LIFE INSURANCE - DO I NEED IT?

By Nathaniel E. Clement, J.D.

I am often asked by clients "do I need life insurance?" I'd like to respond to this question by exploring some of the situations in which I see a need for life insurance in estate planning.

Financial Security. I begin my estate planning meetings with a review for clients of the definition of estate planning and of the "estate planning pyramid." The first part of the definition of estate planning says "I want to be in control of my affairs and any plan I engage in must achieve that." The estate planning pyramid establishes a hierarchy of needs. The foundation of the planning pyramid - the most important need - for the married couple is "Our needs come first." This is followed by, "The financial needs of our children are also important but secondary to us." Simply put, the definition of estate planning and the planning pyramid make sure the client knows that it's ok to say "I/we want to be in control of my/our affairs," and it's ok to say "I want my and my spouse's financial needs taken care of before I engage in any fancy planning to save taxes or give my assets away."

If clients agree with this - and almost all do - I examine their assets, with the invaluable assistance of their financial or insurance advisor, to see if dependent spouses and children will have enough resources to live if the breadwinner spouse (either husband or wife) passes away. If we determine a shortfall exists, then it's easy to explain the remedy to the situation - life insurance on the life of the spouse whose earnings will be cut off in the event of death. That insurance might be permanent or term, depending on other factors.

Life Insurance to Fund the Family Trust. If clients have or are going to have a taxable estate ($2.0 million in 2007) the plan will usually include the establishment of a "Family Trust" at the death of the first spouse. Almost all clients agree on this plan of action. An estate in "taxable territory" means that the married couple will have an estate of greater than the "exemption" amount - currently $2.0 million in 2007. By using the Family Trust, the first spouse to die can leave assets to the survivor in a way that will keep the assets out of the taxable estate of the survivor spouse. We usually assume the husband will die first, and we concentrate on having at least the exemption amount in his estate so that at his death the bypass trust can be fully funded.

In those estates that are (in 2007) between $2.0 million and $4 million, we are not able to divide assets in such a way that both spouses can have estates of $2.0 million. In such situations it means that the Family Trust part of the plan will, in fact, shelter the maximum amount it is capable of if - and only if - the "right" spouse dies first. Since men tend to die earlier than women do, the husband is probably the "right" spouse (at least 4 out of 5 times). Thus, absent the wife being in ill health or her being 5 or more years older, we usually recommend that the husband's estate include at least $2.0 million in assets where that is possible. We let the wife's estate have the difference. But what if the wife, often with far fewer assets, dies first? It means that the family has wasted a one-time-only opportunity to fund the family trust to its limit. And that's too bad, because the family trust will escape all estate taxes when the second spouse dies. Even al! growth in the family trust will escape estate taxation. Life insurance can come to the rescue her - a policy can be designed by a knowledgeable professional to create an estate for the "impoverished spouse" in a sufficient amount to fund her family trust no matter which year she may die.

Sometimes when the married couple has most of their liquid assets in retirement plans or IRAs, it's impossible to divide the assets between the two spouses so that each controls $2.0 million in value. Often, I will see a married couple with at least $3 million in assets, but $2.0 million of this is in the husband's 40l(k) plan or IRA. Even if we put all other assets in wife's name, she has a taxable estate of only $1,000,000. Obviously, if she dies first, her estate would be unable to fully fund the bypass trust. Again, a life insurance policy on the wife's life can solve the risk of the impoverished spouse dying fast.

I am often asked by clients "do I need life insurance?" I'd like to respond to this question in this month's column by exploring some of the situations in which I see a need for life insurance in estate planning.

Liquidity for Estate Taxes. It's always good to project a client's estate to life expectancy. I would rather the client pick a conservative growth rate rather than an aggressive growth rate. I believe that a 4% growth rate is reasonable for most assets. If we (the client, the attorney and the financial advisor) conclude that the estate is going to be in what I call "taxable territory" (greater than $2.0 million 2007), the question arises "What, if anything, can we can do to lower the taxable estate?" Advisors are often too quick to recommend life insurance as a solution to an estate tax problem. I think that before we recommend life insurance as a means to pay (or prepay) the estate tax, we should first determine if there are ways to lower the estate tax bill.

The easiest way to lower the estate is through a gifting program. Caution! A client's financial security is always the most important objective! If gifting will in any way make the client feel financially uncomfortable, the gifting "solution" should be abandoned. (However, see my separate discussion on 529 plans.) Sometimes, compassionate counselling through this part of the engagement will be enough to convince a client that yes, it is OK to begin gifting assets to clients!

If one's estate is heavily illiquid (such as rental property), gifting may have to be in the form of real estate (perhaps partnership interests, LLC interests, even undivided interests, in real estate). If the estate is heavily rental real estate usually the assets will be throwing off a good deal of cash flow. Rather than give this cash flow to children as gifts, this cash flow can be used by the owner-client to purchase life insurance for the purpose of having cash on hand after death to pay the estate taxes that will be due within nine months of death. (Nine months is not much time to sell real estate.)

Life Insurance as a Gifting Tool. If a client's estate is projected to be in taxable territory and the client is already quite liquid (for example, a portfolio of stocks and bonds), there will be plenty of cash on hand after death to pay estate taxes. Using life insurance, in this case, to pay taxes after death, seems inappropriate. If taxes are in fact due after death, the client's estate will get a complete step-up in basis, and the estate can simply sell something in order to raise cash for taxes.

I think the real need for life insurance in this situation is that life insurance can be used as a way to make controlled gifts to children during the client's lifetime. This method allows the client to reduce his or her estate, while also reducing the estate. The client controls the gifts by forming an ILIT (irrevocable life insurance trust) and makes gifts to the ILIT. Since the gifts are made to a trust, the client can dictate to the children (through the trust instruction book) how he wants the life insurance proceeds to be used when the client dies. The trust can purchase "cash value" products, such as variable universal life products that mimic a portfolio of mutual funds, and the cash value in the contract can be used by the trustee to benefit the loved ones even while the client is still alive. If the client is not interested in controlling the gift money he or she gives to children, then one could just give cash or securities to the children. But, if control of the money is important, nothing is better than a trust.

Life Insurance as a Wealth Replacement Tool. I like to design plans that result in as little estate tax as possible and I want to "wring out" as much of these taxes as possible before turning to life insurance. A plan involving some type of charitable gifting is a wonderful way to minimize taxes or even eliminates taxes. But, when assets pass to charity, they don't pass to children! This bothers clients, rightly so. But, it's not as bad as it seems. I urge clients to look at it this way: Here's an example: For sake of simplicity let's assume a 50% estate tax rate. For every dollar over the exemption amount that this client has at death, the government will take 50 cents and the children will get 50 cents. This means that a "zero-tax plan" involving gifts to charity reduces the children's inheritance by 50 cents on the dollar - not a dollar for dollar. This is important, because life insurance can easily make up that 50 cents. When I recommend a plan of this type, I, therefore, always show clients how easy it is to make up that 50 cents and even go beyond it with life insurance. If charitable gifts are made while the client is alive, such as through outright gifts, a charitable remainder trust or a grantor charitable lead trust, the charitable deduction itself can sometimes pay a large portion of the insurance premium. Usually, these clients can afford to make cash gifts, and the gift money pays the balance of the premium on the policy. If control is an issue, again, an ILIT is recommended as the owner of the policy.

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1709 Legion Rd., Ste 214, Chapel Hill, NC 27517

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