A Post-Sunset Wealth Strategy

Should your clients keep their irrevocable life Insurance trusts if they no longer have a tax liability?

by Donna Scalaro, JD

For decades, the Irrevocable Life Insurance Trust (ILIT) has been a popular estate planning device.  Properly drafted, the ILIT can own life insurance on the client’s life, keep the death benefit outside the client’s taxable estate, and still provide liquidity to the estate for taxes and other expenses.

Prior to 2001, the need for this type of planning was fairly common even for people with modest wealth.  At that time, an individual could exempt only $675,000 of estate assets from federal estate tax.

However, with the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), the exemption increased over nine years, leading to full repeal of the federal estate tax for one year in 2010. But because Congress was not able to fully offset the tax revenue lost to EGTRRA, the legislation was designed to “sunset” on December 31, 2010. Last-minute political wrangling extended the tax for two more years, now with a $5,000,000 exemption.  The Taxpayer Relief Act of 2012 made the $5,000,000 permanent, indexed annually for inflation ($5,430,000 in 2015).

Clearly, planning around these laws over the last 14 years has been challenging and turbulent. Your clients who may have had a federal estate tax problem fourteen years ago – or just a few years ago, facing sunset in 2010 – might not be even close to having a federal estate tax problem with an individual exemption amount of $5,430,000.
For married couples the amount is double: $10,860,000. So what should these clients do with their existing trust-owned policies? Should they simply stop funding them?  Of course, each client must evaluate this decision with regard to their own personal situation in consultation with the client’s own attorney. Here is a checklist of some important issues to discuss with your client before making a decision.

Federal Transfer Tax Law May Change

Is the current law really permanent? There is no guarantee that the exemption amounts and rates will stay the same in the future. As we have seen over the last fifteen years, and especially over the entire history of the federal estate tax from the first in 1797, significant change is the norm, not the exception.  Severe revenue challenges, such as major military conflicts, have mandated the highest estate taxes of all. But even in peacetime, as power shifts in Washington, different fiscal philosophies are brought to bear on the taxpayers who elect the policy makers – and those who didn’t.

For example, the current President has advocated for years in his annual budget proposals to reduce the federal exemption amount to $3,500,000. If he had enjoyed a compliant Congress, the estate tax today might look different than it does.

If your client surrenders their life insurance policy because they do not have a federal estate tax issue today, how will you plan for them if future changes to the law expose them to tax again and the client is no longer medically insurable?  Estate planning is a delicate balance between optimistic and pessimistic assumptions: you want to prepare them for the worst, but you don’t want to burden them with unnecessary planning.  As clients age, legislative changes and health changes can have a dramatic impact on their overall plan.

State Death Taxes

Clients who are not subject to the federal estate tax may still be subject to a state “death tax” – estate or inheritance tax. In 2015 there are twenty states that still impose some type of state death tax. Some of these states have exemption amounts much lower than the current federal exemption amount, such as Connecticut ($2,000,000) and New Jersey ($675,000).

Turning back to history, most states lost a major source of revenue under EGTRRA.  Pre-EGTRRA, estates could take a full credit against federal estate tax for state death taxes, up to certain limits. This effectively cost the estate nothing.  Knowing that EGTRRA would sunset, many states opted to wait it out, expecting the possible return of the federal credit.  But at this point in time, it is reasonably clear that the credit won’t be back soon, leaving some states with a dead tax law on the books and no money coming in.

California is one of these. Other states have reacted aggressively, enacting new estate tax regimes (example: Minnesota), while others have permanently repealed their estate and inheritance taxes. Clients should be advised if the state they live or own property in has a state death tax, and account for the possibility of moving to another state either in retirement or for employment or family reasons.  Those clients who have life insurance inside an existing ILIT may want to keep it in reserve for payment of these state death taxes and in turn increase the overall wealth transferred to the heirs.

