One may consider an alternative approach when acquiring life insurance to fund estate taxes. This approach may initially seem to be counter intuitive to the traditional or common practice of purchasing the maximum initial death benefit based upon premiums paid.
Why Large Policies?
Many purchases of large death benefit life insurance policies occur because a property owner perceives that her surviving family members will suffer an unacceptable erosion of wealth upon the owner’s death on account of the imposition of estate tax. The solution is the acquisition of an insurance policy on the property owner’s life. That solution is seldom perfect and, in fact, often will prove more costly than if the insurance hadn’t been acquired and alternative action (traditional estate tax planning) was taken or if an alternative lower death benefit, higher cash value policy had been purchased.
Typically, the death benefit under the policy is selected by running numbers that indicate how much estate tax will be due when a property owner dies. One assumption that a property owner and her advisors must make is what the effective rate of estate tax likely will be when she dies. If the property owner is married, she can postpone the estate tax until her spouse dies, by transferring property to the surviving spouse under the protection of the marital deduction.1 This rate has varied over the past several years from a high of 60 percent to a low of 35 percent.2 About a third of the states currently impose an additional estate tax of 10.4 percent.3 The United States now imposes a rate of 35 percent, but that rate is scheduled to increase after 2012 to 55 percent.4
History indicates that forecasting what the effective rate of estate tax will be on death is difficult, because it’s a political matter. Virtually every Republican presidential candidate has vowed to repeal the estate tax.5 Whether a Republican becomes the next president of the United States, it’s uncertain if the estate tax will be repealed or reduced.6 Years ago, then-president-elect George W. Bush stated that his number one domestic political agenda was the repeal of the estate tax. Repeal didn’t occur until after Bush’s second term ended, and it lasted (by affirmative election) for only one year. In any case, buying life insurance to pay for estate tax often will be perceived as a wasteful decision if there’s no such tax in effect when the insured dies.
Timing of Death
Even if no estate tax is in effect when the insured dies, the purchase of the life insurance policy likely will be viewed as a financially efficient decision if the insured dies earlier than the insurance company had forecast.7 One of the key factors in determining the cost of life insurance is predicting when someone of the insured’s age, gender and health probably will die.8
Although it’s impossible to discern accurately when a particular individual will die (unless death is imminent),9 it’s generally possible to ascertain the average time when a large group of individuals of the same age, gender and health will die. For example, an insurance company may forecast that a healthy 60-year-old male insured will die, on average, in 26 years and will price the premiums accordingly.10 On average, insurance policies have an approximate 6 percent return compounded annually if the insured dies at her actuarial life expectancy, as estimated by the insurer.11 If a particular insured dies earlier, the return will be greater; if she dies later, the return will be smaller.12 Nevertheless, few large death benefit policies acquired to pay estate tax would have been purchased if the insured knew there would be no estate tax: The 6 percent average return, coupled with the uncertainty of that return (which as the insured ages will diminish), because the time of death for a specific individual can’t be accurately predicted, means that the property owner likely would decline to buy the policy.
Additional factors should be, but rarely are, considered by property owners when deciding whether to buy life insurance to pay for estate tax. One is that the majority of policies are cancelled before the insured dies.13 One reason for this is that most life insurance policies become less efficient over time.
A policy’s decreasing efficiency may be due to the fact that the longevity of every age class in the United States has been consistently increased over the past 100 years.14 As average human longevity increases, the cost or level of the insurance premiums (on newly issued policies) for each age decreases.15 Hence, a policy that’s been in effect for a considerable period of time will be more costly than a new policy, all other things being equal. Another reason most policies prove to be inefficient is that the particular insured lives too long.16 Once the insured reaches an advanced age, the cost of the insurance increases significantly because the probability of dying each year increases with age. This makes it appear that the efficiency of the policy worsens over time.
Some policy illustrations indicate that there’s no or minimal cost for life insurance once the individual reaches an advanced age. But, the illustrations may be misunderstood. What’s probably happening is that the amount of real insurance is significantly less than the stated amount of death benefit. Rather, the amount that will be paid at death will consist in large measure of cash value, which is the investment component inside the policy, similar to a brokerage account. This frequently occurs with whole life policies, because they’re structured so the cash value will equal the death benefit at an advanced age (for example, age 100). The cash value is already owned by the policy owner and can be accessed at any time. Often, the amount of real insurance (that is, the amount the insurance company must pay, which is sometimes called the “net amount at risk”) will decline to nothing or almost nothing.
Buy Term Insurance Instead?
