Take-Away: Despite all the talk about the elimination of the federal estate tax, now is not the time for clients to terminate existing life insurance policies that they may have initially purchased for liquidity purposes to pay federal estate taxes. Several more benefits are associated with life insurance than just furnishing instant liquidity to pay federal estate taxes. Moreover, nothing is really permanent when it comes to death, taxes, and Congress.

Context: Many clients  unfortunately tread water with changes to their estate plans in anticipation of the repeal of the federal estate tax. Some clients are even going so far as to terminate existing life insurance policies  based on their assumption that there is no longer a need for the liquidity provided by life insurance. The assumption that life insurance is no longer needed is probably a big mistake, while it overlooks other uses that some  life insurance policies can provide.

Background: Why life insurance is a critical part of any estate plan is the fundamental principle to shift risk. The insured-owner allocates a portion of his/her current liquidity to the life insurance company in the form of premiums paid. At life expectancy, that trade of current liquidity for future liquidity can often produce a return on premiums paid in the 5% to 10% range. In addition, life insurance as an asset class often performs differently from the client’s other investment assets, which non-correlation contributes to a more stable investment portfolio. Additionally the death of the insured usually has an impact that extends far beyond income replacement and estate tax liquidity considerations, e.g. strategic business direction, business governance, key-man replacement, and internal disputes on the death of the insured. These all create challenges that can be addressed, in part, through the sudden and dramatic increase in liquidity that results from the life insurance policy’s death benefit.

Flexibility: One of the unique features of life insurance is that one policy can meet multiple different needs, needs that can and do change over the course of time for the insured or the insured’s family.  One life insurance policy can be used for some or all of the following purposes:

  • To supplement the insured’s retirement income needs;
  • To meet family needs as an income replacement tool;
  • To recruit, retain, and reward business executives;
  • To fund business continuation and transition when the owner-insured dies;
  • To pay estate tax liabilities or debts that become due on the insured’s death, or capital gains taxes on death if that tax replaces the federal estate tax; and
  • To fulfill charitable goals.

Thus, unlike some assets, life insurance can serve one, several, or most of these needs, all with one policy, and usually in a tax-advantaged manner. That is why it is dangerous for an insured to assume that with the possible repeal of the federal estate tax, or the reduction of possible income tax rates, that the insured can confidently surrender existing life insurance policies or put a hold on new life insurance policy purchases.

Tax Benefits: Life insurance enjoys several unique tax attributes which include:

  • Tax deferral on the internal policy growth in a cash surrender type of policy [whole life, universal life, variable life products all carry some investment component that can grow tax deferred;]
  • If held until the insured’s death, the life insurance policy’s death benefit will normally be income tax free [IRC 101 (a);]
  • It is possible to withdraw a portion or all of the policy’s growth in cash surrender value without income taxation, as withdrawals are first treated as a return-of-premiums, which means that if lifetime liquidity is needed,  appreciated assets may not have to be sold to create that liquidity, sales that could possibly expose the policy owner to capital gains tax recognition; and
  • If the growth in the policy cash surrender value exceeds the premiums paid on the policy, the policy owner may still be able to access that excess growth in a tax advantaged manner by taking policy loans.

If the owner of the policy finds him/herself with an immediate need for cash influx, the life insurance policy cash surrender value enables the owner to meet that need without having to liquidate assets and avoid a possible loss. If premium payments later become a burden to the policy owner the owner can elect to use the policy cash surrender values to ‘pay up’ the policy, and thus avoid future premium payments [which results usually in a lower death benefit paid.] Lots of options exist with a cash surrender value life insurance policy which are often overlooked with a focus solely on the continuing obligation to pay policy premiums or the sole need for liquidity to pay federal estate taxes.

Impact of Delay or Termination:

The decision to terminate an existing life insurance a policy or to delay with the acquisition of a life insurance policy needs to be made on the basis of the insured owner’s long-term planning horizon, on the applicant’s health and finances, and the long term purpose of the policy. Any decision with regard to life insurance should not be based upon what might happen in the current political environment or with the promised tax regime over the short-term. Two considerations need to be remembered. First, for most clients, health declines over time, which makes the cost to acquire any life insurance either higher, or impossible to obtain,  if the applicant is later determined to be uninsured. Second, the acquisition costs [compared to the ultimate death benefit purchased] are negatively impacted by premiums that increase with age; if a life insurance policy was purchased years ago, there is considerably more leverage from the lower premiums paid compared to the actual death benefit that is to be paid under the policy.

Conclusion:  Admittedly some clients do not need life insurance as they possess considerable liquid wealth to address many of the needs identified earlier. But if the expense of the policy has already been incurred, and the insurability of the insured has been established and is accurately  reflected in the policy’s underwriting and size of the premium, before the decision to terminate the life insurance policy is made, additional consideration needs to be given to the other possible uses for the life insurance policy, beyond just its use to pay federal estate taxes which might end with the promised repeal of the federal estate tax.

Insureds need to be reminded that Congress has previously permanently repealed the federal estate tax four times in the country’s history. What makes them think that this time, it’s different?