New Tax Law Bodes Well for Life Insurance Sales

Urgency in estate transfer and liquidity planning is not just for the ultrawealthy

By Richard L. Harris

Key Takeaways:

  • The estate, gift and generation-skipping transfer (GST) tax rates have increased to 40 percent from 35 percent.
  • When both estate and gift taxes are combined with the GST tax, the combined rates have increased to 64 percent from 57.75 percent.
  • For certain taxpayers the rate on ordinary income goes to 39.6 percent from 35 percent. Capital gain and dividend tax rates go to 20 percent from 15 percent.
  • For certain taxpayers, the Medicare tax applies to investment income. The Medicare tax rate is 3.8 percent.
Transfer taxes (estate, gift, generation-skipping and inheritance)

The new tax law has created new opportunities for life insurance sales. For the very affluent, the 5 percent estate tax increase (to 40 percent from 35 percent) creates more urgency in estate transfer and liquidity planning. With the same increase in the GST tax, the combined rate of 64 percent presents problems for the very affluent who want to pass assets down to more than one generation.

Both of these tax increases are exacerbated in the 21 states that have decoupled from the old pick-up tax regime and that have their own inheritance and/or estate taxes. For all but three of those states (Delaware, Hawaii and North Carolina) the exemption amount is below $5.25 million for 2013. The lowest starting tax rate is 1 percent, and the highest final rate ranges from 7 percent to 20 percent. Taking into account the federal deduction for state inheritance and/or estate taxes paid, the combined rate in those states can be from 44.2 percent to 52 percent.

Not just for the ultrawealthy

For the “mass” affluent, even though there may not be a federal estate tax because of the size of their estates, the state tax can still be meaningful. If a spouse uses portability and leaves everything to the survivor, it is possible for a $10 million estate to have no federal tax but over $1 million in state taxes. In New Jersey, a $5.25 million estate will have a tax of over $400,000.

How life insurance can help

Life insurance is just the tool to ameliorate the effects of state taxes and increases in federal taxes. Especially when held in a properly structured irrevocable life insurance trust (ILIT), the proceeds on death are not subject to either the federal and state estate or GST taxes. Life insurance has another virtue over other estate planning techniques—simplicity. A life insurance transaction is straightforward and easy to understand. The underlying legal basis is well-settled. The only rub for clients is the need to pay premiums. And there are number of ways to finesse that issue.

Below is an outline of what the new tax landscape looks like for your affluent clients.

Income, Medicare and hospital insurance taxes
  • For married couples with adjusted gross income (AGI) above $450,000 ($400,000 single)
  • Income tax rate increases 4.6 percent to 39.6 from 35 percent.
  • Capital gains and dividend tax rates increase 5 percent to 20 percent from 15 percent.
  • For married couples with incomes above $250,000 ($200,000 single)
  • Medicare tax on net investment income (i.e., dividends, interest, rents, capital gains, passive income) is 3.8 percent.
  • Hospital insurance (HI) tax on earned income is 0.9 percent.
  • For married couples with AGI in excess of $300,000 ($250,000 single)
  • Phase-out of personal and dependent exemption ($3,900 each) of 2 percent for each excess amount of $2,500 (total phase-out when income above the threshold is $125,000).
  • Limitation on itemized deductions to lesser of 3 percent of AGI in excess of $300,000 or 80 percent of itemized deductions (e.g., AGI of $1 million is $700,000 in excess of $300,000—3 percent limitation on $700,000 is $21,000).
  • For non-grantor trusts with AGI over $11,900
  • Income tax rate increases 4.6 percent to 39.6 percent from 35 percent.
  • Capital gains and dividend tax rates increase 5 percent to 20 percent from 15 percent.
  • Medicare tax is 3.8 percent.
  • State income tax deductibility affected by limitation on itemized deductions

The combined effect of all the above (not including phase-out of exemptions and limitation on itemized deductions):

  • For married couples with AGI above $450,000 and non-grantor trusts with AGI over $11,900
  • Combined rate on ordinary income increases 8.4 percent (4.6 percent increase in tax rate plus 3.8 percent Medicare tax).
  • Combined rate on capital gains and dividends increases 8.8 percent (5 percent increase in capital gains tax plus 3.8 percent Medicare tax).
  • Earned income above $300,000 also is subject to 0.9 percent HI tax.

Here’s how life insurance can help

Life insurance special features
  • Life insurance has special tax treatment.
  • Unless improperly transferred, the death benefit is not subject to income tax.
  • Unless the policy is a modified endowment contract (MEC), if the policy is not surrendered or more than basis is withdrawn, the excess of cash value above basis is not subject to income tax.
  • One can avoid tax when taking money out if withdrawals are made up to basis and then loans are taken out for excess above basis.
  • If insured dies with policy in force, any cash value above basis not withdrawn is not subject to income tax, even if the policy is an MEC.
  • Life insurance supplies leverage.
  • Annual premiums paid are a fraction of the death benefit.
  • Death benefit is paid in full regardless of how many or how few premiums have been paid.
  • If life insurance is owned by an ILIT, it can be kept out of the transfer tax system.
  • Only what is paid into the ILIT is subject to gift and GST taxes.
  • There are special rules allowing greater leverage.
Life insurance and income tax planning
  • Using life insurance as a savings vehicle
  • The long-term returns on a properly structured traditional cash value life insurance policy are attractive.
  • Life insurance companies by law are required to keep substantial reserves. The reserves are low risk. The average life insurance company has more than 50 percent of its assets in high-quality bonds.
  • With the additional income and Medicare taxes, because of the tax advantages of life insurance and the risk-averse nature of the insurance companies’ investments, the return is even more attractive.
  • Private placement products
  • Private placement life insurance (PPLI) and private placement variable annuities (PPVA) are special products for use by very affluent people, trusts and family offices.
  • The investment options in these policies are not those available to the general public and include hedge funds and specially managed accounts.
  • They have the same tax benefits as other insurance or annuity products.
  • Because of the higher taxes as a result of the American Taxpayer Relief Act (ATRA), they look more attractive than they have in the past.
  • Employee benefits
  • With the new tax rates, the advantage of an S corporation is diminished.
  • Coupled with the threshold levels for the additional taxes, C corporations have increased attraction, especially by funding benefits for owner-employees.
  • Through regulations in the Internal Revenue Code, money to be used to pay for life insurance can be loaned by the company at low interest rates.
  • Using life insurance death benefit as an alternative investment
  • The net after-tax returns on the death benefit of life insurance have been enhanced by the higher tax rates on other investments.
  • The death benefit is paid when the insured dies.
  • There is no correlation between the death benefits of life insurance and any other asset class.
  • Regardless of the performance of any other investment, the life insurance death benefit is at full value.
  • Using life insurance to provide freedom to the insured
  • For those concerned about leaving something to their children and being able to spend and invest whatever and whenever they want during their lifetime, life insurance offers certainty for the former.
  • As long as premiums are paid, the inheritance is ensured.
  • Apart from the cost of the premiums, clients are free to do whatever they want with their assets, including spending them down or making risky investments.

The new tax law has created both challenges and opportunities for savvy advisors who understand how life insurance can provide affluent clients with piece of mind, responsible estate planning and significant protection of their hard-earned wealth.

About the Author

Richard L. Harris specializes in life insurance sales and consulting for high-net-worth individuals and their advisors. For more than four decades, he has been a trusted expert for accountants, attorneys and trust officers. A life insurance agent, he holds the professional designations of Chartered Life Underwriter, Registered Trust and Estates Practitioner, and Accredited Estate Planner. He may be reached at Richard@rlharrisllc.com or 973-470-5151.