An alternative is to buy what’s called “term” or “pure” insurance. Most insurance (not just life insurance) is term insurance. Car insurance, household insurance, fire insurance and malpractice insurance are simply term policies. The insured pays a premium for the insurance coverage for a fixed period of time (typically one year). If the event that the insured doesn’t want to happen (such as a fire destroying the insured’s home) occurs, the insurance company pays for the loss out of the company’s own resources. If the event doesn’t occur, the insurance company keeps the premiums and the insured gets nothing (except, perhaps, the peace of mind of knowing that if the adverse event had occurred, the insurance company would have had to pay for the loss).
Life insurance works in a similar manner, although cash value policies couple declining term or pure insurance with an investment or cash value account.17 Almost always, if the policy is in effect when the insured dies, a term policy will have been much more efficient than a cash value policy. One reason is that with most cash value policies, each year the insurance company’s own risk declines, because cash value increases and replaces part of the term or pure insurance component under the policy—hence, there’s less term insurance each year, meaning the shift of potential resources from the insurance company to the insured (or the insured’s beneficiary) diminishes each year.
One limitation of term life policies, however, is that if the insured lives to an advanced age, the cost of the insurance becomes extremely high—so high, in fact, that, unless the death of the insured is imminent, the policy almost certainly will be cancelled. Also, very few companies offer term insurance above age 80—hence, the market is very restricted (and the cost or premium climbs very steeply at such ages).18 Although many term policies permit a conversion to a cash value policy when the term policy expires, the cost of such a converted cash value policy is very high and, again, unless death is imminent, probably will be cost-inefficient.19
Funding Estate Taxes
In essence, a life insurance policy is nothing other than a sinking fund: If the insured lives to her estimated normal life expectancy, it will return the premiums paid with about a 6 percent return compounded annually, unless the policy is cancelled before death, which, usually, is what occurs. Even if the policy is held until death, it likely will be insufficient to cover the estate tax if such a tax is in effect at death. That’s because the property owner’s wealth likely will increase over time. Inflation coupled with reasonable investment performance is likely to push the value of the property owner’s wealth to a significantly greater level, and that will mean the insurance covers only a portion, and often only a small portion, of the estate tax due.20
Role of Insurance
Does that mean that it’s unwise to consider acquiring life insurance as part of a well-balanced estate tax plan?21 No. But it does mean that a balanced plan must take into account several additional factors. Foremost, perhaps, is that the property owner should consider taking steps to stabilize or reduce the tax value of her estate. Several arrangements, including grantor retained annuity trusts (GRATs), installment sales to grantor trusts, qualified personal residence trusts, family partnerships and the use, year-in and year-out, of the gift tax annual exclusion, should be considered.22 Such steps, over time, will reduce the growth in wealth, if not the level of wealth. And the key benefit of such action is that the lower the value of wealth, the smaller the estate tax.
Many estate-planning arrangements won’t achieve their goals if death occurs early. For example, all or a portion of a GRAT will be included in the estate of the property owner if she dies while the trust is making annuity payments to her.23 Life insurance can be used to hedge against an early death: Although the GRAT likely may have failed to achieve its goal of removing property from the property owner’s gross estate, the insurance will provide, in effect, an economic windfall for the property owner’s family, providing liquidity to pay estate taxes on the property in the GRAT and, perhaps, much more.
Type of Policy
This leads to the question of what type of policy should be purchased to fund estate tax. Due to the ever increasing cost of term (or pure) life insurance, which is an essential component even of cash value policies, the possibility of estate tax repeal and the prospect of the insured living much longer than the insurance company forecasts (making any policy less efficient), clients should consider acquiring a policy that will not only return the premiums paid, even if the policy is cancelled well before death, but also provide a profit over time. Several life insurance carriers offer such policies.
Certain policies are structured so the cash value growth over time is as an important a component as the initial death benefit. This is accomplished by purchasing a lower initial death benefit (see Policy A in “Consider the Alternatives,” p. 30) than could otherwise be acquired for the same premium. The result of this lower initial death benefit is that it often provides a small profit (that is, cash surrender value above premiums paid) within the first five years and even higher returns over longer periods of time.24 Although the initial death benefit of such policies is often considerably lower than if the policy provided a maximum death benefit (see Policy B in “Consider the Alternatives,” this page), the cash value of these high death benefit policies erodes over time. And, as indicated, in many cases, policies are cancelled before death, meaning the amounts paid for the additional death benefit have been wasted.
To attempt to achieve higher (or adequate) cash value growth, some choose so-called “variable” policies, under which the policy owner may decide to invest the cash value component in the market (essentially, through a selection of mutual funds). However, whenever one chooses to invest in the market, there’s a risk of performance. That is, the returns may be lower than what’s needed to maintain the policy and lower than what the insurance company would credit to the cash value account in a non-variable policy. If the variable product doesn’t produce adequate growth, additional premiums will have to be paid to maintain the desired death benefit, the level of death benefit will have to be reduced or the policy will most likely be cancelled.
