Now that the American Taxpayer Relief Act of 2012 (ATRA) has been enacted and the 3.8 percent Medicare tax on net investment income is in effect, individuals are able to tell on which side of the great financial divide they stand. Some will continue to enjoy lower tax rates on their earned and unearned income and never be exposed to the Medicare tax. Others will find that the amounts and characters of their income and deductions will put them on the other side of that line, with projected tax bills significantly higher in and after 2013 than what they paid in 2012. Still others will find themselves in a bit of a netherworld, where they will continue to benefit from lower rates on their earned and unearned income, but have some exposure to the Medicare tax.
Similarly, with the estate, gift and generation-skipping transfer (GST) tax exemptions made permanent at $5 million ($5.25 million for 2013) and indexed for inflation, many individuals will simply eliminate estate and gift tax planning from their agendas. That’s because they don’t have taxable estates, will not have taxable estates or have become comfortable with the notion that children who will inherit upwards of $5.25 million (per parent) estate tax-free and only pay 40 percent on the excess should count themselves among the very fortunate … and leave it at that. Other individuals will build the now permanent and indexed “tax-free” threshold into their plans and resume their wealth transfer and liquidity planning accordingly.
Regardless of where an individual stands on the income and estate tax spectrum, ATRA and/or the Medicare tax should foster some thinking about how this new rubric of rules can be availed of or parried, as the case may be. Some of that thinking should be devoted to an individual’s life insurance program because, as we will explore:
• The new income tax rules will cause some individuals who are carrying (or considering) life insurance for pure protection to need less coverage for less time or require them to carry (or consider) more coverage for longer.
• A high-income individual who decides that he can forego funding a policy for estate tax liquidity might be able to redeploy the policy as a tax-advantaged investment.
• The combination of the new income tax rules and estate tax exemptions may enable an estate tax-sensitive individual to use a less permanent form of insurance or product design than he might have entertained if the Bush tax cuts had expired entirely. On the other hand, application of these new rules may just be permanent confirmation of the need to maintain the current insurance program and perhaps even build on it.
Effect on Needs Analysis
A life insurance needs analysis is one of the fundamental components of a personal financial plan. Basically, this analysis compares the needs that an individual’s surviving spouse and/or other dependents will have for capital, with the existing sources of that capital. Any deficit, meaning any shortfall in needed capital, can then be covered by life insurance. But, “basically” isn’t good enough because the individual should be able to project how the needs and sources will change over time, for example while the children are young and then after they’re no longer dependents. The more sophisticated the analysis, the more an individual can then tailor his insurance program to provide the right amount of coverage for the right duration at the right price.
Among the most fundamental variables in the analysis are the tax rates on the survivor’s ordinary income and capital gains, respectively. Some analyses prior to this year assumed a sunset of the Bush tax cuts and imposition of the Medicare tax. Some didn’t. Now, depending on the amount and character of the survivor’s income, the analysis should be re-run. It may well be that the combined effects of ATRA and the Medicare tax reduce the tax burden on the survivor’s income and, correspondingly, call for less capital, that is, life insurance. On the other hand, if the earlier analysis looked at the glass as half-full, then the survivor’s after-tax income will be impaired and the need for life insurance increased.
It’s also axiomatic that the new tax rules will have an impact on the individual’s choice of life insurance product to fill the prescription for survivor income. For example, an individual who just recalculated his survivor income needs under the new tax rules might conclude that a 15- to 20-year term policy is all he needs to bridge the gap between now and when his asset base, pension and so forth will support his survivor. In the same way that the new tax rules could materially affect the calculations for the survivor’s income, they could have a similar impact on the “inflection point” for the sufficiency of his assets to provide for a survivor.
Assume that an individual owns a cash value policy that he bought some years ago for survivor income or estate liquidity. Assume further those original purposes for the insurance have now given way to a concern about accumulating assets for retirement. What’s more, that concern is heightened, as he now finds himself in the 39.6 percent bracket with full exposure to the 3.8 percent Medicare tax on his investment income.
