AAII Journal - April 2000

Life insurance is useful in a number of estate planning situations, but elimination of the estate tax will have its greatest effect on estates with liquidity problems. Repeal of the estate tax, however, is not a given. Planning in the face of uncertainty.

Life Insurance and Uncertainty Over Repeal of the Estate Tax

by Peter C. Katt, CFP, LIC

Cries of "the estate tax is ending, the estate tax is ending" echo through the corridors of the nation’s country clubs.

Congress has passed its repeal, and several presidential contenders have promised to end it, but the repeal was vetoed. The vetoed legislation called for the estate tax to be phased out by the year 2009—three presidential and five congressional elections away.

Notwithstanding the applause that comes with the promise to end the "death tax," I suspect the estate tax repealers are a bit politically tone-deaf to the barrage they will face from the opponents of repeal if and when it appears to have any real chance of succeeding. But in deference to those who believed Charlie Brown would finally kick the football, this column discusses how the actual or anticipated repeal of estate taxes would affect life insurance.

There has developed the rather clumsy notion that everyone with a certain amount of assets should buy life insurance to pay estate taxes (for liquidity), without giving primary consideration to asset mix and family relations. The liquidity-only advisors fail to make not-so-subtle distinctions between estates with difficult-to-market assets (and are in need of liquidity), estates consisting primarily of marketable securities (with no liquidity problem), and estates whose primary need is for inheritance equalization among children (a people-planning question). Seen in this light, the elimination of the estate tax will have its greatest effect on estates with liquidity problems, while the other two planning areas will still find life insurance to be quite useful.

Anticipating Repeal: Persons with difficult-to-market assets or assets they want retained (family business) with little liquidity should have life insurance for liquidity to avoid the need to sell or mortgage assets. Even those who believe the repeal of estate taxes is imminent should still acquire life insurance for liquidity to insure against their death(s) before it ends and in case it doesn’t. However, those who believe repeal is imminent should probably avoid full-load permanent life insurance policies because if they then surrender them in a few years, the cost of protection will have been very high due to the loads. These people would be better off purchasing term insurance or low-load universal life because early cancellation of these policies won’t cost nearly as much as a full-load policy.

Post Repeal: Obviously, if the estate tax is repealed, new liquidity life insurance purchases for estates with difficult-to-market assets will no longer be necessary. What isn’t obvious is what to do with existing liquidity life insurance. It would be a mistake for policyowners, after downing their celebratory champagne, to surrender their policies without examining all options. Options that might be considered are:

• Cancel — Appropriate when insureds are in excellent health and there is no taxable gain upon surrender.
• Retain as is — Appropriate when the insureds are in poor health, making the coverage more valuable because of the increased likelihood policies will mature due to the insureds’ deaths.
• Retain, but restructure by reducing death benefits to their minimum amount — Appropriate when the insureds are in excellent health and there is a taxable gain upon surrender. By reducing the policies’ death benefits, the policyowners could probably stop any further premium payments, or they could continue payments and produce better benefits over the long term. (See my August 1996 AAII Journal column,"Passing on Your Wealth: Gift Planning and the Use of Life Insurance").

Persons owning mostly marketable securities don’t have a liquidity problem at all. When the amount of these marketable securities is considerably more than needed for the owners’ comfort, wealth will continue to expand.

Under the current estate tax system, such persons will want to moderate the future increase in asset value within their estates because for every dollar of new wealth generated in their own names, heirs will lose 55 cents to estate taxes. The solution is a wealth-transfer plan. One way to transfer wealth is to make cash gifts to a family partnership or irrevocable trust. Cash gifts need to be invested. Investing in wealth-transfer life insurance (minimum initial death benefits) is ideal because it will outperform similar investments made outside life insurance by reason of the insurance proceeds not being subject to income taxes. (Again, see the August 1996 AAII Journal column). Life insurance’s income tax advantage exists without reference to the existence of an estate tax. Therefore, even if the estate tax has ended, persons interested in maximizing wealth for heirs should still use life insurance because of its excellent income tax savings.

That said, a distinction needs to be made between whole and universal life and variable life with respect to income tax advantages in a world without estate taxes. The keys to understanding this distinction are policy ownership and capital gains taxes. The investment component of whole and universal life policies is mostly fixed-income instruments held for yield. Therefore, a wealth-transfer policy’s results should be compared with similar investments outside life insurance. Since fixed-income investment yields outside of a life insurance policy are taxed year-to-year, anyone wanting to expand their wealth for the next generation using fixed-income investments will be better off doing it inside whole and universal life policies. This is so regardless of whether these policies are owned by the insureds because estate taxes have been repealed, or owned by irrevocable trusts because they have not been repealed.

