Estate Planning Strategies After American Taxpayer Relief Act: Why Insurance Still Makes Sense 

Thanks to the recently enacted American Taxpayer Relief Act, an estimated 99.8 percent of U.S. taxpayers are now shielded from the dreaded "death tax." What does this mean for estate planning?

When the American Tax Relief Act of 2012 (ATRA) was signed into law by President Obama on January 2, 2013, a vast majority of American taxpayers had reason to celebrate. Among ATRA’s more important changes, the new law made permanent the $5 million per individual (indexed for inflation) federal estate, gift and generation-skipping transfer (GST) tax exemptions. It also permanently extended spousal portability, allowing a surviving spouse to use the unused estate tax exemption of a deceased husband or wife to shelter lifetime gifts from gift tax or to pass additional assets free of estate taxes.

Because of ATRA, the vast majority of Americans no longer have to be concerned with federal transfer tax issues. But does the high threshold for the federal transfer tax signal an end to the need for estate planning?

Not at all.

The essential purpose of estate planning has never been just about taxes; it’s about safeguarding your estate for even more important personal and business goals, such as:

  • Planning for future needs, including incapacity or death.
  • Ensuring that your assets are distributed to the people you want, when you want.
  • Eliminating potential conflicts among your heirs over the distribution of your assets.
  • Providing sufficient liquidity to cover not just taxes, but also debts and other expenses at death without the need to force-sell assets.
  • Creating a legacy through planned giving to a favorite charity or other organization.
  • Avoiding probate, if desired, or using probate strategically.
  • Managing money for an heir who has special needs or is too young or financially unable to do so on his or her own.

For these and other reasons, estate planning should be a critical component of a comprehensive financial plan. And for many, permanent life insurance continues to be an important planning tool, both to help them accomplish their estate planning objectives and to add flexibility to address unforeseen situations.

Life insurance can provide secure funds for addressing objectives as simple as income replacement, tax and debt payment, education funding for younger heirs, and charitable legacy planning and as complex as equalizing inheritances and facilitating the transfer and preservation of a closely held business. For retirees concerned about rising health care costs and other expenses, permanent life insurance can also provide a “leave-on” asset that may provide financial security for children and grandchildren.

To understand how, consider the following hypothetical example.

John was 60 when he married Terri (then age 45) five years ago. A second marriage for both, John and Terri each have children and significant assets of their own. Let’s look at a few ways that life insurance can help them meet their estate planning objectives.

  • Balancing Priorities
    One of John’s chief concerns is making sure Terri is taken care of once he passes; another is providing an inheritance for his two children. One of his options is to purchase a life insurance policy on his life and have it payable to Terri or to a trust for her benefit. Doing so would enable him to then leave any assets beyond the policy to his children either outright or in trust for their benefit. This way, John could ensure that all of his loved ones are taken care of as intended.

  • Passing on a Family Business
    John owns and operates a highly successful business that he started 25 years ago. His daughter, Amy, has been working for John since she graduated from college eight years ago and is expected to take her father’s place as the owner of the business some day in the future. John’s son, however, has taken a different direction and is successfully employed at a large corporation in a different industry.

    While John has confidence that Amy is ready to take the reins at any time, he recognizes that if he were to die unexpectedly, his death would be financially challenging for the business. To prevent this, John purchases a life insurance policy on his life; the business owns it and is also the beneficiary. This would give the business cash to continue operations should John pass away unexpectedly and provide Amy breathing room while she makes the transition to business owner.

  • Making Things “Equal.”
    John’s intention is to pass his business to Amy upon his death. However, like many business owners, a significant portion of John’s net worth is tied up in his company. One way to ensure that his son, Brett, receives an inheritance of equal (or appropriate) value is through a life insurance policy owned either by John or a trust he creates. This would enable him to pass his entire ownership in the business to Amy without disinheriting his son.

