In a previous article, we examined the various educational
savings vehicles available to clients, including 529 plans, UGMA/UTMAs,
Coverdell Education IRAs and life insurance. Using life insurance as an
education savings vehicle prompted several questions about other uses
for life insurance. Therefore, this as a follow up, this article examines some of these other common uses for life insurance, the only asset class that can ensure the completion of proper funding for a myriad of unique planning needs regardless of the state of the federal estate tax!

   

  

Income Replacement ("How will my family eat if I die?")
Even if the client is not subject to estate tax, life insurance can
replace lost income if the client dies unexpectedly (more policies pay
out for income replacement than for liquidity to pay estate tax). For
example, clients with young children should consider using life
insurance to ensure that there are sufficient funds available to pay
for child-rearing or college and post-graduate expenses in the event of
a parent’s premature death. For these income replacement policies, the
estate tax, including the possibility of estate tax repeal, has no
significance.

Planning Tip: Clients should consider life insurance to replace income from the premature death of a breadwinner spouse or parent.

Wealth Creation ("What if I die before I build an estate for my family?")
Another
need for life insurance unaffected by the estate tax is the use of life
insurance to create wealth. Examples of this need are families who wish
to add to their wealth for future generations or to fund their
philanthropic objectives.

Planning Tip: Consider life insurance to create wealth or additional wealth for the client’s family and future generations.

Wealth Replacement ("How can my family receive the full value of my assets?")
Traditionally,
life insurance has been used to replace wealth lost to the federal
estate tax. However, with an increasing federal estate tax exemption
(currently $2 million per individual, $4 million per married couple),
fewer clients are subject to federal estate tax. Thus, fewer clients
need traditional wealth replacement policies. However, many clients
have significant other wealth replacement needs.

For example, many clients’ most significant assets are tax-qualified
plans (such as IRAs, 401(k)s and pension plans). Because these assets
are Income in Respect of a Decedent (IRD), they will be subject to
ordinary income tax when distributed to beneficiaries. While we often
discuss with clients maximum income tax deferral ("stretch out"), many
beneficiaries will deplete these assets quickly, incurring significant income tax. Recognizing this, many clients would benefit from life insurance designed to replace this lost wealth.

In addition to traditional wealth replacement needs, wealthier clients
would benefit from wealth replacement for assets transferred to a
charitable remainder trust (CRT) or to a charitable lead trust (CLT),
which is often used to eliminate estate tax.

Planning Tip: Consider
life insurance for non-traditional wealth replacement purposes, such as
to replace income tax paid for significant IRAs and other tax-qualified
plans, or where the client has used a charitable lead trust to avoid
estate tax.

Planning Unrelated to
the Federal Estate Tax ("I didn’t know there were so many other
situations where only life insurance will assure me my goals will be
reached even if I die!")
Clients often use life insurance in planning that is wholly unrelated
to the estate tax. There is a continuing need for life insurance as a
funding vehicle in numerous situations, including:

• buy-sell planning;
• key employee coverage;
• nonqualified deferred compensation;
• death-benefit-only plans;
• liquidity to pay debts;
• liquidity for state death taxes; and
• inheritance equalization.

Income-Tax-Free Status
of Death Benefits ("What a difference not paying taxes can make on the
amount to which my premiums can grow.")
With increasing federal estate tax exemption amounts, there is now an
increased emphasis on income tax planning, with a particular emphasis
on assets that combine basis step-up with tax-free or tax-deferred
growth. Life insurance proceeds paid upon the death of the insured, as
well as proceeds attributable to investment appreciation on the cash
value portion of the policy, are excluded from gross income. As a
result, not only is the death benefit of a life insurance policy
tremendous compared to the premiums paid if the insured dies
prematurely, in a properly designed policy the death benefit remains
quite handsome even if the insured lives past life expectancy.

Planning Tip: The
unique character of life insurance allows a capable and competent life
insurance agent to design a product providing excellent results over a
long time frame.

Irrevocable Life Insurance Trusts ("A little planning can provide enormous tax savings.")
Even though the insurance death benefit is not subject to income tax,
the life insurance proceeds will likely be included in the client’s
gross estate and, therefore, be subject to federal and/or state estate
tax absent a properly drafted and maintained Irrevocable Life Insurance
Trust (ILIT). As a result, many clients create ILITs for the purpose of
owning life insurance to avoid federal and state estate tax on the
death proceeds.

Planning Tip: Use
an Irrevocable Life Insurance Trust to purchase, own and be the
beneficiary of life insurance to avoid having the death proceeds
subject to estate tax. A good lawyer with prompt turnaround of a trust
document is a critical component of the planning team.

Planning Flexibility ("How can I deal with the uncertainty of estate taxes?"  "Will I need the extra cash at my death, or not?")
The uncertainty surrounding the federal estate tax and the exemption
equivalent amount may suggest the use of the most flexible types of
cash value policies, such as universal life policies. These policies
permit the policy owner to vary the amount of premium payment, the
level of death benefit, and the amount of cash value (in exchange for
this flexibility, the client may give up the guarantees that the
premium will provide a guaranteed death benefit for the life of the
policy). No other single asset provides the same degree of planning
flexibility. However, it is incumbent on the planning professional to
ensure that the product selected fits the needs of the particular
client.

Planning Tip: Permanent
life insurance is a unique asset that provides the highest degree of
flexibility for changes in the law or changes in the client’s
circumstances. The quality of the life insurance agent and the life
insurance company he or she selects are among the most important
choices a client can make.

Conclusion

Life insurance is the only asset class (other than cash) that a
client can remove from his or her gross estate, yet it still provides
liquidity (e.g., for federal or state death tax or capital gain tax) or
wealth replacement (e.g., to make beneficiaries "whole" for large IRD
items like IRAs, 401(k)s, and pension plans) without itself incurring
income tax. All other assets removed from the client’s gross estate for
estate tax purposes must be sold and the gain realized to net the
required amount.

To comply with the U.S. Treasury regulations, we must inform you
that (i) any U.S. federal tax advice contained in this newsletter was
not intended or written to be used, and cannot be used, by any person
for the purpose of avoiding U.S. federal tax penalties that may be
imposed on such person and (ii) each taxpayer should seek advice from
their tax advisor based on the taxpayer’s particular circumstances.