Why Life Insurance Is Still Relevant and Important in an Uncertain Tax and Investment Planning Environment
January 21, 2012
"These are the times that try men's souls"
— Thomas Paine
"If everyone is thinking alike, someone is not thinking"
— General George S. Patton
A very grateful thank you to our friend and colleague, Bill Davis, NorthCoast Brokerage, Cleveland, Ohio, for his technical assistance and contributions on the preparation of this article.
This article focuses on the life insurance component of successful planning in the current difficult economic environment. There are many insurance planning opportunities that are not getting the attention that they deserve. This article reviews and analyzes specific situations where life insurance provides a distinct value towards risk management and enhancing wealth creation opportunities.
We juxtapose the two quotes as Thomas Paine's statement reflects how we feel about our economic situation and General Patton's quote tells us we need to look at things differently. With this mental framework as a background, we share with you these thoughts. Our ideas are meant to provoke discussion and re-analysis as to how and when we talk to clients about life insurance.
A. LIFE INSURANCE AND ESTATE TAXES
Traditionally, life insurance has been an important tool for estate planning because of the threat of taxes. Many clients purchased insurance because we could forecast for them projected estate taxes and they would then buy life insurance to pay all or a portion of this future expense. However, current circumstances have diminished the inclination of many clients to buy life insurance to pay estate and inheritance taxes. The primary reasons they may see are:
- Increased federal estate tax exemption that currently protects the first $5,000,000 of an estate from taxation. 
- As to Ohio residents, the elimination of the Ohio estate tax effective January 1, 2013.
- Diminished personal wealth due to market and other conditions.
- Current $5,000,000 gift tax exemption that allows lifetime asset transfers that may further reduce estate taxes.
- Other spending priorities or reluctance to commit to premium payments during times of uncertainty.
Reflecting on this, three thoughts come to mind that we find to be significant:
- There will always be uncertainty with regard to financial and tax planning matters so current uncertainty is an inadequate reason to delay making decisions.
- It is very common that clients purchase life insurance for one reason and it ends up being used for an entirely different (and unexpected or unforeseen) reason.
- Solid life insurance planning involves much more than just tax planning.
In this discussion, we will intertwine these observations. We now turn to a discussion of many planning situations where life insurance can provide valuable benefits. The list of topics is not exhaustive but focuses on common client situations that all of us see.
B. MAXIMIZING THE VALUE OF RETIREMENT PLANS
Retirement plans frequently represent a significant portion of many clients' total net investable assets. Tax deferred growth is very important as it allows us to continue to invest dollars that would otherwise go to the government to pay taxes. The benefit has been further enhanced by the stretch IRA rules that allow continued tax deferral beyond the life of the owner and over the lives of the account beneficiaries. The strategies discussed in this section focus on enhancing the growth of the assets by maximizing the tax deferral periods.
1. Stretch IRA Planning
A sure way to increase family wealth is to establish a plan that names as beneficiaries of a retirement account those family members with the longest life expectancies. Thus, a client who leaves his IRA account to his grandchildren rather than his children will achieve this goal. Naming grandchildren as beneficiaries dramatically decreases the required minimum distributions because of their longer life expectancies. This is a common stretch IRA planning strategy. Of course, the negative to this is that the children are bypassed and do not receive the economic benefit of the IRA. The remedy is the purchase of a life insurance contract on the IRA account owner's life that leaves income tax free death benefits to the children in lieu of the IRA assets.
At our website, www.smith-condeni.com, under News & Publications, is our article on Family IRA Trusts. It provides a comprehensive review of the planning issues and opportunities with stretch IRA planning and how the opportunities are maximized by integrating life insurance into the plan. The example in that article shows us that an IRA account with $500,000 left to a 45 year old will produce about $2,900,000 in minimum required distributions (MRD's) to that person while the same account left to a 17 year old will result in about $9,200,000 of MRD's.