Depending on the type of policy and how it’s constructed, the individual could be pleased to find that he owns an asset that’s far more valuable than he realized. The cash value grows tax-deferred and can be accessed on a tax-free basis through withdrawals up to basis and loans (assuming it’s not a modified endowment contract (MEC)). Also, any residual death benefit will pass to the individual’s beneficiary income tax-free. To the extent that policy design allows, the individual’s agent can illustrate a retrofit of the policy from a death benefit-oriented vehicle to a cash value accumulator. The retrofit might include reducing the death benefit to the extent allowed by the carrier and by the tax law (to preserve the income tax character of the policy as life insurance), in the context of the individual’s new “defined contribution” for the number of years that the individual wishes to make that contribution. Then, the agent can illustrate the maximum tax-free cash flow that the policy can generate for a given number of years without requiring more premium to support the death benefit beyond the individual’s life expectancy. Note that the individual might be inclined (or told) to replace the existing policy; however, the first step should always be to see what can be done with it. An individual who has similar asset accumulation objectives and similar tax posture, but doesn’t own a policy, can explore a new purchase with a policy design drawn along the lines described above.
Incidentally, when the new income tax rules are taken in context with the higher estate tax exemption, an individual who already owns a well-structured cash value policy and was considering or being advised to transfer the policy to an irrevocable life insurance trust (ILIT) for estate-planning purposes, might now find that such a transfer is contra-indicated. That policy was already a valuable tax-advantaged investment asset and became even more so after 2012.
Many individuals purchase life insurance to provide their estates with liquidity to pay taxes and expenses. The liquidity need is frequently (and properly) coordinated with any non-tax needs, such as capital for the individual’s survivors. As with the simpler traditional needs analysis, the amount of life insurance purchased (or considered) might have assumed a complete sunset of the Bush tax cuts or, perhaps, a $3.5 million exemption and a 45 percent rate, which is where the thresholds were in 2009. Now, however, the baseline is a $5.25 million exemption, indexed for inflation, and a 40 percent top rate. It’s tempting to commence liquidity planning at this juncture. It would also be wrong.
Although ATRA was an undeniable positive for wealth distribution, the same can’t be said for its effect on wealth accumulation and preservation. Considering the combined effect on an individual’s finances (let alone his psyche) of ATRA, the 3.8 percent Medicare tax on net investment income and the Obama administration’s interest in more revenue, many high-net-worth individuals could have a lot more to cope with and a lot less to spend this year than last.
The point is that wealth transfer planners and life insurance salespeople are going to have their marketing work cut out for them. It’s fair to say that the only individuals who will be openly receptive to wealth transfer planning or large life insurance purchases are those who are both empirically and viscerally comfortable that they will never outlive their money. In other words, the reports/projections from their money managers will need to be every bit as optimistic as the reports/projections from their physicians, and then some. But many individuals, who have and are projected to maintain taxable estates, may not have that assurance. These are the individuals who should consider running projections depicting their cash flow and financial asset base well beyond life expectancy under conservative assumptions. To the extent that these projections offer the assurance that these individuals can eat and sleep well for the rest of their lives and still leave something for their children, they’re candidates for wealth transfer planning.
Estate Liquidity Cost Curve
A key to well-informed decisions about managing or acquiring life insurance after ATRA might be for individuals to map out their estate liquidity needs (including the need for capital for non-tax purposes) at each spouse’s death. The mapping should incorporate the new, permanent exemption and index it at an assumed inflation rate for the projected years until the death of the individual. The analysis should also incorporate the individual’s assumptions for after-tax growth in asset values, consumption and, importantly, the benefits of whatever additional estate tax reduction planning the individual will do, especially with the ever- increasing gift tax exemption. At the end of the day, the estate may be so large and the liquidity need so great, that the individual will still need every bit of coverage he has (and then some). On the other hand, it may well be that, at least for the foreseeable future, the liquidity cost curve fades away appreciably over time, maybe thanks to the indexed exemption or maybe because there was more consumption than appreciation.
