trillion and could end up double that amount.
The current administration probably hopes the tax-take from rapid, post-shutdown economic growth will cover the bill, but cold reality may force their hand, driving at least a limited rise in taxation. The middle class is hurting and unlikely to accept any major intrusion from the IRS. That leaves the wealthy – your prime clients, perhaps – right in the bullseye.
For wealthier clients, permanent life policies – those featuring a useful cash value component – offer valuable planning advantages and flexibility. The policies are among the safest investments available on the market. The cash value appreciates tax free, and once the preliminary ‘hands-off’ period is past, it can be borrowed against at favorable rates or even drawn down. When employing these tactics, the policy’s death benefit shrinks in tandem until the money is repaid or returned. Caution should be the watchword, but when a client is suddenly strapped for cash, one or both of these ploys can quickly reverse a tense situation.
A waiver of premium rider is also available for permanent life policies. The rider is optional, usually purchased when the policy is issued, and may be paid up-front or incrementally as part of the monthly premium. The waiver kicks in if the insured party becomes disabled or is seriously injured or ill. Clients interested in whole or universal life insurance often find this an appealing option for consideration.
Usually, death benefits are tax-advantageous for beneficiaries, as they trigger no federal or state payments. There are several exceptions. Policyholders sometimes direct that an heir receive the payout with a delay. In such cases, any interest earned in the period between death and payment would be taxable. This case is of limited impact, though, as it is not frequently applied, but everyone involved should be aware of the potential danger.
For a raft of often poorly considered reasons, clients sometimes make “payable to my estate” the beneficiary of their life policy, and do likewise with other common estate planning investments, like IRAs and annuities. We generally don’t recommend the idea: it swells the value of the insured party’s estate, potentially exposing the inheritors to estate taxes.
The federal estate tax exemption for individuals is currently set at a high $11.58 million, a border difficult for most mortals to breach. For your top-flight clients, though, estate taxes can be a burdensome concern. If the feds choose to boost taxes, we can expect the estate tax exemption to be cut early and deep. Likewise, 13 US jurisdictions have their own estate tax, and it’s hard to predict what tax-heavy states like New York and California might do if pressured by budgetary shortfalls.
There’s several ways to protect life insurance from estate taxes. A client can establish an irrevocable trust, whereby ownership of the policy is transferred to one or several parties – the policy owner can have no further say in the matter. However, the latter can designate the trust’s beneficiaries, the key issue, in any case. The trust is then responsible for the policy and must pay the premiums. A problem can arise if the client dies within three years of establishing the trust. In this case, the policy would be considered part of the policyholder’s estate and might be subject to estate taxes.
Another strategy is simple enough: give the policy away. All the holder need do is inform the insurer and fill out the paperwork. Warn your client that once transferred, the policy is the full and fair property of the new holder. They can keep it up, raid the cash component or shut down the show and cash it in, at will. The original policyholder will need to be timely in making the transfer, as the aforementioned three-year rule applies in this case, too.
Unfortunately, the intricacies of the federal gift tax may rear their hydra-heads, depending on the circumstances. Before gifting a permanent life insurance policy, we recommend discussions with a bona fide tax professional to identify any unpleasant ramifications.