Using an analytic approach, we say that the net economic benefit of the stretch strategy is about $6,300,000 and the cost of implementing the strategy is the child is not a beneficiary of the IRA. How do we address the "cost" issue? If the IRA account represents a financial asset that the child would never use (say because of his own personal wealth or other inherited property that will at least satisfy the financial needs of the child), then there is no cost. The child does not need the money and the stretch strategy is selected.
If there is a cost (belief that the child needs or would benefit from the use of the value of the account), then the cost can be quantified as the value of the benefit foregone, in this instance the value of the account that bypasses the child. The cost is further refined as being the economic cost of replacing the asset and if the replacement asset is life insurance, then the cost is reduced to an annual expense, i.e. the premium cost.
However, our cost cannot be expressed merely as the cost of insurance because premium expense will have an offsetting internal rate of return.  For example, the attached Protective Life Insurance Company illustration demonstrates that a premium payment of $13,750 per year on a $500,000 UL policy for a 70 year old with a preferred rating results in an internal rate of return of 7.97% over the median life expectancy of the insured.
In summary, the family will benefit in three ways:
- A 7.97% rate of return on the premium expense which is certainly income tax free and can be structured to be estate tax free.
- Child receives an equivalent amount of value ($500,000) without any imbedded income tax costs.
- An increase in the distributions from the IRA of $6,300,000.
Why would a client not do this?
- Advisor is either unaware of the strategy or cannot credibly explain it to the client.
- Client does not understand it.
- Client does not care.
1 and 2 can be satisfactorily resolved (with patience). As to number 3, move on.
We add one further thought. Stretch IRA planning is a perfect example of insurance being purchased for one reason and used for another. Stretch IRA planning only became available in 2002 when the IRS changed the distribution rules and added life expectancy as a second option for taking money out of an IRA. Prior to that, the entire account had to be distributed within five years of the owner's death. So, clients who bought life insurance policies to say pay estate taxes and no longer need them for that reason can now use these policies for stretch IRA planning.
2. Life Insurance to Avoid Need to Access Retirement Plans Before
This strategy focuses on the client purchasing life insurance to provide support for his spouse so that should something happen to him, his spouse does not have to rely on accessing retirement plan accounts prior to attaining age 70 ½. As an example, assume that a client passes away and leaves a spouse, age 59. His spouse has 11 or 12 years (depending on the birthdate of the spouse) before MRD's are required. Life insurance death benefits can be used, along with other financial resources, to provide for the support of the surviving spouse while allowing the tax deferred growth of the retirement plan. In a study done for one of our clients who was rolling over to an IRA $3,000,000 in a retirement plan, allowing the assets to grow in the IRA undisturbed for this period increases the total MRD's to the spouse and children by over $7,000,000 using moderate assumptions.
Visit our website, www.smith-condeni.com, and under News & Publications, see our internet newsletter for September/October, 2011. It has a detailed discussion of the above example.
3. Life Insurance as an Alternative to Roth Conversions
Yes, Roth IRA's have tremendous advantages for tax-free wealth accumulation. The Roth cost/benefit analysis, however, in our opinion, has been materially affected by the stretch opportunities that the IRS currently allows. As noted above, under the old rules IRA accounts held for non-spouse beneficiaries had to be distributed within five years of the date of the death of the owner. This compacted the tax payment obligation into a short period of time. However, when the IRS changed the rule and allowed the beneficiary to use his life expectancy, thus deferring the payment of income taxes and preserving dollars in the retirement plan account, the value of Roth IRA's, in our opinion, diminished.
To understand how the cost/benefit analysis was changed, we enlisted the assistance of Bill Davis and his technicians at NorthCoast Brokerage. Together (O.K. they did the heavy lifting on this project), we came up with an alternative strategy using life insurance. Attached to this document is a chart that graphically depicts three alternatives, one of them making two different assumptions as to rates of return. One of the major benefits of the life insurance strategy is that the client has more flexibility with regard to estate tax planning. Roth accounts are trapped in the taxable estate of the owner. This accounts for the large spread between the green and blue solid and dotted lines.
