Life Insurance Remains a Strong Source of Stability in an Uncertain Tax Environment
Since 2001, there has been significant uncertainty concerning our transfer tax system, and in the wake of the 2016 election, the possibility of major tax reform (including estate tax repeal) has again gained momentum.
In the face of this uncertainty, it makes practical sense to re-evaluate estate liquidity needs and existing life insurance coverage. The reality is that the need for planning and adequate liquidity funding remains just as important today as ever, and tax considerations alone should not drive estate and life insurance planning. There are many non estate tax reasons for planning and liquidity funding, and there are also potential costs associated with inaction or delay.
Recognizing the Multiple Uses of Life Insurance in Estate Planning
Just as estate planning has changed in recent years, so has the use of life insurance in estate planning. Life insurance can effectively serve multiple purposes and objectives in an estate plan, and has more uses beyond simply providing a death benefit to pay estate taxes. While the primary purpose for purchasing life insurance should be the death benefit it provides, the focus does not have to be exclusively on the policy’s death benefit, nor should it be assumed that the policy will automatically be placed in an irrevocable life insurance trust (ILIT).
Given the present uncertainty, it is especially important to understand the versatility and flexibility of life insurance in this planning context:
- The unique attributes of life insurance include instant mortality based liquidity and tax favored cash accumulation, access, and death benefit (based on long standing tax principles).
- The (generally) tax free death benefit is an important source of predictable liquidity for illiquid estates to cover state or federal estate taxes, income taxes, income in respect of a decedent (IRD), and other expenses or liabilities.
- Life insurance can fulfill specific bequests, and can also ensure a legacy for heirs as an estate is spent down (e.g., living expenses, health care costs, etc.).
- Life insurance can facilitate “estate equalization” or “equity of inheritance” among beneficiaries and heirs, such as between children who are involved in and inherit a family business and those who do not.
- Life insurance offers the liquidity and flexibility needed to assure the continuation of a family business, including death proceeds which can provide a cash bonus to retain a vital key employee, or resources for a “non active” spouse or other dependent who does not receive independent income from the business.
- Life insurance can provide a tax free inheritance to a beneficiary of an IRA, unaffected by the value (rise or fall) of the IRA investment account. The death proceeds can provide liquidity to pay income taxes on IRA distributions, replace amounts lost to income taxes, or pay the income taxes on a Roth conversion from a non IRA source.
- For the charitably inclined, life insurance can accomplish the important planning objective of “wealth replacement”, ensuring the family’s inheritance is preserved (and not diminished) as a result of a significant charitable gift or bequest. Life insurance can also leverage a charitable bequest.
- If there is no anticipated estate tax concern, the insured can retain personal ownership of the policy and enjoy the living benefits and direct access to policy cash value (generally on a tax favored basis).
- The policy’s living benefits can provide a source of retirement and survivor income until other income sources (e.g., social security) become available, and it is a “non- correlated” asset which can help diversify an investment portfolio and offset potential market exposure.
- Life insurance can incorporate desirable policy characteristics and features, including special options and riders such as chronic illness, critical illness, or income to defray financial costs associated with a long term care event.
Evaluating and Re-Purposing Existing Coverage
Broad changes to current tax laws, including estate tax repeal, remains uncertain. If transfer taxes are repealed, what is the likelihood that repeal will be permanent or sustainable for the long term (e.g., “sunset” provision, change of administrations, etc.)? There may also be offsetting revenue raisers associated with any repeal, such as loss of basis “step up” at death which could cause beneficiaries and heirs to incur new income taxes. “Wait and see” or delayed planning may have associated costs. Therefore, it is wise to lock in the flexibility and liquidity of life insurance coverage.
Life insurance never goes out of style – and it represents a flexible and tax advantaged planning tool during these uncertain times. Today’s uncertainty could become the “new normal”, and it’s important to not lose sight of the planning opportunities that currently exist. This should include evaluating existing policies in light of current circumstances, needs, and tax environment – and re-purposing existing coverage if no longer needed for estate taxes. Life insurance will continue to represent a versatile solution for many practical needs, as well as a valuable partner and complement to many planning strategies.
The material contained in this document is based on Penn Mutual’s understanding and interpretation of current law. Penn Mutual, its agents and representatives may not give legal or tax advice. All guarantees are based on the claims paying ability of the issuer. Accessing cash values may require additional premium payments to maintain coverage, and will reduce the death benefit and policy values. Loans are income tax free as long as the policy is not a “modified endowment contract “(MEC) and the policy must not be surrendered, lapsed, or otherwise terminated during the lifetime of the insured. Special options and benefits have additional costs and may be subject to certain limitations and eligibility requirements.