Since the federal estate tax exemption is $5.43 million (single) and $10.86 million (married), does paying premiums for life insurance owned by an Irrevocable Life Insurance Trust (ILIT) that was purchased years ago when the estate tax exemption was much lower make sense anymore?
Are there other important retirement and protection needs that could be covered with the annual premium that has been gifted to the ILIT for many years?
A current no-lapse single-life universal life (UL) policy or no-lapse survivorship universal life (SUL) policy may still provide a good internal rate of return (IRR) on death benefit at life expectancy. And the pre-tax equivalent is even better because the life insurance death benefit is income tax-free. However, the federal estate tax exemption may have only been between $1,000,000 and $2,000,000 when the trust-owned policy was purchased and it made sense at the time to offset projected estate taxes with estate tax-free insurance owned by the ILIT.
The American Taxpayer Relief Act of 2012 changed the dynamics of the federal estate tax in a dramatic way.
By permanently increasing the estate tax exemption to $5 million (single) and $10 million (married) and indexing these amounts each year into the future, many estate owners who formerly had to worry about federal estate taxes don’t have that problem anymore.
Given this very large increase in the federal estate tax exemption, are there any planning concepts where we can preserve some death benefit of the existing ILIT, but redirect the premium flow into taking care of another protection need?
The protection need we have in mind is the need to plan for extended long-term care costs. Even for wealthy estate owners who feel they can pay long-term care costs out of pocket, there is a more economically efficient way to offset these costs rather than by liquidating personal assets at 100 cents on the dollar.
Financial products such as limited pay or full pay Universal Life insurance policies with Long Term Care (LTC) riders are fast becoming a popular way to transfer the risk of covering extended care costs to an insurance carrier. And most LTC riders on UL policies are considered to be qualified long-term care insurance under IRC Section 7702B or tax-free accelerated death benefits for those that are terminally ill or chronically ill under IRC Section 101(g). This means that any LTC benefit claim paid to the policy owner-insured will be received income tax-free. The insured will need to qualify under the usual 2 out of 6 adult daily living (ADL) requirements for an LTC claim to be paid. And any LTC claims paid will reduce the life insurance death benefit dollar for dollar.
Of course, the insured (UL) or insureds (SUL) will have to be medically underwritten for any new UL insurance with an LTC rider.
Maybe the original UL or SUL policies owned by an ILIT were written and placed between the year 2000 and 2008 when the estate tax exemption ranged from $1 million to $2 million. The insured(s) may have been in their 50s or early 60s at that time and are now in their 60s or early 70s. And a preferred underwriting class at the time the original policy was issued may not be preferred anymore because of medical conditions that have manifested themselves over the last decade or so.
In order to determine whether a new UL policy with an LTC rider makes sense, the current financial and tax situation of a client must be analyzed. Then, a recommendation can be made on whether a new UL policy with an LTC rider should be considered. Some of the factors that need to be considered when analyzing the facts include:
- Will there be a surrender charge on the existing no-lapse UL or SUL policy if the face amount is reduced with no more premiums paid into the policy? Many UL or SUL no-lapse policies have a surrender charge period that can last for up to 20 years.
- Will the no-lapse protection age be reduced if the face amount is reduced to the maximum that can be supported with $0 annual out-of-pocket premiums? Many existing full-pay UL or SUL policies provide no-lapse protection all the way to age 100.
- Does it make sense to reduce the face amount rather than continue paying premiums into an existing UL or SUL policy? The existing no-lapse policy may have a very good after-tax Internal Rate of Return (IRR) at life expectancy or joint life expectancy since the death benefit is income tax-free.
- Will the guideline single premium limitations of IRC Section 7702 cause the policy with a reduced death benefit to fail to meet the “definition of life insurance” at some point in time and cause the policy to terminate?
Let’s take a look at an example of an SUL policy owned by an ILIT that was purchased from a competitive carrier years ago to offset estate taxes.
Here are the facts of the case:
Client age 62 (Preferred NS) and spouse age 59 (Preferred NS) had a $6 million taxable estate in 2003 and decided to purchase a full-pay $2,000,000 no-lapse SUL policy from a competitive carrier. This made sense at the time since the 2003 estate tax exemption was only $1,000,000. The policy is owned by their ILIT and they have been making annual premium gifts of $29,000 into the trust for 11 years. They reside in a state that still has state death taxes based on the state death tax table from IRC Section 2011.