Email either of us if you would like to see the full presentation.
4. Retirement Plans and Life Insurance as an Alternative Funding Source for Second Marriages
Should a client in a second marriage consider using a retirement plan to provide financial support for a second spouse where the client wants any remaining account value to pass to his children? To ensure that this happens, the IRA account has to be held in trust for the spouse, with the trust then directing that on her death, trust assets are to pass to the children. This, however, means that the MRD's are determined by using the spouse's age reduced by one year each year. This dramatically reduces the tax deferral period compared to the optimal tax planning solution of a rollover of the account to the surviving spouse who then gets to use the table that allows for annual recalculation of her life expectancy.
The alternative strategy is for the client to purchase a life insurance policy on his life which is then used to fund a trust or buy an annuity contract that, in either case, provides support for the spouse. The client then names his children as beneficiaries of the retirement plan. This maximizes economic benefits for both the spouse and the family. However, if the spouse is younger than the children, we suggest a closer look!
An article on this strategy can be downloaded from our website at www.smith-condeni.com under News & Publications. See the article on Family IRA Trusts.
C. LIFE INSURANCE AS A NON-CORRELATED INVESTMENT
The lack of performance in traditional investments over the past ten plus years leads us to consider whether, in limited situations, clients should consider the purchase of life insurance for its long term investment return. This discussion focuses narrowly on client situations where the client can afford to spend money on insurance premiums without affecting lifestyle spending choices. For a broader, detailed discussion of this topic, I refer you to Richard Weber and Christopher Hause's article, Life Insurance as an Asset Class, a paper commissioned by the Guardian Life Insurance Company of America. The study may be downloaded at www.ethicaledge.biz.
Evaluating life insurance in this context requires that we keep several things in mind:
- Life insurance death benefits are income tax free. No other investment product truly provides this feature.  The closest that we get to this is stepped up basis at death on assets that have appreciated in value.
- Death benefits can reliably be made estate tax free by having the policy owned by someone besides the insured.
- Our analysis presumes that the owner is willing to continue paying premiums on the policy until death.
The attached illustration from MetLife shows the internal rate of return on a policy owned by a 55 year old male rated preferred. The chart allows us to visually compare the economic benefits of this policy to an alternate investment that has an after-tax rate of return of 4%.
This discussion is not to say that clients should buy life insurance solely as an investment. However, there is a predictable rate of return on life insurance premiums so we cannot look at premium payments solely as an expense.
D. BUSINESS SUCCESSION PLANNING WITH LIFE INSURANCE
This is a planning area that is ripe with opportunities. Some observations that support this:
- Most businesses do not have a succession plan.
- Those that do typically have not had them reviewed in decades.
- Life insurance currently in place is frequently inadequate for current and predicted future circumstances.
- Life insurance policies are in need of review.
- Policies are frequently incorrectly owned.
- Tax planning strategy is incorrect or not optimal.
- No exit strategy for ownership of life insurance that is no longer needed.
Why do these issues go unaddressed? There are many reasons including that the business owners are too busy focusing on their businesses and lack of sophistication of business advisors (lawyers, business advisors, accountants and insurance advisors) in this distinct planning area.
Review our article, Planning with Life Insurance Limited Liability Companies, which is on our website, www.smith-condeni.com, under News & Publications. We have devised a planning strategy that is very useful for owning life insurance policies used for all types of business planning purposes.
E. POLICY REVIEWS
Advisors too often overlook the value of policy reviews for their clients. The key issue to look for is the amount of cash value compared to the death benefit. Unless the client is using the policy to accumulate cash values, the focus should be on maximizing the use of the cash value to maximize the death benefit. Here is an example that makes this point.
|Existing Policy||New Policy|
|Policy death benefit:||$500,000||$700,000|
|Annual premium payment:||$14,000||0|
The old policy had some increases to the cash value and new policy will see a declining cash value; however, the client in this example is not concerned with cash value but with the death benefit so a reduction in cash value does not matter.
