Irrevocable Life Insurance Trusts – Fund Them Now

Take-Away: Now would be a good time to fund existing irrevocable life insurance trusts due to the possible change in tax laws beginning in 2021 and to respond to the impact caused by the current low interest rate environment.

Background: The need to increase federal revenues to address the growing federal deficit has been previously covered by me (some would as ad nauseam.) The same could be said with regard to the several missives over the past few months on the impact of the current low interest rate environment. These two themes, along with the increase in claims caused by the pandemic , all come together to prompt the need  to revisit irrevocable life insurance trusts (ILITs.)

Tax Law Changes: It is possible that the current federal gift and estate and generation skipping transfer tax exemptions may soon be cut back from the current $11.7 million per person to either a $5.0 million or even a $3.5 million gift tax exemption. That possible change in federal transfer tax exemptions has prompted thousands to consider making a large gift before the end of 2020 to utilize their large federal transfer tax exemptions while they still exist, following the use it or lose it approach to tax planning.

Interest Rate Changes: Market interest rates are at historically low levels. Those low interest rates have had a significant impact on life insurance companies, impacting their bottom lines. The IRS 7520 rate is at 0.40%. Life insurance companies heavily invest in bonds and other liquid investments to meet liquidity needs and to protect their reserve obligations. The low interest rate environment has seriously impacted the performance of interest-sensitive life insurance policies like universal life and whole life, causing those policies to be underfunded; the low interest rates will probably cause these policies to have a decrease in credit rates for the universal policies and lower dividends for whole life policies. This is unlikely to change for the next few years in light of recent public comments from the Federal Reserve. Many life insurance policies are already underfunded and the recent drop in interest rates only exacerbates the underfunding problem.

Mortality Changes: Add to the weakened financial situation of many life insurance companies is the increase in mortality claims paid by life insurance companies due to the COVID-19 pandemic, and there something close to a ‘perfect storm’ for many life insurance companies.

Example: Mike, age 67, purchased a $5.0 million universal life policy 20 years ago. The current annual premium for Mike’s life insurance policy is $50,000. An updated in-force policy illustration shows that based on the current interest and mortality rates, Mike’s universal life insurance policy will lapse at age 79. The death benefit that is part of Mike’s estate plan may not even exist at the time of his death.

Fixing the Problem: One way to ‘fix’ the underfunded life insurance policy is to make additional policy premiums, or if the policy is held in an ILIT, make a large lifetime gift to the ILIT to ‘prefund’ the policy premiums to thus prevent its lapse. Other alternatives to an under-performing life insurance policy is either to lower the policy’s death benefit or consider replacing the life insurance policy with a new insurance policy if better pricing is available, assuming the insured is still insurable.

Example: Cory created an ILIT several years ago. The ILIT trustee took out a $5.0 million life insurance policy on Cory’s life. The ILIT trustee pays an annual premium of $100,000. The policy is now under-performing due to the low dividends that are applied to reduce the annual premium obligation. Cory could use his currently available federal gift and GST tax exemptions and prepay future premium payments with a one-time $2.0 million gift to the ILIT. If Cory dies two years later, the beneficiaries of the ILIT that he created will receive the $5.0 million death benefit, income tax (and estate and GST tax) free. As an alternative, assume that the trustee of the ILIT did not prepay the future premium obligations with Cory’s $2.0 million gift. Instead, the ILIT trustee used the gifted funds to only pay the annual premium of $100,000. If Cory dies in the second year after his large lump sum gift to the ILIT, the ILIT beneficiaries will receive not only the $5.0 million death benefit paid on Cory’s death, those beneficiaries will also receive the remainder of the $2.0 million gift made by Cory to the ILIT (less the two annual premiums the trustee paid), or the remaining $1.8 million.  $6.8 million gift and income tax-free will be available to the ILIT’s beneficiaries.

Funding the ILIT: Other techniques besides a direct gift can also be used to either ‘prefund’ an ILIT’s premium obligation that holds an under-performing life insurance policy, or used to exploit the low interest rate environment.

• GRATs: The settlor of the ILIT could fund a short-term grantor retained annuity trust (GRAT) which names the ILIT as its remainder beneficiary. The GRAT could be funded in 2021 using the settlor’s large available federal gift tax exemption and the very low IRC 7520 interest rate. When the GRAT’s annuity payment period comes to an end, the residual assets held in the GRAT then pass to the ILIT gift tax-free, if the GRAT’s investments exceeded the current 0.40% IRC 7520 rate that was used to value the settlor’s retained annuity interest in the GRAT.
• Loans: If the ILIT’s settlor is either uncomfortable making a large lifetime gift, or he/she has already used all of their lifetime federal gift tax exemption, an alternative is for the settlor to loan cash to the ILIT trustee, called a private split-dollar loan. The required interest rate for a long-term loan, to avoid an implied gift to the ILIT, is about 1.17%. The ILIT trustee then pays annual interest to the settlor using the 1.12% interest rate. If the ILIT trustee can earn more than the 1.17% annual interest rate charged on the loan (this month’s long term rate), the excess earnings can be invested to ‘prepay’ some of the life insurance premiums and/or used to repay the settlor’s loan in future years.
• Premium Financing: A variation on the loan theme is that the ILIT trustee borrows funds from a bank each year. The ILIT trustee uses the loan to purchase additional life insurance on the insured. The insured makes gifts to the ILIT to pay the annual interest obligation on the bank loan. A whole life policy that accumulates substantial cash value can provide some or all of the funds required to repay the settlor-insured in future years.

Conclusion: All life insurance policies, either owned outright or held in an ILIT, need to be re-evaluated in light of this challenging economic environment. The policy owner needs to obtain an in-force policy illustration to confirm if the existing life insurance policy is adequately funded. If the policy is determined to be under-funded, then steps will need to be taken to stabilize the policy so that it does not lapse. The preserving the life insurance death benefit becomes even more important if the federal estate and GST transfer tax exemptions significantly drop in the next couple of years, and the insurance policy’s death benefit will be required to meet that liquidity demand on the insured’s estate. Frankly, this does not lend itself to a wait-and-see approach to planning.