Historically life insurance has had many tax benefits and uses as a financial tool. Proceeds of life insurance are tax-free to the beneficiary, for instance, and proceeds of a large life insurance policy can be used by heirs to pay a tax bill for those wealthy individuals whose estate surpasses the estate tax-exempt threshold.
“If structured properly, life insurance proceeds can be tax free and circumvent estate tax. There are some issues with this strategy, specifically when people start borrowing against the cash value,” said Derek Holman, CFP, co-founder and managing director of EP Wealth Advisors in Torrance, Calif. “Some people think you can avoid estate tax by getting life insurance but that’s not the case. Life insurance can help minimize the estate tax and provides liquidity for heirs to pay the estate tax, but it doesn’t eliminate it.”
Insurance policies as financial instruments “generally will be income tax-free but they may not be estate tax-free,” said Donna Kellison, CPA/PFS and a tax director emeritus in the Carmel, Ind., office of Blue & Co. Also, to borrow on a policy the client must own the policy – making it part of his or her taxable estate and potentially subject to estate or state inheritance tax.
She added that life insurance used to be much more widely used as an investment instrument to help defray inheritance costs. The major reason for the recent falloff? “Not as many taxpayers are subject to estate tax after tax reform,” Kellison said.
“The cost of owning life insurance is high versus what’s available from an investment perspective. Mutual funds and ETFs we use range from 0.06 to 0.4 percent per year,” said Bruce Primeau, CPA/CFP and president at Summit Wealth Advocates, Prior Lake, Minn. “Cash value life insurance policies also typically have a several-year surrender period in [which] you may be charged up to 10 percent of your cash value.”
Life insurance can be a flexible financial tool. “Many of our clients ask about the ability to dump in large sums of money at once in order to benefit from cash accumulation, long-term care and, of course, a significant death benefit,” said David Eisenberg, senior vice president at Quantum Insurance Services in Los Angeles. “The challenge with large dump-ins is that you create a modified endowment contract (MEC), which causes challenges with tax-free loans in retirement. Often HNW clients use cash value to supplement retirement planning already in place.
“Additionally we see cash value in these policies viewed as an asset which can be used to secure loans for a variety of ventures,” Eisenberg said. “The No. 1 way to structure a life insurance policy to supplement retirement is to max fund the premium on a minimum death benefit while not creating a MEC.”
Another possible arrangement, Kellison said: private-split dollar insurance, in which two individuals (sometimes family members or trusts they’ve established) enter into the agreement. Private-split dollar gives the opportunity to leverage annual gifts and proceeds to purchase a life insurance policy. To keep the death benefit out of the insured’s estate, the policy is usually owned in an irrevocable life insurance trust (ILIT).
“One item that the cash value could be used for is college costs for children [or grandchildren],” Primeau said. “Another may be to cover the costs of an assisted living facility. One new type of permanent policy couples life insurance with a long-term care benefit. A second type of policy I’ve seen HNW folks use is a second-to-die policy, whereby the death benefit is not paid out until both pass away. The proceeds can then be used to pay the federal or state estate taxes for what might be a somewhat illiquid estate, perhaps one that has a lot of real estate.”
“There’s always discussion as to whether the ROI of a life insurance contract is high enough to justify the cost,” Eisenberg said. “Some HNW clients believe they can do better by investing on their own or through a financial planner.”