  • Creating a Legacy
    John has four grandchildren. With adequate funds set aside for retirement, John wants to build a legacy not just for these youngest members of his family but also for generations to come. Here again, life insurance provides an attractive solution to help John achieve his objective while, at the same time, maximizing his federal gift tax and generation-skipping transfer tax exemptions. To do this, John creates and makes gifts to an irrevocable trust for the benefit of his grandkids and future descendants, allocating his generation-skipping transfer tax exemption to the gifts. This so-called “dynasty trust” is designed to avoid inclusion of the assets in the beneficiaries’ estates.1 The trust can then buy a life insurance policy on John’s life.

    Upon his death, the income tax-free insurance proceeds are used for the benefit of his grandchildren, great-grandchildren and future generations. What’s more, some of the death proceeds can be used to pay premiums on life insurance policies that insure later generations. The goal here is to create a cascading death benefit in a trust that provides funds for generation after generation, all the while avoiding any gift, estate and GST tax and, to the extent life insurance is purchased, any income tax. Terri decides to do the same for her three grandchildren through a separate trust.

  • Caring for a Loved One with Special Needs
    John’s youngest grandchild has special needs. While John wants to provide for Ben’s future care, he’s concerned that doing so may disqualify Ben from receiving government benefits in the future if he receives those assets outright upon John’s death. John decides to set up a “special-needs trust” for Ben, using life insurance to fund it. According to the laws of his state, this type of trust can be drafted to allow the trust assets to be used for Ben’s benefit without disqualifying him from receiving government benefits.

  • Creating a Legacy with Charitable Planning
    John and Terri are passionate about green causes and would like to use life insurance as a way to benefit an organization whose work is especially dear to them. If they use an existing policy, they can either donate it directly to the charity or transfer the cash to the charity to purchase a new policy. Both options would provide them with an income tax charitable deduction for the initial transfer and for any subsequent transfers of cash to pay the premiums, subject to certain adjusted gross income (AGI) limits.

What Type of Insurance to Use?

When it comes to serving estate planning needs, a permanent life insurance policy is often a sound choice versus other types of insurance. First, most estate planning needs are permanent and, therefore, better served with a permanent policy than with a term insurance policy. Second, most permanent life insurance accrues cash value, which can add flexibility and security to a wealth management plan. In addition, any cash value in the policy can also provide a valuable source of retirement income.

Using permanent life insurance in an estate plan offers another important benefit. In 2013, clients above certain income levels could be hit with higher income tax rates, reduced personal exemptions or itemized deductions, and a 3.8 percent net investment surtax. Permanent life insurance that grows tax-deferred can help to mitigate the impact of higher income tax rates.

Straight Up or in a Trust?

When including life insurance in an estate plan, you can either own the policy outright or through a trust—an irrevocable life insurance trust (ILIT). Often, the deciding factor in determining which is right for you is made by considering which is more important: maintaining control over and access to the policy’s cash value or keeping the death benefit out of your estate.

If your heirs are unlikely to face the estate tax at death, the answer may be simple. You can own your estate planning life insurance personally, enabling you to retain complete access to the policy’s cash value. If estate taxes are a concern, an ILIT may be a more attractive alternative because it enables your heirs to escape estate taxes on the life insurance death benefit. Where the insurance is owned by an ILIT, you’ll also want the trust to provide as much flexibility as possible. This will allow the trustee to use the cash value for the benefit of your trust beneficiaries during your lifetime, thereby creating flexibility to address future changes and opportunities. Keep in mind that there are other good reasons to consider holding life insurance in a trust. For starters, estate tax laws can change, and assets might appreciate and be subject to estate tax in the future. What’s more, using a trust might help you meet other non-tax objectives.

A Broader Approach to Wealth Management

In this post-ATRA environment, the focus of estate planning has been moving away from wealth transfer tax planning toward a renewed emphasis on helping individuals and families meet important long-term financial security goals. Rather than diminishing the usefulness of permanent life insurance, this shift has served to emphasize the uniquely flexible role insurance can play in helping to meet a wide variety of estate planning objectives.

1Naturally, a dynasty trust is more feasible if it is governed by the laws of a state that allows trusts to last for many generations.