Three recent developments present new and important roles for life insurance in estate planning:
First, the so-called “SECURE Act,” passed just before Christmas, 2019, generally requires that all IRA and similar tax-deferred qualified retirement plan benefits be paid out within 10 years of the owner-participant’s death.
Second, the recent national elections (including the Senate runoff elections in Georgia) will not only likely mean lower federal estate tax exemptions in the near future, but may also result in the loss of income tax basis step-up at death and, potentially even worse, deemed capital gains at death as well as when lifetime gifts are made. These same elections will likely mean higher income tax rates generally, including on capital gains and on distributions from tax-deferred IRAs and qualified retirement plans.
Finally, recent demographic trends involving the movement of retiring baby boomers from traditionally Democrat majority states (such as New York, Illinois and California) into warm weather and traditionally Republican majority states (such as Arizona, Texas and Florida), will likely serve to support this trend towards higher federal taxes in the future.
One approach that may serve to help minimize the new taxes on both tax-deferred investments and taxable investments utilizes cash value life insurance. The build-up in the cash surrender value of a life insurance policy can be accessed income tax free during the insured’s lifetime, through tax-free withdrawals and/or loans, and the death benefit of a life insurance policy is, of course, income tax free. How can these traditional income tax attributes of life insurance help counteract the recent developments described above?
For tax-deferred investments such as IRAs and other qualified plan interests, investing in cash value life insurance, either annually as part of the individual’s retirement planning, or by taking taxable withdrawals from the owner-participant’s tax-deferred investments over time and reinvesting them in cash value life insurance, will have the effect of pushing these funds into a tax-free, as opposed to tax-deferred, environment. This step may not only serve to minimize income taxes to the owner-participant over time, but it will also significantly reduce the adverse tax effects of the SECURE Act on the owner-participant’s beneficiaries after his or her death, since the life insurance proceeds are income tax free.
As an option to investing all in taxable investments such as brokerage accounts, investing part of the individual’s savings in cash value life insurance can help counteract the effects of the proposed loss of income tax basis step-up at the investor’s death and/or deemed sales at the investor’s death. As described above, because the life insurance proceeds will be income tax free to the insured’s beneficiaries, the otherwise adverse effects of the proposed loss in income tax basis step-up and/or deemed sales at death will become moot. This option will also minimize the investor’s current income taxes on what would have been taxable investments, including on capital gains.
Finally, if estate taxes are a concern as a result of the likely significant lowering of the current $11.7 million federal estate tax exemption, the life insurance policy can be placed inside an irrevocable life insurance trust and the death benefit will thereby be removed from the insured’s taxable estate. The insured may still access the cash value of the insurance policy during his or her lifetime, either via a so-called “spousal access trust,” if the insured is married, or via a traditional irrevocable life insurance trust, if the insured is not. In the case of the single individual, cash value of the life insurance policy would be accessed through tax-free loans from the insurance trust. Because Roth IRAs cannot be invested inside an irrevocable trust, this feature of life insurance presents a unique advantage over investing in Roths.
Obviously the income tax-tax free life insurance proceeds can also be utilized by the insured’s family after his or her death to help pay any additional income taxes caused by the SECURE Act and/loss of income tax basis step-up, as well as any additional estate taxes caused by a lowering of the federal estate tax exemption.
There is of course a lot more to this discussion than is presented here, which the individual can examine with his or her own estate planning attorney and life insurance advisor. The message of this article is merely that cash value life insurance can play an important role in counteracting recent developments adverse to the accumulation of wealth through traditional tax-deferred or taxable investing.