Life insurance can in some instances help clients lower estate taxes, particularly in cases where expiring provisions of the 2017 Tax Cuts and Jobs Act could lead to higher levies, according to advisors.
At the end of next year, the estate-tax breaks of 2017’s Tax Cuts and Jobs Act will, without the intervention of Congress, expire. As wealthy clients begin to realize that the estate tax exemption will likely be halved from its current $13.61 million for an individual in just 19 months, they may start scrambling for tactics to save on estate taxes.
A life insurance policy can, for the cost of the premiums and if placed in a specially created and administered trust, facilitate use of policy proceeds to pay federal estate taxes and avoid a forced sale of assets, said Daniel F. Rahill, wealth strategist with Wintrust Wealth Management in Chicago. Life insurance can also be used to fund the buyout of a decedent’s interest in a closely held business.
With a significant reduction to the federal estate tax exclusion looming, establishing an ILIT can also exclude life insurance proceeds from the taxable estate, Rahill said. Either by gift of an existing policy or by purchase of a new policy by the trust, the trust becomes the policyholder and beneficiary of the insurance proceeds. The insurance proceeds are shielded from estate taxes, ensuring that beneficiaries receive the proceeds of the policy tax-free, he said.
The current federal estate tax is 18% to 40% on amounts exceeding the exception amount. President Joe Biden has also mentioned increasing the estate tax.
“Even though life insurance passes tax-free to the beneficiary, the value of the life insurance is included in the decedent’s estate, which could trigger estate tax liabilities,” said Steve Resch, vice president of retirement strategies at Finance of America Reverse. But “life insurance held by a trust removes the proceeds from the estate and allows [the money] to pass to beneficiaries both estate and income-tax free.”
Most ILITs are funded with the purchase of a new 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,” Rahill said.
The grantor appoints a trustee to manage the ILIT and administer the life insurance policies held within the trust. The trustee is responsible for paying insurance premiums, collecting policy proceeds and distributing them to the trust beneficiaries according to the terms. Though the grantor relinquishes direct control over the policies in the ILIT, they can give instructions regarding the management and distribution of the trust assets. Life insurance proceeds also pass directly to the beneficiaries outside of probate.
To fund the ILIT, the grantor typically gifts funds to the trust each year to cover the premiums. “These gifts may be subject to gift tax, but they can be structured to utilize the grantor’s annual gift tax exclusion and ... lifetime gift tax exemption,” Rahill said.
These trusts can often accommodate clients’ various circumstances but must be precisely set up.
“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 or higher coverage, or both, given the couple’s longer joint life expectancy,” Rahill said. Upon the second spouse’s death, the ILIT then lends money to or purchase assets from the estate to provide it with liquidity to pay estate taxes.
Financing life insurance policy premiums using banks or premium financing companies has become popular. “For high-premium life insurance policies, borrowing funds to pay the premium allows the policy owner cash to pay for the premiums outright, leaving their assets either untouched—presumably avoiding an unfavorable taxable event—or available for other, higher-yielding investments,” Rahill said.
Some additional up-front 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, Rahill added.
An ILIT, once it’s created and funded, can’t be changed or revoked without the beneficiaries’ OK, Resch said, adding that reverse mortgages can be used to generate annual gifts to the ILIT, which in turn would pay the annual insurance premiums. “This limits the flexibility and control of the [grantor] over their assets and estate plan. It is also a complex legal instrument that requires careful drafting and administration.”