Hence, a high cash value policy should be considered.25 Nevertheless, in all events, additional estate tax planning should be implemented. In some cases, the lifetime estate-planning steps will be so successful that the need for life insurance to fund estate taxes will be minimized and, in some circumstances, eliminated.
“Consider the Alternatives” illustrates various types of cash value products and the ways they can be funded. The three polices are all traditional cash value universal life funded with a single $5 million premium. Policy B has the maximum initial death benefit that’s effectively maintained throughout the life of the insured. Policy A has a minimum initial death benefit at inception. By the time the insured reaches age 80, Policy A results in more death benefit than Policy B through any age thereafter. In addition, Policy A consistently has more cash surrender value than Policy B. Hence, there appears to be a mismatch with respect to Policy B: The death benefit is greater than Policy A when the insured is less likely to die and lower than Policy A when the insured is more likely to die. Policy C has a guaranteed death benefit (in which the death benefit is constant regardless of when the insured dies).
Under Policy C, there’s a high death benefit, which is maintained throughout the insured’s lifetime, but cash value is rapidly eroded and disappears shortly after the insured turns 80. That means there’s limited flexibility if it’s determined that the resources dedicated to acquire and maintain the policy would be better applied elsewhere (such as when a decision is made that the insured will live a very long time or the estate tax is repealed or other means have been or could be taken to reduce the size of the taxable estate). Also, Policy A (the low initial death benefit) not only will produce a higher death benefit by age 80 than Policy B (the maximum initial death benefit) as well as Policy C (the maximum initial guaranteed death benefit) by age 85, but also, it will have more cash surrender value in all instances.
Weighing the Options
Life insurance often is used as a tool to fund estate taxes that will be due when the property owner dies. Term insurance, initially, will be much less expensive than a cash value policy. However, term policies end typically when the insured turns 80 and, as a result, such policies provide no help in funding estate tax if the insured lives beyond that age. In addition, the cost of annual term premiums becomes very high as the insured reaches advantaged ages. Approximately 85 percent of term policies are cancelled before the insured dies.26
Cash value policies may last until the insured dies, no matter how old she may then be. Cash value policies are structured in many ways. The most efficient cash value policy, if there’s a significant chance that the insured will live to or beyond her actuarial life expectancy, is one that provides the minimum initial death benefit, but maximum cash value.27 Although the initial death benefit obviously will be lower with such a maximum cash value policy, it ultimately will provide a greater death benefit at older ages and almost always will provide greater cash value if the policy is cancelled before death. Regardless of what type of insurance is acquired to fund estate taxes, additional planning steps to retard or reduce the value of what will be included in the insured gross estate for federal estate tax purpose are an essential ingredient of any sensible estate tax plan.
1. See Internal Revenue Code Section 2056(a).
2. See IRC Section 2001(c).
3. Under IRC Section 2058, an estate tax deduction is allowed for state death tax imposed. Most states impose 16 percent as their highest death tax rate. Because the current highest federal estate tax rate is 35 percent, the effective state death tax rate is .65 x .16 or 10.4 percent. See www.actec.org/private/freeform/page.asp?PageID=165, prepared by attorney Charles Fox. Under current law, the federal estate tax rate will increase back to 55 percent, as it was before 2001. In addition, Section 2058 will be eliminated, and the credit for state death tax under Section 2011 will be restored.
4. See IRC Section 2001(c).
5. See The Tax Foundation, Election 2012: Presidential Candidate Tax Plan Comparison.
6. Hani Sarji, “Estate of Confusion: Estate Tax Bills In Front of 112th Congress,” http://blogs.forbes.com/hanisarji/estate-tax-bills/.
7. For example, assume an initial premium of $10,000 is paid for a policy with a $1 million death benefit. If the insured dies at the end of the year, the return on the premium is over 9500 percent, using a 5 percent discount rate.
8. Almost universally, insurance carriers charge different premiums for females.
9. Cf. Treasury Regulations Section 25.7520-3(b)(3), which doesn’t permit the use of standard mortality tables if “an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50 percent probability that the individual will die within 1 year.”
10. Calculation made from the 2008 Select and Ultimate VBT Tables for Male Non-Smokers.
11. Returns calculated for an insured age 60 paying the level premium until life expectancy. Returns vary with the age at issue and sex of the insured.
