By Steve Tepper, CFP®, MBA
Let’s talk about insurance. If you made it past that first sentence without nodding off, that’s a great start! For wealthy Americans, the Tax Cuts and Jobs Act can have significant implications on their insurance needs.
For years, the estate tax “exemption” has been around $5.5 million, meaning if your estate is worth less than that (not including assets passed to a surviving spouse), there will be no estate tax on the assets you leave to your beneficiaries. With the new tax law, the exemption doubles, to about $11.2 million. Note those limits are per taxpayer, so for spouses, the exemption limit is effectively doubled.
How many taxpayers are above the exemption limit? Not many. According to the US Congress Joint Committee on Taxation, only 2 out of 1,000 estates were subject to the estate tax before the law. It’s highly likely with the new law that number is now below 1 in 1,000.
But for people with assets between $5 million and $11 million, the law is big news. Many people with estates that size carry life insurance policies with the intent that the proceeds from those policies will pay any estate tax due upon their passing. With the new higher limits, that insurance may no longer be needed. If you’ve built up a high cash balance in a permanent insurance policy, you could be looking at a double windfall – you no longer need to pay premiums for the policy and the cash balance is now available for other purposes.
Even if your estate is likely to exceed the new higher limit, the effective tax rate on your estate may now be much less than before the law went into effect. Here’s an illustration:
George was single, had a total taxable estate valued at $15 million and died in 2017. Less the $5.5 million exemption, taxes were owed on $9.5 million, at a rate of 40%, or a total tax bill of about $3.8 million.
Sally had exactly the same amount of assets, but held on until 2018. When she died, only $3.8 million of her estate was subject to the tax, which comes to about $1.5 million in taxes.
Under the new tax law, an estate that would have paid about 25% in estate taxes would now pay about 10%. And even better, if you were planning to use life insurance to pay the tax bill, you’d need $2.3 million less in coverage.
If you have a permanent insurance policy, this would be a great opportunity to “stress test” your coverage, to determine if you have the right amount or if you need it at all.
To help our clients in making that determination, we’d do the following:
Assess the Policy
When life insurance is sold, the policy holder is given estimates of what the cash value and death benefit will be over time. Those estimates may or may not come to fruition. Some policies overperform and some underperform. If it has overperformed, you may have built up all the cash value you need, or more, and if it’s underperformed, you may not have enough coverage.
Sitting with the client, we would contact the insurance company and ask for an “inforce illustration,” which is basically an update of those original estimates of cash value and death benefit. This will help us determine how the policy is performing and if the coverage is adequate.
Optimize Premium Payments
The most common and easy-to-understand way to pay premiums is just to write out a check each month, quarter or year, or have the premium amount automatically withdrawn from a bank account. You know, like you pay all your other bills.
But life insurance is unique in that there are other ways to pay the premium, particularly after you’ve built up a large cash balance. For example, you could tap that cash balance to pay the premium. That would lower the cash value of the policy, but if you have more cash value than you need, it might make more sense to stop paying the premiums out of pocket. We can analyze the alternatives to come up with the best solution.
Optimize the Policy
The bottom line is figuring out whether you have the right coverage. Do we keep the policy as it is, get rid of it, or restructure it?
Keeping the policy in place may be the best option if coverage is still required for the original purpose and the coverage amount is still the correct amount (or close enough). You might also decide, even if you don’t need the coverage for the estate tax, to consider the benefit amount to be an extra tax-free inheritance for your children or other beneficiaries, so you’d decide to keep it in place.
If you decide the coverage is not needed for the original purpose or for any other, you can go ahead and sell or cash out the policy. Keep in mind there will be taxes owed on gains, which is the amount you receive in excess of the premiums you’ve paid.
A third option is to create a new (or restructured) policy that better suits your needs. You could reduce the amount of death benefit if you need less, and create a “paid up” policy so that you never have to make another premium payment. We could also inquire about using some or all of that cash value to add on a product like a long-term care benefit. There are many options to tap the cash value without triggering a “taxable event,” which is to say you wouldn’t owe any taxes on the use of that money.
Regardless of giant revisions to the U.S. tax code, it is a good idea to revisit your insurance every few years to make sure you have the proper coverage in place. If you haven’t had an insurance “stress test” in a while, or have family members you think would benefit from one, give your financial professional a call.
Ten Facts You Should Know About The Federal Estate Tax by Chye-Ching Huang and Chloe Cho, Center on Budget and Policy Priorities, October 30, 2017
Too Much Of A Good Thing? What To Do If You’re Overinsured by Russ Alan Prince and John J. Bowen, June, 2018