Life insurance for effective estate tax planning

By Kevin T. Hopperton & John A. O’Brien

Have you been considering changing your estate plan this year? As we near the end of 2020 many wealthy families are examining if changes to their estate plan are necessary. With the possibility of a political shift and potential changes to estate taxation rules, clients are eager to utilize lifetime gift exemption and create long-term planning vehicles that will help them avoid taxation in a way that works for their lives. Which strategies to choose can be complex and is necessarily tailored to each client’s financial goals. One solution that often gets underutilized is using life insurance as part of a comprehensive estate tax planning strategy.

Life insurance has been considered estate-tax planning 101 for decades now, the basic premise being that the client purchases a life insurance policy in the amount of the calculated estate tax bill in order to replace the amount lost due to taxation. This policy is held within an Irrevocable Life Insurance Trust, or ILIT, and the life insurance death benefit then pays out free from both income and estate taxes. Clients will often utilize a second-to-die policy, insuring both themselves and their spouse, as the estate tax becomes due on the second death. This helps provide a lower cost for the desired death benefit, and represents solid core estate planning.

Too often clients look at life insurance in their estate plan as a risk mitigation strategy hedging the value lost to taxation just as a term life insurance policy hedges the risk of early death by providing income for your family. Rather, permanent life insurance should be considered an asset. Life insurance can be written with guarantees for life and thus represents an incredibly stable investment. Further, death benefits pay out income tax free. Given that the time horizon of your investment is the end of your life, life insurance provides an excellent return with very little risk when compared to a portfolio of marketable securities. Further, it is an excellent source of diversification, especially in a low interest environment where bond performance continues to lag. 

If life insurance is a good investment, how much life insurance should be part of your estate plan? The answer depends on your overall financial goals. Life insurance is often used to define a legacy, either to heirs or to charity. For example, if a client says they want to make sure they leave $20mm to their children and the balance of their estate to charity, a very simple and clean estate plan is to purchase a life insurance policy for that amount. The policy is held outside the estate in an ILIT and passes to heirs estate tax free. Since all in-estate assets would then go to charity at end of life, no estate taxes would be paid. This leaves the client free to spend and/or gift as much as they like during their lives, knowing their legacy goals have been achieved. Conversely clients will often use life insurance to define a legacy gift to a charity, church, or school they are passionate about.

For privately held business owners and other individuals whose net worth exceeds the current lifetime exemption levels, more complex strategies are needed to help maximize the transfer of wealth to heirs. Lifetime exclusion gifts should be used on the highest appreciating assets owned. For business owners this is usually shares of business interest. Families will then look to purchase life insurance as a maximization and diversification strategy by loaning money to a trust in order to pay necessary premiums. Using leveraging and estate freeze techniques allows massive amounts of wealth to be transferred to heirs estate tax free. Clients may even elect to skip a generation, purchasing second-to-die life insurance on two of their children, to benefit future generations and help with dynastic wealth planning.

Life insurance is an incredibly powerful tool for wealth transfer. It is tax efficient, can be guaranteed, and helps clients create certainty that their goals for their estate are realized. Every family has different goals, but we all want as much certainty as possible that those goals are achieved. No matter what those may be, most estate plans can be enhanced and made more efficient with the addition of life insurance to their overall planning. 

John A. O’Brien, CFP®, ChFC®, CLU® is vice president, senior high net worth insurance specialist at Fifth Third Bank, and Kevin T. Hopperton, MBA, CFP® is assistant vice president, high net worth insurance specialist at Fifth Third Bank. 

Fifth Third Bank is a Goering Center corporate partner, and the Goering Center is sharing this content as part of its monthly newsletter, which features corporate partner articles.