Irrevocable Life Insurance Trusts – “The Low Hanging Fruit” of Estate Planning
Married couples whose estates exceed $22.4 million (or a single individual with an estate over
$11.2 million) have a federal estate and possibly a state inheritance tax problem. These problems are compounded if illiquid assets (closely held business, real estate, etc.) dominate the estate’s total value, and force an unwanted sale (at possibly fire sale prices) after the estate has been drained of liquid assets to pay taxes.
Life insurance owned by an irrevocable life insurance trust (the ILIT) is an effective and flexible estate planning tool for three primary reasons. First, life insurance death benefits paid to a properly designed irrevocable trust are estate and income tax free and are indirectly available to either loan to or purchase assets from the estate, providing much-needed liquidity to pay estate taxes. Second, life insurance premiums paid (essentially invested in the policy) during the life of the insured are removed from the estate, further reducing the eventual estate tax liability. Third, the rate of return on the premiums paid on maturing policies (held to term with death benefits) for certain types of policies can be quite compelling, even when the insured lives well beyond normal life expectancy.
Consider a couple in their mid 60’s with a net taxable estate of $40 million – split evenly between liquid (cash, equities and bonds) and illiquid (closely held business, real estate) assets. Assuming no prior taxable gifts, and using the now portable, combined exemptions of $22.4 million and a federal estate tax rate of 40%, this couple would owe $11.8 million in federal estate taxes upon the death of the survivor in 2013.
| No ILIT Established | ILIT – $10 million Death Benefit | |
| Gross Estate | 40,000,000 | 40,000,000 |
| Total Estate Tax Exemption | 22,400,000 | 22,400,000 |
| Taxable Estate | 17,600,000 | 17,600,000 |
| Federal Estate Tax Liability (40%) | 7,040,000 | 7,040,000 |
| Insurance Benefit at Death | 0 | 10,000,000 |
| Liquid Assets Transferred to Heirs | 12,960,000 | 22,960,000 |
In this scenario, over $7 million of the couple’s $20 million in liquid assets would be consumed to pay estate taxes and other estate settlement costs. An ILIT solves this liquidity bottleneck and here is how it works: the couple sets up an irrevocable trust that is either funded with income producing assets which are used to pay the insurance premiums; or is unfunded (dry trust) where periodic gifts are made by the grantor (under the Crummey trust provisions) to pay the premiums. Because the irrevocable trust is the owner and beneficiary of the life insurance policy, the death benefit is paid to the trust free of estate and income taxes.
The amount of death benefit available per dollar of premium may surprise you. A No-Lapse Guarantee Survivorship Universal Life (NLGSUL) policy (insuring two lives) is an attractive investment for those with large taxable estates. The table below assumes a $10 million face value policy is written for a couple in their mid-sixties in good health. The ‘Premiums Paid on Policy’ column shows the annualized
investment return presuming $100,000 in annual premiums are paid for a NLGSUL policy held until the time of death. The ‘No Policy – Premiums Invested’ column shows the compound value of investing the $100,000 earning 5% after tax and not buying the insurance policy. In this example, even if the surviving insured lives another 35 years and died at age 100, an investment payoff of $10 million is still far better than what would have been earned by retaining and investing the $100,000 annually.
No Lapse Guarantee Survivorship Universal Life Insurance Policy
| If Death Occurs | Premiums Paid on Policy | No Policy- Premiums Invested |
| In | Effective Rate of Return | Assuming a 5% after tax return |
| 10 Years | 47.60% | 1,257,789 |
| 15 Years | 24.02% | 2,157,856 |
| 20 Years | 14.88% | 3,306,595 |
| 25 Years | 10.18% | 4,772,710 |
| 30 Years | 7.37% | 6,643,885 |
| 35 Years | 5.54% | 9,032,031 |
Why would an insurance company offer such an attractive return? Insurance professionals advising high net worth clients, explain. “No-Lapse Universal Life policies provide attractive returns, but they must be designed and administered carefully to ensure that the death benefit is paid as planned. Premiums must be paid on time each year. If a policyholder does not faithfully pay their premiums as scheduled, the policy can be at risk of lapsing. Insurance companies depend on these lapses and ‘burnouts’ in order to fund policies that are paid out. This is known as lapse-supported pricing, which is a critical factor used by actuaries when pricing No Lapse policies. Those who faithfully pay their premiums on time are rewarded with low-cost policies, in part from those policyholders who lapse their policies.” It is critical that policyholders have the patience and discipline necessary to reap the eventual death benefit.
How do you secure the best-priced policy for your client to ensure the best return? Beginning in 2013, the National Association of Insurance Commissioners (NAIC) enacted new reserving requirements that significantly changed the marketplace for No Lapse products. Higher reserve requirements have translated into higher costs for many insurers. Although there are still very competitively priced policies to be found, it now requires a more thorough and methodical due diligence process than in the past.
Insurance agents must take a completely independent approach and shop a multitude of carriers to arrive at the best deals for their clients, especially when it comes to large coverage amounts. There is simply no particular life insurance company that charges the lowest premiums at all ages, underwriting classes, and amounts of insurance.
Given the importance of administering the trust correctly (and paying the premiums on a timely basis), it is wise to retain a trust company experienced in ILIT’s to oversee and manage. A properly designed ILIT can be a critical piece of the estate planning process – particularly for those whose estates a high concentration of real estate, closely held business or other illiquid assets.
