Blunders involving life insurance cause more dollars to be lost to the IRS than any other area in the income tax or estate tax.
Modern Machine Shop, Irving L. Blackman
Life insurance is a powerful weapon to enrich yourself at the expense of the IRS, because the Internal Revenue Code is very kind to every aspect of life insurance. Unfortunately, the law is complex, and if you don’t use the law properly, it will eat your lunch. Here’s how to take advantage of it.
Let’s start by examining the economics of life insurance. The schedule below shows you the typical annual premium amount to buy a new (universal life) insurance policy with a $1 million death benefit. Three facts jump out:
1. Premiums grow significantly as you age.
2. It pays to be healthy. “Preferred Risk” males get about a 20-percent discount compared with “Standard Risk” males.
3. Second-to-die insurance is a true bargain.
But one significant fact (really a question) does not jump out at you: How does the insurance company make money?
For example, if 60-year-old Max is rated a standard risk with a 20-year life expectancy, in 20 years, he will have paid only $383,200 ($19,160 × 20). If he lives to age 80, his heirs will receive a $1 million death benefit—an almost $600,000 profit—all income tax free. Sure looks like the insurance company will take a big hit.
Not so fast. Studies show that about 90 percent of so-called “permanent life insurance policies” do not pay a death benefit. Nice business model: Collect premiums year after year and then your customer decides to cancel his policy. The insurance company is off the death benefit hook.
There are many ways to escape the estate tax. In Max’s case, we ensured that all of the $1 million would avoid the tax by putting the insurance into an “irrevocable life insurance trust” (ILIT). Here are some other ways to ensure life insurance victory.
Example 1: Insurance-funded buy/sell agreements. Warren (56) and his brother Bill (58) have an insurance-funded buy/sell agreement. Both are in excellent health. An audit of their policies showed that Bill’s would lapse at age 70 and Warren’s at age 69. My insurance guru arranged for a tax-free exchange so the policies would be guaranteed to pay the death benefits ($2.1 million for each) no matter how long Warren or Bill might live (without any added premium cost). Nice!
CAUTION: It is rare that we find insurance-funded buy/sell agreements properly done. Always get a second opinion.
Example 2: Using life insurance as a tax-advantaged investment. Wendy, a 76-year-old widow, is worth more than $12 million in mostly liquid investments earning income that far exceeds her lifestyle costs. First, Wendy paid $2 million for a single premium immediate annuity (this means the insurance company will pay Wendy the same annuity dollar amount every year for as long as she lives). Then, Wendy bought a $5.6 million insurance policy (actually owned by an ILIT, so the death benefit will go to her kids tax-free). The annuity payments were used to pay the premiums, and a taxable $2 million turned into a tax-free $5.6 million!
Example 3: Turning a tax disaster (qualified plan funds) into a tax victory. Zelda (73) and Izzy (76) are married and worth $10.5 million, including $2,720,000 in a rollover IRA. We used a strategy called a “Retirement Plan Rescue” to purchase $5 million of second-to-die insurance (again, in an ILIT). The crazy American tax laws hit all qualified plans (including IRAs) with both income and estate tax—an astounding $1.66 million, leaving the family with only $1.06 million. Using our strategy, the family will get the full $5 million, tax-free.
Example 4: You have an old policy and are no longer paying premiums out-of-pocket. If you have a so called “paid-up-policy,” you are getting ripped off. Here’s a classic example: Alfred (71) had a policy with a death benefit of $4.2 million, with a CSV of $1.7 million. He no longer paid premiums because the annual earnings on the CSV was large enough to pay the premiums when due. Alfred was able to trade in the old policy (a tax-free transaction) for a new policy with a $7 million death benefit (using an ILIT again to make it all tax-free).Wow!
Detailing all the possibilities for using life insurance to increase wealth would take a book. So, I cornered my insurance guru and twisted his arm into agreeing to audit the insurance policies of readers of this column without any obligation.