By: Julius H. Giarmarco, Chair of the Trusts & Estates Practice Group, Giarmarco, Mullins & Horton, P.C.

February 17, 2016 9:42 am EST
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With the estate tax exemption currently at $5.45 million ($10.9 million for a married couple), it is estimated that less than 0.02% of Americans have taxable estates. Thus, purchasing life insurance for estate liquidity purposes is not necessary for 99.8% of Americans. Nevertheless, cash value life insurance has additional merits as an alternative asset class for high-net-worth individuals and high-income earners. Following are some of the many benefits of cash value life insurance.

1. Reducing Risk.

Many investors develop their financial portfolios with a focus on accumulation. These investors often overlook the need to reduce risk. Life insurance offers predictable value with tax efficiencies. Life insurance death benefits can be designed as a fixed amount to avoid stock market volatility (subject to the claims paying ability of the insurance carrier). Moreover, there are a variety of life insurance policies available that can be designed to match the investor’s risk tolerance.

2. Internal Rate of Return.

A policy’s internal rate of return (IRR) is the rate that the cumulative premiums paid for a policy would have to earn in order to equal the death benefit (when paid at the insured’s death). Thus, the exact IRR of a policy cannot be determined until the insured dies. The IRR on a policy’s death benefit usually starts well above 100% and gradually declines to less than 10% over 20-30 years, depending on the insured’s age and health rating. For example, if the preferred annual premium for a $1 million policy (to age 100) for a 65-year-old male is $18,000, the IRR on the death benefit is 8.9% at age 85, 5.6% at age 90, and 3.7% at age 95. Of course, it is the insured’s heirs who reap the benefits of a higher IRR. But as yields available to investors continue to fall, investing in a cash value life insurance policy as an asset class will be attractive to conservative investors.

Since life insurance benefits are income tax free, a taxable investment would have to earn more to net the same return that a life insurance policy would return. The calculation looks like this:

Tax-free rate of return
÷ (100 – income tax rate)
= Taxable equivalent rate of return

Thus, to achieve a 3.7% after-tax IRR, a taxable investment (for a taxpayer in a 45% combined state and federal tax bracket) would have to earn 6.7% (i.e., 3.7% ÷ 55% = 6.7%).

3. Income Tax Efficiencies.

High-income earners face a federal income tax rate of 39.6%, a long-term capital gain rate of 20%, a qualified dividends tax rate of 20%, a 3.8% net investment income tax, and possible state income taxes. As mentioned above, the IRR at the insured’s death is a valuable measure of a policy’s effectiveness. However, income tax free access to a policy’s cash value is another important consideration.

The interest credited to a policy’s cash value is generally tax deferred. And a policy’s cash value can be accessed tax free by withdrawals (up to cost basis) and policy loans thereafter (assuming the policy is not a Modified Endowment Contract (MEC). Finally, the death benefit can be structured to be received income tax free by the beneficiaries.

This “triple threat” feature of life insurance (i.e., tax-free accumulation, tax-free access to cash values, and income tax free death benefit) is exceptionally attractive to high-networth and high-income taxpayers.

4. Estate Tax Efficiencies.

By having the policy owned by an irrevocable life insurance trust (“ILIT”), the death proceeds will avoid estate taxes at the insured’s death. If the insured is married, the insured’s spouse can be the primary beneficiary of the ILIT. When properly structured, the ILIT keeps the death proceeds outside of both spouses’ estates, while allowing the trustee to access both the policy’s cash value and death proceeds for the benefit of the grantor’s spouse. Thus, during the grantor’s lifetime, the grantor’s spouse has direct access to the policy’s cash values, and the grantor has “indirect” access (through his/her spouse).

5. Comparison to Other Savings Vehicles.

When compared to a qualified plan or IRA, a life insurance policy fairs favorably. Only a life insurance policy has all of these attributes:

  • Tax-free accumulation (same as qualified plans and IRAs).
  • Tax-free distributions (unlike qualified plans and traditional IRAs).
  • Tax-free death benefits (unlike qualified plans and IRAs).
  • No contribution limits (other than avoiding MEC status).
  • No income restrictions (you can use earned or unearned income to pay premiums).
  • No ERISA requirements (as with qualified plans).
  • No discrimination testing (as with qualified plans).
  • No early withdrawal penalties (as with qualified plans and IRAs).
  • No required minimum distributions (as with qualified plans and IRAs).

Due to the tax favored treatment of life insurance (both in the accumulation phase and in the distribution of funds within the policy), life insurance can be a powerful tool for high-income earners and high-net-worth individuals – even if they do not have taxable estates.

The views and opinions expressed herein are those of the author(s). Core Compass’s Terms Of Use applies.

About the author

Julius H. Giarmarco, J.D., LL.M., is chair of Giarmarco, Mullins & Horton’s Trusts and Estates Practice Group in Troy, Michigan. Julius received his law degree from Wayne State University, and his master of laws from New York University. He is licensed to practice law in both Michigan and New York. Julius’ primary practice areas include estate planning, business succession planning, wealth transfer planning, and life insurance applications. Julius can be contacted by email or by phone at (248) 457-7200.

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