In the closer cases, meaning those in which the liquidity need isn’t beyond question, an individual who already has insurance in place should determine whether his current insurance program cost-efficiently tracks the new curve or is a blunt 55 percent of his original need, maybe even increased by inflation. If the coverage is off track, then the individual can take steps to get it or its cost structure back on.1 In the case of an individual who’s considering buying life insurance for estate liquidity, it may be that the new paradigm suggests that, rather than the heavily funded permanent policy he was originally considering, a 15- to 20-year level premium term policy may provide all the liquidity he needs for the time he needs it. Of course, the individual might be concerned that the 15 to 20 years could go by faster than his liquidity need will abate. In that case, either the conversion feature of the term policy could act as a safety valve, or he could consider using a flexible premium permanent policy that would enable him to manage the premium and avoid the risks sometimes associated with term conversions.
Finally, if the mapping suggests that the liquidity (and non-tax) needs recede over time, but never phase out altogether, he can layer the coverage in a cost-effective manner, artfully combining some term insurance with some permanent product. The point is that the individual should “stress test” the analysis and see what the insurance marketplace can offer in response.
Now’s a good time to come to the aid of your ILIT.
Many individuals established ILITs to keep the proceeds of large life insurance policies out of their taxable estates. These individuals have been funding the policies with gifts to the trusts that either qualify for the gift tax annual exclusion or, if the premiums are large enough, consume the individuals’ lifetime gift tax exemptions.
For the past few years, many of these individuals have been hearing that the policies need considerably higher premiums to support their death benefits or that the same premium will have to be paid for many more years than was originally projected. In a nutshell, interest rates have fallen so far for so long that the policies simply need more sustenance—read “premiums”—to remain viable for an acceptable period of time or otherwise meet some specific needs with an acceptable outlay. The call for higher or longer premiums will mean different things to different individuals, but in those cases in which individuals have been hesitant to add more funding to their ILITs because of gift and/or GST tax implications, the higher exemptions (along with indexing) can certainly be put to good use.
For example, an individual might transfer a discountable income-producing asset to his ILIT so that the ILIT will have some cash to contribute to the premiums. This transfer can save the individual a lot of gift tax down the road because every dollar of premium that the ILIT can pay with its own money is a dollar of taxable gift that the individual doesn’t have to make. If the ILIT is a grantor trust for income tax purposes, so much the better, as the grantor will pay the taxes on the ILIT’s income, reducing his estate, but not being treated as a gift.
Speaking of ILITs, a potential upshot of the financial and estate-planning reassessments that many individuals will make this year might be that they no longer want their policies in ILITs or are no longer comfortable with the terms of their ILITs in this new tax and financial environment. These concerns will require some careful attention, as removing policies from ILITs or moving them among ILITs can have myriad tax and fiduciary implications.
The issues we’ve just framed can be particularly acute for any individuals who are funding the premiums by way of split-dollar life insurance plans that are either employment-based, running between the individuals’ companies and their ILITs, or private arrangements, running between the individuals themselves and their ILITs. In either type of design, an arrangement established before Sept. 17, 2003 will have annual income tax and/or gift and GST tax implications for the individual/insured. In an employment-based plan, the individual/insured has an imputed economic benefit because of the insurance protection he receives. The measure of the economic benefit is typically the insurance company’s one-year term rate, if lower than the table rate, which increases each year as the insured gets older. The insured’s imputed income from the plan is reduced by any premium contribution he makes to the policy. Because an ILIT owns the policy in this type of plan, the annual economic benefit is a gift by the insured to the ILIT. In a contributory plan, which most are, the insured usually makes gifts of the economic benefit to the ILIT, which contributes that amount to the plan. The economic benefit attributable to the coverage is imputed (or must be contributed) each year as long as the plan is in force—even if the company is no longer advancing premiums to the insurer.
In a private type of design, the individual stands in the shoes of the company, advancing premiums to the insurance company. An economic benefit is bestowed on the ILIT each year by virtue of the arrangement, and it’s measured in a similar fashion to the employment-based plan. However, there are no income tax implications to the private design; the excess of the annual economic benefit over the ILIT’s contribution to the policy is a gift from the individual to the ILIT. Here again, absent other funding, the ILIT typically gets the cash for that contribution by way of gifts from the individual/insured.