12. There are two reasons for that. The sooner the insured dies, the smaller the total premiums paid (keeping in mind that even if the premiums have been paid up, there will be term insurance charges against the cash value inside the policy). Also, the longer the time until the death benefit is paid, the lower the return on a present value basis. In other words, if the death benefit, for example, is $1 million and is paid five years after the policy is issued, the annualized return is much higher than if it’s paid 20 years after the policy is issued.
13. Timothy C. Pfeifer, F.S.A., Milliman USA (Feb. 19, 2004).
14. U.S. Vital Statistics 2007.
15. “[T]he actual cost of product has come down when it comes to life products, which is something that the industry has done a lousy job of advertising. A term policy is somewhere between 30 and 50 percent cheaper than it was 10 years ago. Cheaper!” See “American College Chief: Insurance Industry Must Fight for Relevance,” Insurancenewsnet.com, Larry Barton (President of the American College).
16. Another factor is that once a premium is paid and the insured doesn’t die before the next premium is due, the premium previously paid has been “wasted.” However, it’s generally impossible to forecast whether that will occur. Hence, it doesn’t appear to be a reasonable factor to consider in determining whether an existing policy is more efficient than a newly issued one.
17. Some cash value policies (commonly called “universal life” policies) permit the amount of the term insurance component to be maintained at a fixed level and even beyond age 80 (at which point most companies will not provide pure term insurance protection), but the annual cost of the term insurance will increase dramatically at older ages. ACLI Life Insurer’s Fact Book 2011, p. 64.
18. At www.thepg.com/term-quotes, only Protective Life and Transamerica sell term insurance for individuals over age 80, and there were no companies that sold term insurance when the insured reaches age 89.
19. One reason the premiums on such a converted policy are so high (on a relative basis) is the rule of adverse selection. Those whose health has diminished while the term insurance is owned are more likely to convert than those whose health hasn’t declined, as the latter can shop for less expensive (lower premium) policies.
20. For example, say a 50 year old, who’s already used her wealth transfer tax exemption, has $50 million in wealth, and her advisors estimate that the effective estate tax rate at her death will be 50 percent. She, therefore, acquires a $25 million death benefit policy and arranges for the proceeds, which will be used to fund the estimated $25 million of estate tax, to be excluded from her gross estate for federal estate tax purposes. However, she lives for 30 years, and her wealth grows at 7 percent a year compounded. At the time of her death, her wealth will have grown to $200 million. If the advisors were correct that the effective tax rate would be 50 percent, her estate would owe $100 million in estate tax, of which the $25 million of insurance proceeds will provide only one quarter of the amount needed to pay the estate tax. Of course, she could acquire additional life insurance as her wealth grows. However, as she ages, the insurance will be more costly, the ability to avoid gift tax to prevent having the proceeds themselves being subject to estate tax will become more difficult (and likely impossible as a practical matter) and her health may decline making the premiums on a new policy cost prohibitive.
21. There are many reasons to acquire life insurance other than to fund estate tax that may arise on death. The most common reason is to replace lost earnings when a breadwinner dies and her salary or wages are lost. Of course, that may also occur when the breadwinner retires. In fact, many insureds who have acquired policies to replace lost earnings at death cancel their life insurance policies soon after retirement. See CNN Money, “How Long a Term for Term Life Insurance?” http://money.cnn.com/magazines/
22. The Obama Administration has proposed several changes to the federal wealth transfer tax system that would reduce the wealth transfer tax efficiency of arrangements commonly used to reduce estate and similar taxes. See generally Jonathan G. Blattmachr, Michael L. Graham and Douglas J. Blattmachr, “A Look at the Obama Estate Tax Proposals: What They Mean for Planners and Clients,” Alaska Trust Company Newsletter (March 2012), www.alaskatrust.com/assets/files/newsletters/Newsletter-2012-03.pdf.
23. Treas. Regs. Section 20.2036-1(b).
24. That’s based upon current earnings crediting rates and current charges for the term insurance provided under the policy. Each policy provides a minimum earnings crediting rate (against which the insurance company charges expenses and cost of insurance charges (COI)) and a maximum COI charge.
25. Note that the IRC requires a minimum amount of death benefit for each dollar of premium paid based upon the age (or deemed age on account of health profile) and gender of the insured for the contract to constitute a life insurance policy under the IRC. The amount of death benefit necessary to constitute a life insurance policy decreases with age (or deemed age). See IRC Section 7702(a).
26. Letter dated Feb. 19, 2004 from Timothy C. Pfeifer, F.S.A., Milliman USA to Coventry First. It should be noted that often a new term policy is acquired when a currently owned term policy is cancelled or lapses.
27. As indicated above, for a contract to constitute a life insurance policy, it must provide for a minimum death benefit. See IRC Section 7702(a).