In January Congress stepped back from the fiscal cliff and passed The American Taxpayer Relief Act of 2012 (ATRA), which answered questions about the Bush tax cuts by making most of them permanent.* Many people and organizations have published good summaries of ATRA’s provisions. This article tries to focus on how it impacts life insurance and wealth transfer opportunities. If this article fails to clear up how this legislation affects your life insurance policy then it may be worth speaking to a life insurance expert similar to those found at Tempe Insurance.
Life Insurance Income Taxation Un-changed. Over the years, Congress has granted life insurance policies a unique combination of valuable income tax benefits. Whenever politicians talk about increasing taxes and raising revenue, there is always concern that some of life insurance’s tax benefits may be reduced.
Fortunately, ATRA makes no changes in how life insurance policies are taxed. Income tax-free death benefits, tax-deferred cash-value growth, 1035 exchanges and the taxation of cash value distributions all remain the same under federal tax laws.
New Income Tax Rates for High Income Taxpayers. ATRA left income tax rates unchanged for all taxpayers except those with large taxable incomes. Single taxpayers earning more than $400,000 and married couples filing jointly earning more than $450,000 will be subject to a marginal rate of 39.6 percent on the portion of their income which exceeds these limits. ATRA also increases tax rates on capital gains and dividend income to 20 percent for these high income taxpayers.
Transfer Tax Rules Made Permanent.* ATRA ends the 12 years of regular change and uncertainty on the taxation of wealth transfers during life and at death. It retains the concept of unification of the gift, estate and generation skipping transfer (GST) taxes by setting their top marginal rates at 40 percent and establishing their 2013 exemptions at $5.25 million (which will be adjusted annually for inflation).
The ATRA provision that adjusts these exemptions annually for inflation is important because it gives these exemptions the potential to keep growing year after year. ATRA also simplifies wealth transfer planning for married couples by making permanent the portability of the estate tax exemption to a surviving spouse.
The Transfer Tax Landscape in 2013. Now that the phase-ins, phase-outs and sunsets have ended, 2013 may be the beginning of a new era in wealth transfer planning. Legal and tax advisors retained all their planning tools and now they have increasing exemptions with which to use them:
Lifetime Gifts*
Annual Exclusion Gift Limit (per donee) $ ? 14,000
Lifetime Gift Tax Exemption 5,250,000
GST Tax Exemption on Gifts 5,250,000
*Married couples can work together to combine their gift tax annual exclusions and lifetime gift tax exemptions through coordinated separate actions or through “split gifts” under IRC Section 2522.
Transfers At Death*
Estate Tax Exclusion $5,250,000
GST Tax Exemption on Death Transfers 5,250,000
*Married couples may use the “portability” feature of the Act to defer use of the estate tax exemption of the first spouse to die until the death of the surviving spouse.
General Impact on Wealth Transfer Planning. ATRA simplifies wealth transfer planning in several important ways:
?1.?Fewer people will need to plan and position their assets to avoid federal estate and GST taxes. Establishing the gift, estate and GST tax exemptions at more than $5 million per person and indexing them annually for inflation likely means that less than 1 percent of estates will be subject to federal estate taxes.
With inflation indexing, these exemptions will keep growing year after year. As a result, only the very wealthy (currently individuals with estates in excess of $5.25 million and married couples with estates in excess of $10.5 million) will have federal estate tax problems.
?2.?Portability of estate tax exemptions between spouses, now permanent, could change how many married couples decide to transfer their wealth. Permanent portability could greatly simplify planning for wealth transfers between spouses.
When a federal estate tax return is filed at the first spouse’s death, the surviving spouse will be able to use two estate tax exemptions instead of one. As a result, married couples shouldn’t need to divide their assets to make sure each has enough to use their individual exemptions. When portability is used, the order of spouses’ deaths is irrelevant for estate tax purposes. Both exemptions can potentially be used, regardless of which spouse dies first.
?3.?Opportunities to transfer wealth by making large gifts have been reinforced. By indexing the lifetime gift tax exemption for inflation, taxpayers will have new and recurring opportunities to make large gifts (even those who may have “maxed out” their gift tax exemptions in previous years).
Because of these changes, many attorneys could change how they draft wills, revocable trusts and other wealth transfer documents for married couples. Portable estate tax exemptions allow married spouses the convenience of full use of the marital deduction without any increase in estate taxes.
