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A Life Insurance Perspective on Potential Estate Tax Change

Be careful about dropping policies

I rarely see someone pass up an excuse to not buy or to drop life insurance. The talk about possible estate tax repeal is certainly one of those current excuses. Life insurance is something most consumers feel is a need more than a want. Without being forced into it by responsibility or a contractual obligation, people aren’t generally lining up to buy it—it’s clearly something that’s usually sold. Rational people will differ regarding this as a reasonable perspective.

Generally speaking, I live in a death benefit world and work with high net worth owners of closely held businesses. These people are the target market for life insurance sales to provide liquidity for business succession and estate tax liability. Many take advantage of it but given an alternative, many wouldn’t.

What should these people be thinking today? Move forward with current plans to purchase insurance? Back burner everything to see what shakes out? Drop what they currently have? Let’s first understand that there are no answers to these questions on which there will be a significant level of agreement, so I’ll simply share my thoughts. 

Don’t Drop Policies

Let’s start with those who have insurance. (No, don’t use this as an excuse to drop existing policies.) First of all, nothing has changed as of now, and there’s serious disagreement on the chances of the tax going away. Second, if the estate tax itself does change materially, there are other taxes that may very well be at play.

For years, advisors have been bringing me in to give advice to policy owners who bought insurance for estate taxes, but no longer have an estate tax liability due to the rising exemption. This initiates a stand-alone analysis of the policies from a financial perspective. We start by determining if the policy is doing what it’s supposed to be doing, and if it’s a reasonable use of money on an internal rate of return basis independent of any tax liability. Many times, the contracts are proven to be a good deployment of assets even if no taxes will be due, and the policy settles in as a portion of a diversified estate portfolio. After all, one dies with stuff, and life insurance is just one pot of stuff. Financially, intellectually and emotionally, what does it bring to the table?

It’s difficult for me to understand how easily people will believe what they want to believe. Few saw the election results coming, and if it went the other way, we’d be talking about lower exemptions and higher taxes. It begs the question, why are so many people willing to bet the farm on the fact that there won’t be a Tax Code with potentially debilitating consequences in effect 17, 26, 35 or 42 years from now?

I’ve read that the earliest taxes at death were from 700 B.C. in Egypt. In the United States, they go back to 1797, and the modern estate tax just celebrated its 100th anniversary in 2016. It’s like thinking in 1999 that the stock market was never again going to go down. It’s like thinking gas will never again hit $4 a gallon. The list could go on.

A well-crafted, astutely managed life insurance portfolio can be a bright spot in an estate portfolio, and the economic dynamics of it don’t change whether or not there’s an estate tax in effect at a given moment. Your traditional investment performance doesn’t change due to an estate tax. Your company performance doesn’t change due to an estate tax. 

Countering Self-Destructive Tendencies

All that being said, we intellectually know consumers will still grasp at straws. What are some ideas to counter their sometimes self-destructive tendencies? Talking about the likelihood of tax change probably won’t sway them. As an insurance professional, I am particularly tuned in to insurability. In my market, this is an issue that torpedoes potential planning solutions regularly. Salvaging insurability for an individual who’s otherwise willing to leave herself twisting in the wind between now and the inevitable next change is important. 

Term Insurance

There’s a great way to do this for a portion of the market and it’s through term insurance. I wouldn’t lead with it, but I would certainly bring it up to keep someone from walking out the door naked. Term rates are cheaper than most people think and sometimes ridiculously so. I’ve had advisors ask me for rates, and when I give them an annual premium, they think I’ve quoted monthly. Convertibility features of various products are important, and convertibility to age 75 is available in some contracts. Remember that with the right products and carrier, individual term policies on each spouse can be convertible to a second-to-die policy as well. There’s a lot more at play here than most people realize, so be sure to seek out an expert. For the love of goodness, please don’t view term insurance as a commodity.

A potential downside is that pricing for permanent products has been on an upward trend for a half-dozen years now and product availability is much different now than it was not long ago. While one can preserve insurability with term insurance, pricing and products available for conversion in the future still pose a risk. A potential solution to that, as well as for individuals for whom an age 70 or 75 deadline doesn’t make sense because they’re already almost that age or have exceeded it, is “underfunding” a flexible premium product. That can produce similar results and take the pricing and availability unknowns off the table.

A few carriers even offer second-to-die term insurance options. Personally, I’ve always maintained a significant amount of term insurance on my life, as well as on my wife’s, for future convertibility to single life or survivor life coverage for tax or charitable purposes.

Keep in the back of your mind that an astute advisor should never let a client bail on existing policies before recommending an independent evaluation. For some, a life settlement will bring more to the table than surrendering a policy. Every policy owner’s contract is in either a gain or a loss position. If it’s in a gain position, he needs to understand the tax implications. If it’s in a loss position, though not generally deductible, there are very effective ways to salvage the loss, shelter future gain or take a future loss, and it would be a shame to throw that out the window.

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