HOW TO MAKE LIFE INSURANCE

ACCOMPLISH ITS PURPOSE

By Nathaniel E. Clement, J.D.

NOTE: The estate tax exemption illustrated in this article is $1.5 million - the estate tax exemption that existed in 2001. The principles illustrated apply no matter the size of the estate tax exemption.

After a consumer agrees that life insurance is necessary for his or her estate plan to work, it is critical for the life insurance professional to discuss with the client how the life insurance policy should be owned.

In the estate planning context, usually the need for life insurance will be for either income replacement (replace earnings of the breadwinner ) or for wealth replacement (to replace assets lost to estate tax avoidance planning or to provide liquidity to pay estate taxes). It is possible that the individual bought life insurance in order to make the heirs inheritance equal a certain minimum amount Usually "Dad" or "Mom" will own the policy in their individual names. If the insurance is "second to die" life insurance, Mom and Dad sometimes will think the kids should own the policy. Are these options best? If you are an insurance advisor, you have a duty to educate your clients on options beyond these conventional approaches which involve individuals owning policies.

Which ownership method will best insure that the client's planning objectives will be met? Let's first talk about individuals owning the policy.

Earnings-Replacement Policy: Peter is the breadwinner spouse and you have determined that a $500,000 policy is needed on his life - and the clients agree. Peter says that his estate planning objective is: "If I die, I want there to be a pile of money to be invested and Mom will get the earnings - dividends, interest, capital gains - for her life. If she needs some of the principal to live on she can have that too." Peter also says, "and, by the way, if anything is left when Mom dies, I want the balance to go to the kids in equal shares." You allow Peter to own the policy and you recommend that he name Mom as beneficiary. Of course, this means that during Peter's life, he can get to the cash value and use it for his and Mom's support (this is good because this helps Peter justify putting $20,000 a year into this policy).

Are there other implications to Peter owning the policy? Yes! Let's say Peter gets into a jam with creditors who get a judgment against him for money owed. The creditors can't get the policy cash value because it is protected from creditors under North Carolina law so long as Mom or the kids are named as beneficiaries (this is good). Now let's say Peter dies. The policy proceeds of $500,000 are includible in his taxable estate. But... this is not a problem because the marital exception to the estate tax protects assets that husbands leave to wives (this is good). Mom gets the money without estate taxes. Now, what does Mom do? Choose one of the following: (i) Mom is experienced with money and she invests the money appropriately; (ii) She is not experienced and she hasn't a clue of what to do with the money. Under option (i) Mom invests the money well and draws out income and principal, as needed, for her support for the rest of her life. Under option (2) Mom did not know what to do with the money. What happens? Choose one: (i) She spends the principal very quickly and has nothing after one year to live on; (ii) She invests the money inappropriately and the funds are lost; (iii) She remarries on the re-bound.. If the choice is (iii), choose one of the following: (a) Mom wisely refuses to title any of her assets in a joint account with hubby #2; (b) She retitles everything as joint property with hubby #2, then dies so, with hubby #2 getting the money; (c) She retitles everything as joint property with hubby #2, then gets divorced with hubby #2 getting half of the money.

OK, so Mom does all the right things - she invests the money appropriately and she uses the investments properly for her support by taking out each year only enough of the income and principal that she needs to maintain her lifestyle. Now Mom dies in 2001 - still with $500,000 in the investment account. Mom's taxable estate is $1,200,000 and her Will leaves all to the children in equal shares. Mom has used none of her "unified credit" so she is allowed to leave to the children $700,000 tax-free (the 2001 "exemption"); the balance is taxed at 40%. This means that 40% of $500,000 (the amount of the insurance money now in the investment account) goes to the I.R.S. This is $200,000!

As you can see, there are any number of things that can (but, possibly won't) go wrong from a financial and estate planning standpoint when the insured owns the life insurance policy outright in his own name.

Second-to-Die Policy: Let's say you have determined that a $500,000 policy is needed on the lives of both Peter and Nancy. You have worked with Peter and Nancy to get their estate taxes as low as possible, but it does leave the children a little short on what Mom and Dad would like for the children to get. So, you have recommended the second-to-die policy to pay what tax remains or to replace the estate lost to tax-planning. As their insurance advisor, you allow Peter and Nancy to own the policy. This way the insureds will have access to the cash value while they live. The clients agree that they want the estate of the last to die to go to the kids in equal shares. The policy names the children as beneficiaries.

What happens when Peter dies? Nothing, tax-wise, because Peter's interest passes to Nancy under his Will and it is fully protected from taxes by the marital deduction. Of course the death benefit doesn't pay out because Nancy is still alive. Nancy lives for ten more years and dies in 2011. Not counting life insurance death proceeds, Nancy's estate, including that which Peter has left her, is $1,200,000, which is $1 million of rental property and residence and $200,000 of IRAs. But, don't forget the death proceeds from the life insurance! - That boosts Nancy's taxable estate to $1,700,000. Nancy's estate owes estate taxes of about $300,000! The extra tax caused by the life insurance is $200,000! The U.S. government takes 43.6% of the life insurance money. And how is this tax going to be paid? With the very life insurance money that was supposed to "replace" lost wealth!

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