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Life Insurance: The Oft-Missed Financial Tool

How you can add this service to your practice and grow your clientele.

November 20, 2008
by James McHale, CPA, PFS

Life insurance is poorly understood as a financial-planning tool. Many advisors use life insurance only in conjunction with the establishment of one or more irrevocable life insurance trusts. This article focuses on various life insurance planning techniques.

Life Insurance As an Asset Class

Financial planners should recognize life insurance as an asset class. Our firm worked with a financial advisor to address the needs of a married couple, Tom and Thelma, 70 and 68. The couple has a $5 million estate including $2 million in retirement accounts, a $1 million home and a $2 million portfolio comprised mainly of fixed income securities.

This year, at age 70, Tom will begin taking required minimum distributions (RMD). The current year distribution is $72,993 ($2 million/27.4). Tom became concerned when he realized that, with RMDs, his income will exceed the income he earned while working.

If Tom were to purchase a $2 million guaranteed no lapse Universal Life Policy (GUL) with a preferred rating, the annual premium would be $53,940. If Tom lives to age 80, the policy will yield an internal rate of return (IRR) of 23.02 percent; at age 90 the policy has an IRR of 5.57 percent; if Tom is part of the 1.25 percent of males who live to age 100, the IRR slips to 1.33 percent and certificates of deposit (CDs) may have been a better choice.

Given the couple's financial position, risk aversion and the uncertain economic climate, we recommended using a Survivorship Guaranteed Universal Life Policy (SGUL) to fulfill their life insurance needs (these policies are easier to underwrite since they are written over two lives and can be very effective when one spouse may be in poor health). Using the SGUL, a preferred rated couple's annual premium is $27,865. This policy will provide an IRR of 4.5 percent until Thelma reaches 104. The 4.5 percent nearly matches the fixed income returns the couple has been earning. Life insurance is, in essence, a self-completing financial plan. The inheritance planned at policy inception will be available; it is not based upon projected market returns.

Generally, there is a 62 percent probability of a policy being offered with a rating better than standard. With an Irrevocable Life Insurance Trust, the proceeds will also be excluded from the decedent's estate.

Male Aged 70/Female Aged 68
Survivorship Guaranteed Universal Life

    Standard —
No Tobacco
  Standard Plus —
No Tobacco
  Preferred —
No Tobacco
  Super Preferred —
No Tobacco
Premium   $37,601   $34,252   $27,865   $26,031
IRR Age 82/80   21.59%   22.91%   28.81%   26.77%
IRR Age 92/90   7.11%   7.81%   9.34%   9.84%
IRR Age 102/100   2.91%   3.41%   4.5%   4.85%

Male Aged 70
Guaranteed Universal Life

    Standard —
No Tobacco
  Standard Plus —
No Tobacco
  Preferred —
No Tobacco
  Super Preferred —
No Tobacco
Premium   $72,794   $66,910   $53,940   $48,162
IRR Age 80   17.82%   19.281%   23.02%   24.98%
IRR Age 90   2.93%   3.69%   5.57%   6.54%
IRR Age 100   (0.57%)   (0.02%)   1.33%   2.02%

Intentionally Defective Grantor Trusts

One of the most popular planning techniques is the use of an Intentionally Defective Grantor Trust (IDGT), which capitalizes on the differences between the Grantor Trust Rules outlined in Internal Revenue Code Sections 671-679 and the Estate Tax Rules outlined in Sections 2036-2042. Sec. 671 mandates that grantor has the legal obligation to pay any income tax on income from the trust, although the grantor is not the beneficiary of that trust. This is a meaningful financial benefit to the taxpayer since in 2008, the 35 percent tax rate for trusts begins at $10,700 of annual income, but not until $357,700 for individuals.

The IDGT property is excluded for estate and gift tax purposes as long as the grantor does not have a retained life estate under Sec. 2036 or the transfer is not a Revocable Transfers under Sec.2038. The transfer of assets to a trust provides a dual benefit: 1) It allows the transferred assets to be frozen for estate tax purposes; 2) The assets within the trust can appreciate without any tax drag.

