Part I Of II: A New Look At Life Insurance
Special To The Dispatch
OCEAN CITY -- Life insurance has a bit of an image problem. Many people put off buying it, incorrectly viewing it as “an expensive product that is a poor investment,” says James D. Gothers, a director with Merrill Lynch’s Wealth Structuring Group.
But that may be because they’re thinking about life insurance in its most basic form — a replacement for the income of the family’s wage earner should he or she die prematurely. That’s obviously a very important benefit, but a closer look reveals life insurance to be a more flexible product than many may realize.
“Life insurance can be used as an estate planning tool, whether it’s for wealth transfer or for liquidity to pay taxes,” says Gothers. “Life insurance has gotten more cost effective over the last 10 years as the mortality tables have been re-evaluated. People are living longer, which has made insurance less expensive.”
If your goal is transferring wealth, life insurance can potentially increase the size of the inheritance and reduce much of the tax burden on your heirs. As an example, consider a 70-year-old couple taking advantage of their annual federal gift tax exclusion ($13,000 per person, per year) by giving their two children a total of $52,000 every year. In 20 years, when the couple is 90 years of age, they will have given their children a total of roughly $1 million, all of it exempt from estate and gift taxes.
Now consider how much the same couple could have transferred by making their $52,000 annual gift to an irrevocable life insurance trust (ILIT). Let’s assume that the husband and wife make gifts of the $52,000 to the ILIT, and the ILIT uses those gifts as an insurance premium. At their ages, assuming good health, the $52,000 will purchase about $2.8 million of second-to-die life insurance. Second-to-die insurance has both individuals insured under the same contract, and the death benefit pays out when the second person passes away.
If we assume that both parents pass away at age 90 — meaning that the parents had paid the $52,000 premium for 20 years — they will have put in a total of roughly $1 million over the years, but their beneficiaries will actually receive the insurance company-guaranteed $2.8 million death benefit free of income and estate taxes.“The rate of return at age 90 is about 8.8% net of all taxes and fees,” says Gothers.
One could argue that this same rate of return would be difficult to achieve in a taxable account. To help illustrate this, hypothetically it would take investing $52,000 each year for the next 20 years, with an average return of about 8.8% net of all taxes and fees, to produce roughly $2.8 million.
The products used in these scenarios are typically guaranteed universal life contracts. Provided the scheduled premiums are paid on time, the death benefits are guaranteed by the insurance company.
“With those kinds of returns, you can make a solid argument for investing excess income into a life insurance contract held in trust,” Gothers says. “Having this low-risk asset means you don’t have to worry whether your current asset allocation will deliver the inheritance you want to leave. That offers you more freedom in investing your other assets.”
This approach can work for smaller estates too. “The $52,000 per year in that example is taking advantage of the annual gift exclusion, currently $13,000 per year, per person,” says Gothers. “The strategy will work for smaller amounts as well. If you have income that you are reinvesting with a goal of wealth transfer, consider leveraging the excess income into a life insurance policy.”
(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)