Life insurance can in some instances help your clients lower their estate taxes, particularly in cases where the expiring provisions of the 2017 Tax Cuts and Jobs Act could mean 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 could likely be halved in 19 months from its current $13.61 million for individuals, they may start scrambling for tactics to save on estate taxes.

The current federal estate tax is 18% to 40% on amounts exceeding the exception amount. President Joe Biden has also suggested there should be an increase in the estate tax.

It’s times like this when life insurance can come into play. When life insurance policies are placed in a specially created and administered trust, the proceeds can be used after the insured person dies to pay federal estate taxes. That helps heirs 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.

One of the tools clients can use is an irrevocable life insurance trust, also known as an “ILIT.”  With this tool, the trust can become the insurance policy holder and an existing policy can be gifted to the trust or the trust itself can purchase the policy. (“Irrevocable” means the grantor no longer owns or has control of the assets in the trust, the trustee does. It also means the assets are now outside the taxable estate and not subject to estate tax.)

The insurance proceeds in this case are shielded from estate taxes, ensuring that beneficiaries receive the proceeds of the policy tax-free, Rahill says.

“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,” says 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 says.

The grantor appoints a trustee to manage the ILIT and administer the life insurance policies held within it. 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.

For example, said Rahill, an individual, 69, is worth $100 million after all the other estate planning is done. His estate will owe 40% of that upon his death, or $40 million. He takes out a $50 million life insurance policy inside an irrevocable life insurance trust for his kids. The policy has a onetime premium payment of $10 million. 

The life insurance trust can borrow the $10 million from a premium finance company or bank at today’s interest rate of approximately 6.5%. The ILIT must have enough cash to pay the interest each year (via gifts) or let the interest accrue until the end of term (end of life); it’s repaid then.

At the grantor’s death, his estate owes $40 million in estate tax, as noted above—but his beneficiaries also inherit $40 million tax-free from the ILIT after it pays off the $10 million loan, replacing the estate taxes paid by the estate. “The life insurance just replaces the estate tax liability dollar for dollar, with the only cost being interest on the premium finance loan,” Rahill said.

The beneficiaries net the full $100 million, and not the $60 million they would have received without the insurance.

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 says.

ILITs must also be precisely set up and administered.

“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 purchases assets from the estate to provide it with liquidity to pay estate taxes.

Borrowing from banks or premium financing companies to fund the policy premiums within the ILIT 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 the initial costs of the ILIT; this money can be lent to the trust by the grantor and taken back as the policy cash surrender value grows over time, Rahill adds.

An ILIT, once it’s created and funded, can’t be changed or revoked without the beneficiaries’ OK, Resch said. He adds 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.”