How the new tax act affects life insurance planning

Thomas F. Commito, JD, LL.M, CLU, ChFC
Director - Sales Concepts, Lincoln Financial Distributors

At the end of last year, Congress enacted The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, initiating important changes in the federal estate and gift tax laws. The tax law changes are scheduled to expire at the end of 2012, at which point estate and gift tax exemptions will decrease, and tax rates will dramatically increase.

The 2010 Tax Act affects nearly all estate plans, with the potential to create unintended consequences for estates of individuals dying in 2011 and 2012 if action isn't taken. Given the limited time period available to take advantage of the opportunities presented, it's important to sit down with your clients and review the law's effects on their insurance plans for the future. We're excited to present you with industry expert Thomas J. Commito's take on the provisions of the law and planning strategies you can use immediately.

Overview of the New Law

Increased Exemptions - Lower Rates

The new law sets the estate, gift and generation-skipping tax exemptions at $5 million per person and $10 million per couple. The exemption amount is indexed for inflation, in increments of $10,000 beginning in 2012. The bill also imposes a top tax rate of 35 percent (which is reduced from the prior top rate of 45%).

Reunification of the Estate and Gift Taxes

The new law "reunifies" the estate and gift taxes, effective for gifts made after December 31, 2010. This means that the $5 million exemption can be used for gifts, for the estate tax or any combination of the two.

Planning Under the New Law

Planning for Individuals with Small Estates

In the case of individuals with small estates (i.e. estates valued at less than $5 million for a single person and $10 million for couples), many of the traditional uses of life insurance will still be applicable. This includes the following:

• Income Replacement. This is the most traditional use of life insurance – to provide for income to the family if one of the bread winners were to die.
• Estate Equalization. In many business situations, one child of the owner is active in the business, while one or more of the children are not involved in the business. In these situations, the business is left to the active child, and life insurance is used to provide funds to the non-active children in an amount equal to the business value. Thus, all children are treated equally.
• Life Insurance in Qualified Plans. This is a big winner under the new law. When life insurance is part of a qualified plan, the premiums are deductible and the employee reports only a low term cost (or Table 2001) for income tax purposes. In a profit sharing plan, second to die coverage can be used and the income tax is extremely low – the term rates modified by U.S Table 38. Life insurance in a qualified plan is an asset for estate tax purposes. If a couple has less than $10 million in assets, including the life insurance death benefit, there is no estate tax, thereby eliminating the double taxation problem that existed in prior law.

Planning for Individuals with Large Estates

For individuals with estates over $5 million for a single person or $10 million for couples, or with asset growth, these people will have an estate tax problem, the planning issues do not change from what they were under prior law.

The key here is to use trusts, including Irrevocable Life Insurance Trusts (ILITs). Here is why trusts are so important.

• Dynasty Trusts. Dynasty trusts are trusts that last from generation to generation. Under many states laws, a trust can last forever. These states have repealed the Rule Against Perpetuities. If these trusts are funded at or below the Generation-Skipping Tax Exemption level of $5 million for a single person or $10 million per couple, the generation-skipping tax is NEVER imposed and an estate tax is NEVER imposed. Thus, the assets grow dramatically over time and can be used to provide benefits for all descendents. Life Insurance is important here, since it can dramatically grow the size of the dynasty trust. Life insurance can also be a "non-correlated" alternative asset, which can perform well financially in both good and bad times.
• Appreciation Never Taxed. After assets are transferred to a trust, the appreciation can escape both future gift and future estate taxation. The life insurance death benefit is never taxed.
• Benefits of Trust Law. Modern trust law can provide many benefits. The assets held in trust can be protected from the creditors of the trust beneficiaries (and to a lesser extent, from failed marriages of beneficiaries). The anticipated large death benefit from life insurance can be managed by a professional trustee with investment management expertise.
• State Law Advantages. There are state estate tax reasons that support the continued use of trusts. Due to the revenue shortfall in many states, the state estate tax exemption is less than the federal exemption amount. Most states have no gift tax – therefore, you can fund the trust during life without paying any state gift tax, and then at death, the trust will be free of state estate taxes.
• ILIT Advantages. The new law means that many ILITs can be funded using the higher new gift-tax exemptions. This means that you do not have to rely on the annual exclusion to avoid gift tax. In turn, you may be able to eliminate many administrative hassles, such as having to send out Crummey notice letters. This can save costs since an individual can be the trustee without needing a professional trust company. In addition, the new law makes it easier to avoid "Modified Endowment Contract" (MEC) status. The reason for this is that the ILIT can be funded with assets creating a "side fund." Annual premiums can be paid out of the side fund thereby avoiding MEC status. The end result is that you get the advantage of the new higher exemptions without creating a MEC.

But What if the Exemptions Go Back Down After 2012?

In general, this problem is being referred to as the "Clawback" problem. The good news is that in most situations there is no penalty if you use the higher new exemptions now – and the exemptions are less when you die.

The problem comes about since your estate tax return is your final return. In essence, in the unified system, the amount of taxable gifts is added to the taxable estate, the estate tax is computed on the total amount, and the gift tax previously paid (or deemed to be previously paid, pursuant to a computation in the Worksheets to the Form 706) is then backed out of the computation. If the tax rates used to compute both the estate tax and the gift tax deemed to be previously paid are the same, there should be no impact on the computation, either to increase or decrease the total tax.

FOR AGENT USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC. 11586 - 2011/3/9 | LCN201102-2051167

Agents may not give tax, legal, accounting or investment advice. Individuals should consult with a professional specializing in these areas regarding the applicability of this information to his/her situation.