Consequently, the need for credit shelter trusts (also known as “bypass” trusts and “family” trusts) may be significantly reduced. Instead, more people may use the so-called “I Love You” plans in which the first spouse leaves everything to the surviving spouse. If a spouse wants to limit the amount of control a surviving spouse has over estate assets, he could use any of the different marital trusts, including qualified terminal interest property (QTIP) trusts.
The potential simplicity and relative ease of using portability will change how many married couples implement their wealth transfer plans. Portability could allow these couples to postpone some difficult decisions about distributing assets until the second spouse’s death. Many couples could benefit from a review of their current wills, revocable trusts, beneficiary designations and other wealth transfer documents to see if portability will help them meet their wealth transfer goals.
General Impact on Income Tax Planning. ATRA’s increase in income taxes on high income taxpayers, coupled with the 3.8 percent increase in taxes on investment income under the Affordable Health Care Act, may also have a significant impact. Many high income taxpayers may be interested in strategies to offset their tax increases.
?1.?Changing the makeup of their asset portfolio and shifting some of their holdings into assets with the potential to provide tax-deferred growth but which don’t generate current taxable income.
Cash value life insurance is an asset with this potential. High income taxpayers who also have a need for death benefits may wish to use life insurance to “warehouse” funds that they don’t expect to need in the near future. Life insurance cash values are generally quite liquid and have the potential to grow in value over time.
Long term irrevocable trusts might also benefit from using cash value life insurance to reduce income tax exposure. Trusts that don’t distribute their income annually are taxed at a 39.6 percent rate on all taxable income in excess of $11,800. When an insurable interest is present, cash value life insurance could help reduce the impact of income taxes on these trusts.
?2.?Income tax savings could become an incentive for lifetime gifts. High income taxpayers could elect to make gifts of income-producing assets to children and grandchildren who are in lower-income tax brackets than the donor. Income from the gifted assets could avoid both the new 3.8 percent tax on investment income and the 39.6 percent marginal income tax bracket, as long as the child’s/grandchild’s taxable income stays below the $400,000 to $450,000 threshold.
?3.?Using “portability” at the first spouse’s death. That potential income tax advantage is a possible “double” step-up in basis. Many assets in the first spouse’s taxable estate will be eligible for a step-up in basis, and any of those assets still owned by the surviving spouse could receive another step-up in basis at the spouse’s death.
For example, suppose a husband acquired $500,000 of IBM stock and when he dies the stock is worth $1 million. At his death, under the terms of his will, the IBM stock goes to his wife. She takes it with a stepped-up basis to $1 million. If the stock has grown in value to $2 million at her death, her heirs will get another step-up in basis to $2 million. They could sell it immediately and avoid capital gains tax on all the stock’s growth. If the spouse earns less than that, they could be eligible for an LCGE (Lifetime Capital Gains Exemption) on their taxes, it is best to check with your lawyer if this applies to you.
Impact on Life Insurance. Life insurance comes through ATRA unchanged. It continues to offer protection against potential financial problems caused by an insured’s death. Over the years life insurance has been very effective in helping people accomplish important financial objectives, including: (1) replacing future earnings that could be lost through premature death, (2) solving equalization problems arising when assets won’t be divided equally, (3) serving as a source for supplemental retirement income, (4) providing liquidity to pay estate settlement costs and expenses, and/or (5) transferring wealth at death.
ATRA does not change the ability of life insurance to accomplish any of these important financial goals. In fact, the market for four of these five uses of life insurance remains unchanged.
The only use of life insurance negatively impacted by ATRA is the estate liquidity market (number 4 on the list above) and only part of that market has been hurt by the new wealth transfer tax rules.
Life Insurance and Estate Liquidity. A portable and inflation-indexed estate tax exemption of $5.25 million per person ($10.5 million per married couple) will likely reduce the number of people who will have federal estate tax concerns. And lowering the maximum estate tax rate to 40 percent reduces how much federal estate tax will be due from the few taxpayers with taxable estates in excess of the exemption. (Estates of decedents residing in the 20 states that have estate/inheritance taxes will still need liquidity to pay those taxes.)
The bottom line here is that only people with very large estates will need to plan for federal estate taxes. As a result, there will likely be fewer opportunities to sell life insurance for federal estate tax liquidity.
?Although fewer people will need to pay federal estate taxes, many will still have significant liquidity needs at death. Life insurance death benefits can still provide funds for a number of death-related liquidity needs, including:
??State estate/inheritance taxes
??Income tax liabilities
??Funeral expenses
??Debts
??Nursing home costs
?Medical expenses
??Estate administration expenses
??Cash bequests
??Property management fees
??Charitable bequests
Change in Marketing to Part of the High-Net-Worth Market. The increase in exemption limits should change how life insurance is sold to the segment of high-net-worth market that no longer has a federal estate tax problem. Even though they may not need as much estate liquidity, they may still enjoy significant benefits from using life insurance.