Income Taxes

Federal and state death taxes may not only be the taxes that are due at your client’s death. Don’t forget federal and state income taxes. For clients who die with traditional IRAs, qualified plans and tax-deferred annuities, the beneficiary of those assets must pay federal and state income taxes upon receipt of the funds. With the highest federal income tax bracket at 39.6% that could greatly diminish the amount of wealth transferred to those beneficiaries. Life insurance in an ILIT can help offset the loss in value of those assets from income tax, and enhance the wealth transferred to a client’s heirs.

Asset Appreciation

Though a client’s estate is not large enough today to incur a federal estate tax, it could still be taxable in the future, even if the current rules don’t change.  If the value of the estate today far exceeds the amount the client is likely to spend in retirement, then anything from a real estate bubble to a bull market on Wall Street could push their estate into tax territory.
Look at it this way: the federal exemption increases annually based on the change to the consumer price index over the previous 12 months.  For 2014, the increase was about 1.7%.

Even assuming higher increases, would your benchmark growth rate for your client’s assets catch up?  If so, when?  To plan adequately, clients should examine the types of assets they own, their investment strategy, and assumed growth rates. In addition, in projecting the size of their estate in the future they should consider other factors such as receiving an inheritance or proceeds from the sale of a business.

Retention as Part of the Portfolio

One way to think of life insurance is as another financial vehicle in the client’s portfolio. Even though circumstances may have changed since your client first bought the life insurance for estate tax liquidity purposes, consider retaining it as part of the client’s overall portfolio. The internal rate of return (IRR) on the policy’s death benefit may be a compelling reason to keep the policy. You may also be able to improve the client’s IRR by exchanging the policy for a new one based on modern mortality assumptions.  In addition, the inside buildup of cash value in the policy is not subject to income tax, including the 3.8% Medicare surtax on investments.

Planning for the Cost of Terminal or Chronic Illness

Discuss with your clients how they plan on paying for expenses if they should experience a terminal or chronic illness.
In the case of terminal illness, most permanent life contracts in force today can accelerate the death proceeds while the insured is still living, to help with expenses during a very difficult time.

In the case of chronic illness, does the client own a traditional long term care policy or a life insurance policy with a chronic illness rider? If not, then explore the possibility of  doing an exchange of the life insurance policy owned by the ILIT, no longer needed for federal estate taxes, to a life insurance policy with a chronic illness rider. Depending on the actual terms of the ILIT and the specific type of life insurance policy and rider purchased, the death proceeds of the policy may or may not be counted as part of the insured’s taxable estate. However, if the federal estate tax is no longer a consideration for your client, then estate inclusion under this scenario might not be an issue.

Even though the policy is trust owned, if the trustee decides to access the benefits under the chronic illness rider, depending on the terms of the trust, the trustee’s powers may permit distribution of these types of benefits to adult children or a spouse who are also trust beneficiaries, thereby indirectly helping the insured client.

Conclusion

Cancelling a life insurance policy is a momentous decision. It is a decision to be made in consultation with the client’s attorney in light of all the client’s planning objectives.  Once it’s gone, it’s gone forever and the client may not be able to qualify for a new policy.  Even if none of the foregoing points are relevant to your client, remember that you can always reduce the cost of a life policy by reducing the coverage amount.

It may even be possible to exchange the contract for a new one requiring no annual premiums, assuming the client passes medical underwriting.  If the ILIT itself is the problem, it may be possible to change its terms under the laws of various states.  The terms of the actual ILIT should be carefully reviewed by the client’s attorney.  Also, remember that the trustee of an ILIT often has a fiduciary duty to all beneficiaries of the trust to maximize the value of the trust assets, and may be able to acquire the funds to maintain it from a source other than the trust grantor.  Whatever the situation, always carefully consider the true value and potential of your client’s life insurance policy.

This material is designed to provide general information in regard to the subject matter covered. It should be used with the understanding that we are not rendering legal, accounting or tax advice. Such services should be provided by a client’s advisors. ◊