F. LIFE INSURANCE FOR EMPLOYEES
Employers who are searching for ways to promote goodwill and loyalty with their employees should consider life insurance as an employee benefit. The simplest strategy is that the employee owns the policy. The company either pays the premium (adding this to the employee's W-2 income) or bonuses the employee who then pays the premium himself. Income might be grossed up to cover the income tax cost to the employee for receiving the bonus. This is a tax deductible expense to the company.
Another alternative is a split dollar arrangement where the company's cost of insurance is recovered upon the death of the employee. There are multiple variations on the split dollar strategy which are beyond the scope of this paper.
Employers who provide insurance as a benefit recognize that a dollar spent on life insurance will probably have a greater appreciation value to their employee than a dollar of compensation.
G. PURCHASING LIFE INSURANCE INSIDE A 401(k)
The benefit of purchasing life insurance inside a retirement plan is that the client can use money not otherwise readily available to pay life insurance premiums. It is a relatively painless way to pay insurance premiums.
This is not a commonly used strategy because there are specific rules and limitations involved. Also, you need to develop an exit strategy as in most cases, at some point in time, the policy should be removed from the retirement plan. The preferred course of action is for the policy owner to take out the policy before the cash value becomes too large.
H. IDENTIFYING THE SHORTCOMINGS OF GROUP TERM LIFE INSURANCE
Group term insurance has a place in estate and wealth management planning but it has hidden shortcomings that frequently give clients a false sense of security as to the quality of their insurance coverage. Group term insurance is inexpensive for a number of reasons that clients need to understand:
- It frequently terminates at retirement.
- Alternatively, the amount of the death benefit may decrease post retirement.
- It can be subject to premium increases at various times.
- If the client leaves the employer, coverage terminates.
- It is not transferable say to an irrevocable life insurance trust for estate tax planning reasons.
- Conversion privilege is limited to a specific product which will not be as good as other policies available on the market.
Group term insurance is not designed for long-term coverage. An employer implements a group term plan primarily out of concern for current employees. It is a benefit designed to promote loyalty.
Clients need to recognize the limitations of their group term insurance and advisors need to apprise them of the benefits of owning their own insurance.
I. GUARANTEEING A PREDICTABLE RESULT
Some clients will consider insurance when they want a guarantee that they will secure for their beneficiaries a specific amount of money in all events upon their deaths. Here are two examples:
- Charitable gift to one's church, school or other charitable organization.
- Guaranteed inheritance for children or other family members.
Life insurance is an ideal tool for clients with disposable income that want the guarantee of a specific result.
J. LIFE INSURANCE AND DYNASTY PLANNING
There are special dynamic benefits to the ownership of life insurance inside an irrevocable life insurance trust (ILIT) with dynasty provisions. We want to take advantage of the leveraging effect of life insurance where a reasonable expectation is that cumulative life insurance premiums are frequently significantly less than the amount of the death benefit. These are the major benefits:
- Gifts to an ILIT with Crummey withdrawal provisions for the beneficiaries removes the gifted property from the estate of the decedent and eliminates the attendant estate taxes. The tax savings can be seen as effectively reducing insurance premium costs because of reduced estate taxes.
- Life insurance death benefits can be permanently removed from the federal estate tax system by allocation of the generation-skipping transfer tax exemption. The amount of the exemption to be allocated is the amount of the gifts to the ILIT not the death benefit amount when received.
- The exemption from further estate taxation applies to the value of the gifts, all of the insurance death benefit and all of the growth in the investments in the account. Thus, a properly structured ILIT provides leveraging opportunities at multiple levels.
