Use Life Insurance for a Tax Free Estate Plan

Life insurance is best if bought when you are young, because premiums for seniors can be astronomical.

But there are exceptions for people in the right circumstances, like a strategy that uses those high premiums to reduce or pay tax on investments and other assets that will be left to heirs, says Dave Buckwald, senior partner at Atlas Advisory Group, headquartered in Cranford, New Jersey.

"When most people think about life insurance, they think about using it to protect their income to provide for their family in the case of an unexpected and early death," he says. "That's a smart reason to buy life insurance, but it certainly isn't the only one. In fact, when properly integrated into an overall financial plan, life insurance can help turn highly taxed assets into assets that are never taxed – saving 30 percent or more in taxes on that portion of a retiree's savings."

Life insurance was often recommended for investors expecting to leave substantial assets to heirs. The death benefit, for instance, could provide quick cash to pay property taxes and upkeep until a home left by the policyholder could be sold. And it could help pay expenses while the estate went through a lengthy legal process.

Life insurance was also recommended if the investor would leave enough assets to trigger estate taxes. In 1997, estate tax applied to assets above $600,000. The exemption was gradually lifted to $1 million in 2002, then to $5 million in 2011. Today, because of inflation adjustments, it's at $5.49 million and a married couple can shelter twice as much.

But life insurance strategies can still have value for many investors who are not in estate-tax danger. Because a life insurance death benefit is tax free, a policyholder and heirs can come out ahead with a policy purchased in the retirement years even if premiums are very high. In effect, the policy converts taxable assets used to pay premiums into a tax-free death benefit that may be much larger than the premiums paid before the policyholder's death.

"It makes sense for a client to consider this strategy if the [total] amount of premiums paid will not exceed the face value of the policy over approximately 20 years," says Bill Kardos, financial advisor at Mutual of Omaha Investor Services. It can be a winning strategy so long as the investor can pay premiums with money not needed for living expenses. Kardos says he often gets clients to pay a lump sum for an immediate annuity that pays enough income to cover premiums on a new life policy.

"This strategy works effectively for retirees that have rainy-day money that they don't need for themselves," David Meche of David N. Meche & Associates in Lafayette, Louisiana, says of life insurance to protect investments. "At death, the named beneficiary receives the leveraged or larger amount, which is much greater than the premium amount, and it passes to them tax-free. "Wealthy investors often feel they don't need life insurance because they have plenty to leave heirs, Buckwald says. Buckwald says life insurance can be especially valuable for investors with lots of assets in traditional individual retirement accounts and 401(k)s. Withdrawals from those accounts, by the investor or heirs after the investor's death, are taxed as income. "Life insurance is the only vehicle of its kind that enables you to save tax-free and allows your heirs to access the benefit amount tax-free," Buckwald says. "It is also one of the only assets that is secure from the exorbitant costs of health care in old age."

Key to the strategy is to assess tax rates that apply not just to the investor but to heirs as well. The strategy can be especially valuable if the children will be in a higher tax bracket than the investor. Instead of paying a high tax on inherited assets, they'll pay no tax on the death benefit. The family can therefore come out ahead even if the investor must pay income tax on retirement account withdrawals used to pay insurance premiums.

To minimize taxes on money used for premiums, the investor can parcel out IRA and 401(k) distributions over time to avoid big withdrawals that would raise the investor's tax bracket.

Alternatively, the investor can pay the premiums with investment withdrawals that will be taxed at lower rates than a retirement account withdrawal. That could be done, for instance, by selling taxable investments subject to the lower long-term capital gains rate rather than retirement account funds taxed as income, or by liquidating taxable investments with a high cost basis that will leave little or no profit to tax. The investor must, however, remember that taxable assets enjoy a step-up in cost basis when passed to heirs after the original owner's death. Another option: Pay the insurance premium with money that must be taken, and taxed, anyway as required minimum distributions that begin after age 70.5.

Most experts say bare-bones term life polices do not work well with these strategies, and many prefer guaranteed universal life policies, which offer long-term coverage for less than most types of permanent insurance. To make a life insurance strategy work best, it's often necessary to get a policy with a rider that will pay for long-term care, Buckwald says. And he notes that it's often best to have the policy owned by a trust set up for the purpose. A trust keeps the death benefit from being added to the estate and triggering estate tax. "Even with higher age-related premiums, a single-pay life insurance policy with a long-term care rider inside a trust is worth considering," he says. "Whether you're wealthy or not, as long as you have assets you want to protect throughout retirement – and especially if you expect to live long enough to pay for some amount of age-related health care – life insurance may indeed be one of the best options available." Get your quote for a tax free estate plan here.

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