Estate Planning Series Part 5: What should be done with life insurance?
Traditional Use of Life Insurance
Life insurance for 99 percent of people is no longer needed to fund federal estate tax liability. If that was the only reason to acquire the policy, and if you don't see any other benefit in retaining it, you might wish to cancel the policy. Traditionally, life insurance was to provide financial security for heirs. Now, however, estate planning via a trust or will is the primary tool for providing financial security, and life insurance fills other, nontraditional roles.
If life insurance was acquired for more traditional planning reasons, such as payment of death related expenses or financial security for heirs or education funding, and its central focus was not just to be a source of death tax payment, then it remains a viable asset. In this planning environment, you may wish to use the life insurance to pay income tax or transfer tax. Other reasons to acquire or keep life insurance would be to:
1. create an estate for financial support and security of a family in the event of premature death;
2. to provide educational funding for young children;
3. to provide a readily available source of liquidity to pay debts, address funeral and administration expenses, fund bequests, and where necessary, fund buyout agreements and other possible contractual obligations.
Optimal Basis Step Up
Despite your best efforts to engage in comprehensive planning, it is possible that not all assets owned by a decedent will achieve the optimal basis step up. In such a situation, life insurance policies benefitting your children may be used to pay for the income tax cost the children will bear when the low basis assets are acquired by them and subsequently sold. The life insurance payable to the heirs at death can provide a source of income tax payment or wealth replacement if these assets are liquidated. Planning may have favored a bypass credit shelter trust for a surviving spouse that resulted in a basis step up at the first death, but not at the second death when the children inherit property still bearing the first decedent's date of death basis. The future sale of the trust assets by the children may result in capital gains to them.
Used for Direct Bequests
Life insurance can be used to provide direct bequests to children from a prior marriage. This may satisfy the desire to provide for children without having to address the blended family concerns of trusts or dividing assets between the current spouse and the children of an earlier marriage. Insurance left to the children so that the balance of the insured's estate can be left outright to the surviving spouse or others may be advisable both to maintain simplicity and achieve a full basis step up for the assets passing to the spouse or other beneficiaries.
Income Tax Shelter
Additional life insurance is an excellent income tax shelter. The build up of cash within a permanent life insurance policy is not considered net investment income and is not taxable to the policy owner. If you are in a high income tax bracket unconcerned about federal estate taxes, the favorable income tax treatment of life insurance, which is the tax free build up of cash values and the ability to access that cash value in a tax advantaged manner through policy loans may become an attractive planning option.
Access to cash values within a life insurance policy is possible even if the policy is held in an irrevocable trust, assuming the trust is properly drafted.
Reasons to Retain Direct Ownership of the Life Insurance Policy
With the concern about federal estate tax alleviated for the moderate wealth taxpayer, there is less reason to feel compelled to transfer a life insurance policy to an irrevocable trust. Retaining ownership of the policy allows the policy owner to access policy features such as long term care riders or other benefits, and to withdraw cash values as needed without having to look to trustees or strain the language of the trust to secure a withdrawal from the policy.
Example: Consider you have created and own a successful business. Planning prior to the 2017 Act may have suggested giving away pieces of the business during lifetime to avoid federal estate tax on appreciation and to secure other discounts as the gifts are made. Now, consider leaving the business in the hands of the owner(s) to assure a stepped up basis on death, especially if it is likely to be retained by the surviving family members.
Similar considerations favoring life insurance ownership would apply if the asset owned by the senior family member was appreciated real estate, rather than a a business interest. Where family business succession planning is a potentially difficult issue if one family member is an appropriate successor to the business interest and other family members are loved equally but not seen as appropriate business successors, using life insurance to equalize benefits among heirs becomes an even more attractive option when the life insurance proceeds left to heirs will avoid estate tax. The business interest can be held until death, thus assuring a date of death basis to the heir and be specifically bequeathed to the intended beneficiary. If other children are residuary beneficiaries of the estate and named beneficiaries of life insurance policies, there is a greater likelihood that equalization among beneficiaries can be achieved absent concerns about who inherits a family business interest and whose share of the estate will be reduced through transfer tax payments.
The next Estate Planning Series, 6, will be what should be done with life insurance trusts?