Finally, we add that all of the assets in a properly structured ILIT are exempt from claims of creditors and the spouse of a beneficiary in a divorce proceeding. These assets cannot be marital property because the beneficiary does not own them. The trust is the owner.
K. PAYMENT OF ESTATE TAXES
Besides creating money to pay estate taxes, life insurance also means that the client's other assets do not need to be liquidated to pay these taxes. This avoids the cost of liquidation, forced sales and disruption to the overall investment strategy. The client's long term financial plan for the security of his family continues uninterrupted.
L. INSUFFICIENT INSURANCE
It is very common for us to see couples with young children who are inadequately insured. $500,000 of life insurance is insufficient to generate the cash flow that a family will need if their primary wage earner dies. A very rough rule of thumb is that beneficiaries should plan on consuming about 4% of investable assets if they want to make sure that the investment fund will last a long time. Remember that we have to provide for the payment of income taxes on interest, dividends and gains and that inflation reduces the economic value of all investments. $500,000 will only produce about $20,000 of annual income.
M. INSURING THE HOMEMAKER
Advisors should discuss with their clients insuring the homemaker spouse. The amount to be purchased is not based on replacing earnings but rather recognizes that there are significant expenses involved with running a household. For couples with young children, we usually recommend $250,000 to $500,000 depending on the clients' standard of living and other issues.
Term insurance is a good solution for this situation as the time period for the need is fairly predictable.
N. CLIENT HAS THE WRONG TYPE OF LIFE INSURANCE
The life insurance product has to be closely correlated to the objective. This does not always happen. Example: Husband and wife owned a $1,000,000 second to die life insurance policy with about $115,000 of cash value. The problem is that they did not need to create wealth on the death of the survivor; they need the wealth to support the wife if the husband, who is the chief wage earner in the family, dies. At our direction, the clients' Financial Advisor worked with them and used the cash value in the second to die policy to purchase and fund a new policy insuring the husband. If assets remain after the death of the survivor, they will go to the children. We helped the clients to realign their life insurance strategy with their priorities.
O. PURCHASE OF LIFE INSURANCE INSIDE A CREDIT SHELTER TRUST
Assets in credit shelter trusts, by design, are not included in the estate of the spouse/beneficiary for determining estate taxes. This is because the spouse does not own the assets in this type of a trust. The downside of this is that these assets do not qualify for stepped up basis and capital gains must be recognized on their subsequent sale by the next beneficiary.
Consider the purchase of life insurance inside this type of trust to improve investment return and offset the inability to get stepped up basis on the death of the spouse/beneficiary. Earlier in this paper, we talked about the economic return provided by permanent insurance. Life insurance inside a credit shelter trust has an enhanced value compared to other investments in this type of trust because the entire death benefit is received free of all taxes. Caveat: The spouse cannot be the Trustee of a trust that owns life insurance on her life. This restriction can be planned around, however.
This strategy will work for all types of irrevocable trusts where the assets in the trust are not includable in the estate of the beneficiary for determining estate taxes.
P. RISK MANAGEMENT WITH LIFE INSURANCE
We cannot forget that fundamentally life insurance is a risk management tool. We are willing to part with a small portion of our personal wealth on a regular basis to protect our families and our wealth from the consequences of our untimely deaths. The last chart attached helps us to both quantify and visualize this. At anytime before the crossover point, where investment performance might exceed the value of the life insurance death benefit, there is an additional financial benefit that is not otherwise available.
In these uncertain times, advisors need to rethink traditional uses of life insurance for estate and business planning. It should be seen as both a tool for risk management and a valuable component of a long term wealth creation strategy.
 Overlooking perhaps the sunset of the Bush tax cuts and reduced federal estate and gift tax exemptions.
 Compare to other types of insurance. Auto insurance is for one year, has a zero rate of return (unless you have a claim) and no right to continue the policy in following years.
 Municipal bonds, for example, are income tax free but the interest paid is discounted to reflect this.