In 2015, the client and spouse are now ages 74 and 71 respectively. Their taxable estate has fluctuated over the last decade based on both negative and positive portfolio experience and is currently around $7.5 million. The 2015 estate tax exemption has increased dramatically to $5.43 million per individual ($10.86 million married). Their estate planning attorney has informed them that they will probably not need to worry about federal estate taxes anymore. The question that now lingers in their mind is whether they need to keep paying the premium for the $2,000,000 SUL policy owned by their ILIT.
- Should this couple continue to pay the $29,000 annual premiums into their ILIT?
- Or should they consider reducing the face amount of their SUL policy and redirect the $29,000 annually into another financial or protection need?
Now in their 70s, they have become concerned about possible extended long-term care costs. They ask you, their financial professional, what options are available on their $2,000,000 no-lapse SUL policy if they stop paying the premium and redirect the $29,000 premium into long-term care protection.
Hypothetical Recommendation to Accomplish Client Objectives
- Stop paying the $29,000 annual premium into the $2,000,000 no-lapse SUL policy owned by the ILIT. The face amount can be reduced to about $738,000 which will provide no-lapse protection until the younger insured reaches age 92. There will be a net surrender charge of about $20,500 when the face amount is reduced to $738,000.
- The reduced face amount of the SUL policy to $738,000 will be enough to offset the estimated $705,000 state death taxes on the current $7.5 million taxable estate.
- Redirect the $29,000 cash flow into two new single life UL policies with long-term care (LTC) riders from a competitive carrier. These policies will be personally owned by the client and spouse. Consider allocating $14,500 annual premium into a $295,000 UL policy with LTC rider on the male age 74 (Standard NS) and $14,500 annual premium into a $413,000 UL policy with LTC rider on the female age 71 (Standard NS).
- Description of competitive new $295,000 UL policy with indemnity LTC rider on male age 74 (SNS):
- Guaranteed death benefit of $295,000 funded by $14,500 annual premium. These death proceeds are income tax-free. Residual death benefit of $10,000 if LTC benefit pool is completely depleted.
- $295,000 pool of potential LTC benefit claim payments ($197 per day). These benefits (2 of 6 ADLs) are income-tax-free long-term care benefits.
- If death occurs before the use of any LTC benefits, the IRR at life expectancy (age 87) is 6.22%. In a 30% tax bracket, the pre-tax equivalent IRR is 8.89%.
- Description of competitive new $364,000 UL policy with indemnity LTC rider on female age 71 (SNS):
- Guaranteed death benefit of $413,000 funded by $14,500 annual premium. These death proceeds are income tax-free. Residual death benefit of $10,000 if LTC benefit pool is completely depleted.
- $413,000 pool of potential LTC benefit claim payments ($275 per day). These benefits (2 of 6 ADLs) are income tax-free long-term care benefits.
- If death occurs before the use of any LTC benefits, the IRR at life expectancy (age 86) is 7.67%. In a 30% tax bracket, the pre-tax equivalent IRR is 10.96%.
- The reduced no-lapse death benefit of the SUL policy ($738,000) until the younger insured’s age 92 should be enough to offset estimated state death taxes of $705,000 on a $7.5 million taxable estate.
- The $29,000 annual premium that was formerly paid into the SUL policy has been redirected into premiums for two new UL policies with LTC riders on both the client and the spouse.
- Rather than retaining the LTC risk which could deplete personal assets at 100 cents on the dollar, the LTC risk has been transferred to the insurance carrier by paying a combined annual premium of $29,000 for both new UL policies. For this annual premium, a potential combined tax-free LTC benefit pool of $708,000 ($295,000 for male + $413,000 for female) has been created for the client and spouse.
- Even if no LTC benefit claims are made during their lives, the client and spouse receive a very good IRR at life expectancy on the life insurance death benefits paid to their heirs. In this continuing low-interest environment, the pre-tax equivalent IRR of 8.89% for the male and 10.96% for the female is exceptionally good for a fixed financial asset.
Every case must be analyzed individually based on the facts as they exist. Surrender charges reduced years of no-lapse protection on existing insurance, new medical underwriting, and other factors all come into play when reviewing your client’s changing protection needs.
Brokers' Service Marketing Group has selling agreements with insurance carriers that have developed UL policies with LTC riders. These new types of policies may be more traditional full-pay UL policies with LTC riders as described in this article or so-called “combo” products that offer single-pay or flexible limited-pay premium options.
For a discussion of life insurance and LTC options that can cover the protection needs of your upscale, high net worth individual (HNWI) clients, contact your BSMG Life Insurance and/or Long Term Care Advisors.
Call BSMG at 800-343-7772 today to discuss a case or feel free to reach out to Russ Towers, Vice President Business & Estate Planning directly.