Generally, the grantor transfers assets to a trust in exchange for an installment note. Rev. Rul. 85-13 held that since the grantor is deemed to be the owner under Sec. 675(3) and 671, any transfer is a transfer to oneself and is not considered a sale for federal tax purposes, nor are the payments on note deemed to be income to the holder.

Using life insurance within a grantor trust will allow families to further leverage wealth transfer. Another advisor had a married couple owning a rapidly growing limited liability company (LLC) currently valued at $5,400,000 as a client; their combined estate is valued at $19 million. Bob and Carol, 67 and 63, worry about potential estate tax law changes and are looking for a way to remove assets from their estate. An asset sale to a grantor trust may effectively accomplish their objectives. Under this scenario, the couple would sell their interest in the LLC to the Grantor Trust. They appointed their son Elvis as trustee. After a valuation discount of 27 percent was taken, the actual sale to the trust will be $3,942,000 using a 10-year interest only balloon note. Based on the current long-term AFR of 4.32 percent, current year interest payments will be $170,294. In order for the trust not to violate Sec. 2036(a) (1) (and PLR9515039), a gift of approximately 10 percent of the sale amount is needed in order to seed
the trust.

The LLC generates $445,500 or an 8.25 percent return on $5,400,000 the actual value of the assets sold to the trust. The seed money of $540,000 is assumed to generate another $21,600 per year at a conservative four percent return. This provides annual trust income of $461,000. The couple elects to purchase a $10 million SGUL. The policy will be a limited-pay policy, with all premiums paid over the term of the 10-year interest only note. The premiums on this policy, based upon a preferred rating
are $228,693.

Annual Income from the Trust    $467,100
Less annual Interest payments    ($170,294)
Less annual premiums    ($228,693)
Excess Cushion    $62,013

Male Aged 67/Female Aged 63
Survivorship Guaranteed Universal Life/10 pay

    Standard —
No Tobacco
  Standard Plus —
No Tobacco
  Preferred —
No Tobacco
  Super Preferred —
No Tobacco
Premium   $250,234   $239,133   $228,693   $226,227
IRR Age 77/73   21.01%   22.91%   22.91%   22.54%
IRR Age 87/83   8.58%   8.86%   9.15%   9.21%
IRR Age 97/93   5.32%   5.50%   5.68%   5.72%
IRR Age 107/103   3.85%   3.98%   4.11%   4.14%

Conclusion

The use of the grantor trust is an effective planning technique. Some factors to remember: a sale of assets is not subject to gift tax; the tax paid by the grantor is at the grantors tax rate; assets sold to a trust can be discounted and the appreciation is removed from the estate; the annual trust income, taxed to the grantor can be used by the trust to pay life insurance premiums which will further leverage the trusts assets and enhance the estate's wealth transfer; and finally, asset sales to a grantor trust, and the use of income generated by the trust, do not fall under
Sec. 2035.

Life insurance planning techniques can add significant value in estate planning, leveraging assets and reducing your client's tax exposure. Obviously, the efficacy of these and many other life insurance planning techniques depends upon your client's specific situation; consulting a life insurance specialist can yield significant immediate and long-term benefits.

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Jim McHale is a CPA, PFS and a Certified Financial Planner. He works as general agent assisting financial advisors with the implementation of complex insurance strategies including business succession planning, advanced estate planning and tax protected strategies for closely held and family owned businesses. Jim takes a holistic approach to your client's financial well being by ensuring protection of their assets while maximizing their net worth. He is a part-time instructor of the Certified Financial Planning curriculum for Kaplan-Schweser and one of few instructors nationwide who teach all the six prerequisite classes as well as the entire comprehensive review. He is a member of the American Institute of Certified Public Accountants, California Society of Certified Public Accountants and the Financial Planning Association.