Financial advisors will simply need to discuss life insurance in a different way. They will need to design their presentations to demonstrate how life insurance can help them meet their wealth transfer objective more easily and efficiently.
Why Life Insurance May Be a Useful Wealth Transfer Tool. Over the years many high-net-worth people have used life insurance to accomplish many different goals. With their tax and legal advisors, they’ve adopted customized plans to pass on their wealth. Although many different financial products and strategies are available to them, when they are in good health, they often use life insurance in their planning.
Why? Because life insurance offers them a unique combination of potential advantages:
??Predictable Value-a policy can be structured to pay a known death benefit amount when the insured dies.
??Death Benefit Value Not Linked to Market Performance-a policy may be structured so that the death benefit is a fixed amount which is known in advance.
??Liquidity-death benefits are paid in cash when the insured dies; generally no taxes, costs, commissions or fees are subtracted.
??Growth/Leverage-premiums paid for death benefit protection may provide a reasonable rate of return through life expectancy.
??Federal Income Tax-Free Payment-policy death benefits (including the amount in excess of premiums) are generally federal income tax-free under IRC Section 101.
??Avoids Probate-Death benefits may be structured to be paid directly to the beneficiaries (or a trust for their benefit) without the costs and delays that often impact assets distributed through probate.
Most high-net-worth people and their advisors are careful people. They didn’t accrue their fortunes by being reckless. Many don’t need to make more money. Often protecting what they have is more important to them. Consequently, they are usually interested in products and strategies that offer protection and minimize risk. Before they act, they carefully analyze available alternatives and the potential risks associated with them.
Every financial product and strategy has an element of risk, and life insurance is no different. However, when properly designed and implemented, policies issued by financially strong insurance companies can be reliable financial tools. Although results will vary with a variety of factors, when premiums are paid in a timely manner and the policy is well managed, life insurance can provide a reasonable rate of return through life expectancy. An internal rate of return analysis can help show the financial benefits a life insurance policy has the potential to deliver.
The changes the American Taxpayer Relief Act makes in the federal estate tax could actually make it easier for some high-net-worth people to benefit from using life insurance. People who don’t have a federal estate tax problem may not need an ILIT to own the policy; instead, they may be able to own the policy themselves. Personal ownership makes life insurance more attractive and easier to use in several ways:
?1.?Eliminates Extra Costs-when insureds can own their policy, they don’t need to pay an attorney to draft an ILIT and they don’t have to pay a trustee to administer it.
?2.?Easier to Pay Premiums-gifts or loans to supply premium dollars to a trustee aren’t needed; Crummey withdrawal powers aren’t a problem. Insureds can pay their premiums directly to the insurance company.
?3.?Privacy-owning a policy personally means no one else has to know about it; there are no trustees or trust beneficiaries with a right to know about the policy or to ask questions about it.
?4.?Control-when insureds own their own policy, they are in full control; within the limits of the policy they can exercise all policy rights, including changing the death benefit, premiums, primary and contingent beneficiaries, 1035 exchanges, etc. Unlike ILIT ownership, policyowners can manage their policies to fit their needs and make adjustments whenever they wish. If they wish to control how policy benefits are delivered to family members, they can create a trust in their will and name it the policy beneficiary. And they can retain the ability to change the terms of the trust as long as they live.
Conclusion. The American Taxpayer Relief Act is good news for life insurance! It doesn’t change any of the advantages life insurance policies have enjoyed or the ways in which they can help clients accomplish their financial goals. In addition, ATRA opens up new opportunities for high income and high-net-worth individuals to use life insurance. Although some high-net-worth individuals may not need as much life insurance for estate tax liquidity, the increased gift, estate and GST tax exemptions make life insurance for wealth transfer simpler and easier to use. The opportunity for some to own policies personally without increasing their transfer taxes increases its attractiveness. The ability to retain control and privacy without the need to pay for complex trusts creates new sales opportunities.
We’ve entered a new era of wealth transfer planning-2013 is a great time to show your high-net-worth clients the many reasons they’ll want to use life insurance as part of their legacy.
*Many of the provisions of ATRA are considered permanent enactments. This does not mean that these provisions cannot be changed by Congress in the future (even this year). To designate a provision as permanent indicates only that the provision will not expire unless Congress acts to change it.