Because split-dollar plans involve those annual, increasing income and/or gift tax implications, the arrangements are usually designed to last for a certain number of years and then roll out during the insured’s lifetime, meaning the ILIT would use the cash value to repay the company or the individual. The earlier the plan can be rolled out, the better; otherwise, the annual income and/or gift tax implications can become very problematic. But, thanks to those lower interest rates, many split-dollar roll outs that were predicated on having enough cash value in a policy by a given year are now given little chance to roll out before they roll out the insured, as it were. One way to accelerate the roll out is to transfer money to the ILIT to augment any cash values that can be used to repay the company. But the transfer of that cash is a taxable gift and, in some cases, a GST tax transfer. So, the plans have rolled along with any resolution marked ahead, liberally.
Note that even in split-dollar plans established after Sept. 17, 2003, the basic concept still applies, that is, the longer the arrangement runs, the more costly it becomes over time. Therefore, even today’s split-dollar plans should have an exit strategy other than the death of the insured.
Fortunately, the $5.25 million gift and GST tax exemptions available in 2013 offer individuals a unique opportunity to fund their ILITs with cash or income-producing property without gift or GST tax implications. The accelerated funding can go a long way to providing the ILITs with the cash they need to support the policies for the targeted duration. In split-dollar cases, the accelerated funding can give the ILIT the cash flow to contribute its share of the premium under the split-dollar arrangements (or pay interest on the split-dollar loans), contribute to the roll out or both.
Leaving the topic of existing plans aside, the higher gift and GST tax exemptions could allow individuals to generously fund their ILITs upfront and, therefore, leave any proposed plans for complex, “multi-factor dependent” transactions on the cutting room floor. If individuals’ ILITs can purchase the policies with cash and not split-dollar or premium financing, the ILITs can keep things simple, purchase less expensive policies and not be at the mercy of the vicissitudes of interest rates or resetting loan terms. That said, an artful combination of split-dollar or premium financing could allow the increased exemptions to be used to transfer those discounted assets to the ILITs—arguably, a better use of those exemptions.
We’re hearing a lot about funding ILITs for capital transfer these days; far more than we’d hear if the picture for traditional liquidity sales were brighter. Still, many high-net-worth individuals are being told to consider applying their gift and GST tax exemptions to funding an ILIT, so it can purchase life insurance as a trust investment. The story line is that the internal rate of return on the death benefit may be as good or better on a risk and attitude-adjusted basis as anything else they would use for this purpose.
This approach may be appropriate for some people, but caveats apply. Survivorship insurance, often no-lapse universal life, is often shown as the product of choice in this setting. That product absolutely has its place and, in certain cases, can be the only show in town. But when it’s shown to two relatively young people, meaning those whose joint life expectancy is 35 to 40 years, we suggest that they consider that if one of them were to die tomorrow, the other would likely survive for several decades with no investable payout from the policy for all those years. It might well be that single life coverage, which by definition could pay a death benefit tomorrow, is the better choice. What’s more, it might be helpful and enlightening to ask the person more actuarially likely to be the surviving spouse whether he’s truly committed to supporting those premiums with his own money after the first spouse dies. Anecdotal evidence suggests that the answer will be “No.” There will be an unabridged answer available for the asking as well.
Another aspect of this use of insurance is product selection, design and funding. We so often hear that there’s no reason to develop cash value in the policy because it’s in a trust, no reason to care if it’s a MEC or whatever. That may be true, but consider that if you have grantors/insureds in their early 50s, they might want to have a lot of cash value in the policy, so the trust can take tax-free withdrawals or loans in 15 to 20 years to make distributions to the children or grandchildren.
This Time It’s Different
Like any other major tax act, ATRA creates new opportunities for both life insurance professionals and estate planners, and we will undoubtedly hear all about these opportunities in the coming months. But this time around, the greatest opportunity could be how ATRA gives those who own or fund policies the flexibility to refashion their life insurance programs for utmost cost efficiency and responsiveness to their needs and circumstances.
—The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or Bryan Cave LLP.
1. Charles L. Ratner, “Insurance Policy Management,” Trusts & Estates (April 2011) at p. 42.