Likewise, variable life invested primarily in equities needs to be compared with similar equity investments outside life insurance. However, there is an important difference: Equities that have increased in value that are owned by individuals receive a step-up in basis upon death. However, equities owned by an irrevocable trust do not receive a step-up in basis upon the death of the trust grantor. So in a world with estate taxes and irrevocable trusts, variable life purchased for wealth transfer is far better because its equity growth is not subject to capital gains taxes upon the insured’s death. But in a world without estate taxes, equities owned by individuals receive the step-up in basis and therefore have no disadvantage compared with variable life. And since equity returns that are not subject to capital gains taxes will do better outside variable life because there are no insurance policy expenses, equities owned by individuals are preferable to variable life for transferring wealth in a world witho ut estate taxes—with one rather important caveat. Equities owned outside cannot be re-allocated without capital gains taxes being due (assuming there is a gain) because the step-up of cost basis only applies at death. So, if you wish to maintain the flexibility of re-allocating your investments, variable life should be used because changing funds doesn’t trigger any taxes.

Anticipating Repeal: Wealth-transfer planning that uses fixed-income investments will be unaffected by the anticipated repeal of estate taxes because of the previously discussed income tax advantage, so selecting the policy you believe will have the best long-term value regardless of loads is recommended. However, wealth-transfer planning using equities should purchase low-load variable life to avoid the large acquisition expenses in case it is subsequently canceled in order to invest in equities outside life insurance upon the termination of the estate tax. All wealth-transfer policies should be applied for and owned by an irrevocable trust and if the estate tax were repealed, the trust might be ignored with policies transferred to the insureds if proper steps are taken to protect the interests of beneficiaries.

Post Repeal: Whole and universal life wealth-transfer policies should be retained. Variable life wealth-transfer policies that have substantial gains should also be retained because canceling them would generate ordinary income on the gains. Variable life wealth-transfer policies with no gain could be canceled if the insured wishes to invest in equities that would not subsequently be re-allocated. Or, if the insured wishes to maintain the flexibility to periodically re-allocate investments, retaining the variable life policy would be preferred. Wealth-transfer policies retained might be transferred to the insureds as long as trust beneficiaries’ interest is protected.

The need for inheritance equalization planning is almost always associated with a family business or children from several marriages.

• Family Businesses: When at least one, but not all, children work in the family business, it is generally unwise for the business to be inherited by the children not involved because of the potential for disputes about business affairs between involved and uninvolved children. Rather, it is much better planning to leave the business to involved children while equalizing assets given to uninvolved children. However, when the business value is much greater than the other assets, and estate taxes add more complications, equalizing inheritances will not be possible without life insurance. Typically children involved in the business will own a policy insuring the parents, and will then buy the business with the proceeds upon their parents’ death; the policy thus provides the additional resources to equalize inheritances and pay estate taxes. Alternatively, a policy insuring the parents could be owned by an irrevocable trust in favor of the children not involved with the business.

Anticipating Repeal: If inheritance equalization for family business planning is needed regardless of the existence of the estate tax, the form of the planning would be unaffected, but the amount of necessary coverage might be affected. Avoiding large acquisition costs would be advisable if, after repeal, the coverage is substantially reduced.

Post Repeal: If the only reason for life insurance coverage is to cover estate taxes, refer to the previously covered liquidity options. If policies used to equalize an inheritance that will be retained are owned by an irrevocable trust, they might be transferred to the insureds as long as the trust beneficiaries’ rights are protected.

• Children from Several Marriages: A typical situation involves Don, 58, with children Paul and Sarah, both in their 30s and from a first marriage, and children in their early teens from a second wife, Cindy, in her early 40s. Under a characteristic estate plan, no assets are distributed to any children until the second parent’s passing. However, since Cindy, Paul and Sarah are so close in age, Paul and Sarah would likely not receive an inheritance until they were in their 60s or 70s. This circumstance after Don’s passing is likely to strain family relations, which is something Don wants very much to avoid for his family. Don and Cindy have assets valued at $5 million. Don wishes to give Paul and Sarah their inheritance upon his death even if Cindy survives him, which is very probable. However, under current estate tax law he can only leave them assets in the amount of his unified credit ($675,000 in 2000). To leave them any more would trigger estate taxes on any excess. Don wants to leave Pau l and Sarah $1 million each. The solution is to acquire life insurance of $2 million owned by and payable to an irrevocable trust with an estimated annual cost of some $36,000. Upon Don’s death, Paul and Sarah receive their inheritance without any estate taxes being triggered, smoothing the way for pleasant family relations. This is the obvious answer in a world with estate taxes because to leave Paul and Sarah $1 million each from the estate would trigger estate taxes of some $650,000.

If the estate tax were repealed, it isn’t obvious that the life insurance should be avoided because Don and Cindy may conclude that the premium, estimated to be some $36,000 annually, is more palatable than sending 40% of the current estate to Paul and Sarah, leaving Cindy and her children with only $3 million. In that event, it would make sense for Don to buy coverage and continue it even if the estate tax were repealed. However, if life insurance is only necessary because of the estate tax and it is repealed, the options presented for the liquidity situation should be considered.

Although I don’t expect the estate tax to be repealed now or in the long term, I know some do. Indeed, several months ago I spoke with a life insurance company product developer who told me his company had decided against developing a second-to-die policy because they expect estate taxes to be repealed. This column has tried to put into perspective life insurance issues that ought to be considered by those who do believe there is a good chance estate taxes will be repealed.

Reprinted with permission from the American Association of Individual Investors.