January 1, 2004    Copyright © 2003, Greenwich Financial Management Inc.

 YOUR WEALTH

Demystifying Insurance, Part 2:

Use of Life Insurance as an Effective Tax Shelter

 

There are significant tax benefits related to life insurance.  Virtually every serious exercise in tax and estate planning considers life insurance as a component.  We will discuss here four potential tax benefits you can obtain through life insurance policies.  Each is considered uncontroversial and well-accepted by law.

 The first large tax break regards the “death benefit,” which is the money payable to the beneficiary of a life insurance policy in force when the insured person dies.  The death benefit, paid in a lump sum, is entirely exempt from income tax.  The benefit can be very helpful when there is estate tax to pay and assets are tied up in illiquid investments, especially where the family desires to hold onto those assets or sell them at the best time and price.  If the beneficiary decides to annuitize the death benefit, then the future interest portion but not the principal will be taxable.

 The second tax benefit is growth of the cash value of the policy without income tax (since a Tax Court decision in 1963).  The cash value is the equity in a whole life or universal life policy.  The growth of the cash value is untaxed, and no federal tax report goes out to the policyholder or the IRS, even though the investments made by or on behalf of the policyholder might otherwise lead to realization of ordinary income or capital gains.   This benefit does not apply, however, to term life, which does not develop cash value.  So-called “dividends” normally represent premiums paid earlier on a whole life policy; these are not subject to income tax either

A third advantage is that the policyholder may also borrow against the cash value of a life insurance policy, to the extent of any premiums paid to date, without tax effect.  [Limits: where borrowing exceeds premiums paid, or when the policy is deemed a “modified endowment contract” (MEC).  We usually structure tax shelter oriented policies to include periodic premiums equal to the maximum non-MEC amounts.]   Typically, interest paid is credited back to your policy’s cash value, so the borrowing is effectively free or of minimal cost.

A fourth benefit is exemption from estate tax on the estate of the insured, when the future proceeds to a beneficiary (or beneficiaries) are transferred to an irrevocable life insurance trust (ILIT).   A properly structured trust places the property outside probate and the estate tax system.  Exception: if you transfer property to an ILIT, but die within three years, the transfer may be subject to estate tax as made "in contemplation of death."  (Alternatively, your intended beneficiary could apply for and purchase insurance on your life, assuming that person has an "insurable interest.") Your trust and estates attorney may establish "Crummey powers" within the ILIT to allow your contributions to qualify for the $11,000 per person ($22,000 for a married couple) annual exclusion from gift tax.  However, the cash value of an existing policy transferred to an ILIT could still be subject to gift tax or reduce your lifetime exclusion.  Frequently, ILIT's provide a tax-efficient way to transmit wealth upon death to the next generation.

Background on estate taxes: For tax year 2003, under the federal Unified Estate and Gift Tax, up to $1MM is excluded from a person’s estate (minus amounts used up during that person’s lifetime, for example, by gifts); this excluded amount is scheduled to increase in future years up to $3,500,000 in 2009, and the maximum marginal estate tax will drop from the current 49% to 45%.  The estate (but not gift) tax is slated to cease in 2010, then returns back to a $1,000,000 exclusion and maximum 55% rate in 2011, under a crazy-quilt “sunset” provision that Congress enacted.   Unless you expect to die exactly in 2010, not planning for estate taxes could be costly.

                       

Andy Szabo, CFA, is Managing Director of Greenwich Financial Management Inc., a Registered Investment Advisor, which advises individuals and companies on investments, insurance and employee benefits.  Questions or comments welcome by phone (203-531-2877) or e-mail: Szabo@GreenwichFinancial.com.