Life insurance can be a highly efficient, multi-purpose estate-planning tool when used correctly. Although there are many ways to structure and fund a trust-owned life insurance policy designed to achieve strategic estate planning goals, I like to think of the whole application broadly as Estate Planning Insurance.
The Tradeoff
While assets in your client’s estate are exposed to estate tax liability, assets held in an irrevocable trust, if properly designed, are not.
However, your clients’ heirs receive a “step up” in the cost basis of estate assets when your client dies. In other words, their basis in those assets becomes their fair market value at the date of death.
That means clients would be wise to weigh the comparative benefits of avoiding estate tax or capital gains tax when contemplating which and how much assets to move into trusts. This is especially true if the estate is not subject to federal estate tax due to the high life time exemption.
As of this writing, the Federal estate tax rate is 40%, plus any applicable state estate tax. Total Federal long-term capital gains tax rate is currently 23.8%, with some states tacking on up to an additional 13%. Current proposed legislation, however, may increase the top Federal rate to 31.8% in 2022.
Clients may therefore find it attractive to own tax-advantaged assets such as life insurance in trust to avoid capital gains tax exposure during the grantor’s lifetime, or pay capital gains tax to “reset” basis on highly appreciated assets at the grantor’s death.
Which Asset Will Pay the Tax?
The IRS will come for the estate tax bill nine months after your client’s death. The tax must be paid out of the estate – not the trust.
So it may be a good idea to ask your client which of their assets will pay the estate tax bill?
Managed accounts of stocks and bonds and funds are typically the easiest to liquidate. However, if your client passes away during a market downturn, the estate will have to sell more assets to get the cash it needs. That untimely selloff could result in unnecessary losses in the heirs’ inherited portfolio.
Your client might have valuable illiquid assets, like commercial real estate or an interest in a private business. The estate may also hold big-ticket luxury goods such as artwork, vacation homes or yachts and jets.
Those assets are typically hard to sell at a good price in a nine-month window, even in a favorable market. Especially if potential buyers know they must be sold and can drive a hard bargain.
Your client could potentially borrow against any of these assets from a third-party lender instead of selling. However, your client will eventually need to come up with the liquidity to repay the loan, or else bear the ongoing borrowing costs.
Trust-owned life insurance, therefore, may provide an efficient solution.
Estate Planning Insurance
Since life insurance owned by an irrevocable trust is typically outside the estate, the death benefit is not only income tax-free, but also estate-tax free.
Meanwhile, the cost basis of assets remaining in your client’s estate is now equal to their fair market value at the date of death. The trust can use the life insurance proceeds buy assets out of the estate without triggering any capital gains tax. This provides cash to pay the estate tax, while keeping assets intact and in the family.
The trust can also lend money to the estate at the preferential applicable federal rate (AFR), avoiding the estate’s need to borrow from a third-party commercial lender.
Within the trust, the life insurance proceeds are available to pay the capital gains tax on the sale of any appreciated trust assets, or simply provide cash to the kids and grandkids for investment opportunities and lifestyle support.
The fundamental concept of Estate Planning Insurance is that it ensures there will be enough tax-free liquidity to facilitate a safe, efficient and predictable transfer of wealth from one generation to the next.
Jacob L. Hartz is a Director at NFP Insurance Solutions. He joined the firm in 2020, building on a wealth advisory career that began after law school at a single-family office. His practice focuses on estate planning for highly successful families.