Life Insurance Trusts - What to do in the Event of High Estate Tax Exemptions

Do I Really Still Need This Trust?

(A conversation overheard recently at an estate planning client meeting.)

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Client (C): So, now that the federal estate tax exemption is $11,200,000 for an individual and $22,400,000 for a married couple, why do I still need to have a life insurance trust? I am tired of paying the premiums and also the bother of sending out the annual withdrawal notices.

Lawyer (L): Certainly the law has changed mightily from the time when we established your trust, and the estate tax exemption was $600,000 and you were saving 55% of the death benefit which would otherwise be have been paid in estate tax. Recall the current estate tax exemptions are estimated to fall back to about $6,000,000 and $12,000,000 in 2026 if Congress does not extend them, and only God knows (if anyone does) what will happen to the exemptions in 2026, but it is quite likely the exemption will be more than your assets will be. Not true for a privileged few, but probably true for both you and me.

(C): I agree. I am not very likely to pay the estate tax, so what about my life insurance trust? Can I get rid of it?

(L): Assuming you are willing to roll the dice on estate tax exposure, and certainly the tide seems to be going out on the estate tax, we can discuss ways to dismantle the trust which is no longer useful in avoiding estate taxes which you will probably never see.

(C): Yes!! Music to my ears!

(L): But before pulling the plug, let me ask you—do you have any liability concerns, malpractice risk, bank debt business exposure, environmental problems? If so, you might consider keeping the trust as an asset protection vehicle for your spouse or children. Maybe your estate could use a little cash to keep your lenders less paranoid about your business loans should you die. Or perhaps setting aside a few million dollars for your spouse free of the claims of creditors would be an idea.

(C): I hadn’t thought of that, but I don’t think anything like that is a problem for me.

(L): Okay. Then let’s talk about trust exit strategies. I can think of several:

• Distribute the policy as it is to your spouse.  (If it is a single life policy and your spouse is a beneficiary of the trust during your lifetime, the trustee just gives it to her.)  With no assets to hold, the trust is dead.
• The trustee would likely want the consent or approval of any remainder beneficiaries (children, for example). But, if they stand to inherit the rest of your estate and you could change your mind, we might find them very cooperative.
• Although trust codes vary from state to state, a nervous trustee (a bank or non-family member) could be quite comfortable with this option in the context of what we call a non-judicial settlement agreement. Such a procedure could even allow a return of your policy to you. There are some gift tax issues, but they are not likely to be an obstacle with the large gift tax exemption which will likely go unused.

(C): All right, the trust is gone. What do I or my spouse do with the policy? Cash it in and spend the money?

(L): Getting rid of the trust and what to do with the policy are two entirely separate questions, and the options should be reviewed carefully. It’s a case of finding the shoe that fits.

(C): What do you mean?

(L): First of all, surrendering the policy could result in an income tax gain that can cost you big bucks.

(C): Why? I thought the receipt of life insurance proceeds are income tax free?

(L): Insurance proceeds are income tax free, but only if you die.  If the cash value exceeds the premiums paid, and you surrender the policy during lifetime, there is a gain taxable at ordinary rates, not capital gains rates.

(C): Nasty!

(L): Yes. Nasty, and often a very unpleasant surprise.

(C): So, what then? I am really tired of paying the premiums. How can I get out of this with my skin intact?

(L): First of all, a decent life insurance policy, where a proper premium has been paid, is often an attractive fixed income investment. The death benefit rate of return (double income tax free – state and federal) has traditionally beat tax free municipal bond rates at normal life expectancy and even a bit beyond. Regardless of what kind of policy you have, be sure to have your agent run an in-force illustration to make sure you are paying premiums that will keep your policy in force well beyond your life expectancy. With the downturn in the bond market, many previously adequate premiums no longer make the grade, and your policy could die before you do. I am assuming you are in great health; if you are not, the policy is an even better investment.

(C): Great!; Thankfully, I am in good health. So, I understand paying premiums could be a good investment, but I am retired and I want to live off my investments, not continue making them.

(L): Then you should consider converting your policy to paid-up status if it is a traditional policy, or reducing the death benefit on a universal life policy to a level which will support the policy with the existing cash values. This will stop the premiums.

(C): But how do I get the cash?

(L): There are several ways:

• On a policy issued by a company that is (or was) a mutual (non-stock) life insurance company, take the annual dividends in cash. They are tax-free until the dividends withdrawn exceed the premiums paid.
• On a universal life policy, take periodic withdrawals from the cash, possibly with further death benefit reductions, but always retain enough cash in the policy to carry the policy to death if you want to avoid any gain in the policy.
• If neither of these work, either now or at some later date, convert the policy into an annuity. You can do this tax free. You will lose the death benefit, but you will get all of the cash, recognizing any gain in the policy over the distribution period. The annuity could be immediate (starting now) or deferred (where you take cash as you need it) or annuitized later (equal payments each month).

(C): So, my old life insurance policy can become a retirement plan supplementing my other retirement income?

(L): Right you are! It is a repurposing of the policy because the death benefit is no longer needed to pay for estate tax.

(C): What other options do I have?

(L): Well, what have you done about long-term care expenses?

(C): Nothing, so I guess I am self-insuring.

(L): That is an option, but for clients who are above the poverty level (say $2-to-3 million), but not as rich as Croesus (say, over $15-to-20 million), we often find that clients buy some long-term care coverage. Not fully insuring (the premiums can be heart-stopping, eliminating the need for any coverage at all), but also not fully self-insuring. In other words, you take a middle course with some insurance and some self-insuring.

(C): So, how does my current life insurance policy factor into this?

(L): Well, combining that policy with your other “cats & dogs” policies, where the risk of loss is no longer relevant (kids are grown, mortgage is paid, retirement funds are adequately replacing earnings), you can repurpose the insurance policy cash value to purchase some long-term care insurance coverage.

(C): How so?

(L): In several ways:

• All the single life policies could be exchanged tax free (no gain realized) to purchase a new life policy with an advanced benefit rider to pay more than the death benefit face value for long-term care expenses. If you never make a long-term care claim (I hope to wake up dead in my 90s), you get the death benefit. If you have long term insurance costs, those get paid and you get a lower death benefit. You have to be insurable to have this option though.
• You could also do partial tax-free exchanges from the existing policies to pay the annual premiums on a traditional long-term care policy that would pay a fixed monthly benefit for a three or six year period.
• If a tax-free exchange of existing life insurance policies doesn’t work to pay the annual premiums, you could do a tax-free exchange of the existing policy to a deferred annuity and then do a partial tax-free exchanges from the annuity to pay the annual long-term care premiums each year. Because the exchanges are tax-free, you never pay tax on the gain.

(C): So my old “cats and dogs” policies and my irrevocable trust policies could be repurposed to address a different, pressing risk (more relevant now that I have attained an age)—that is to say, address the potential long-term care financial train wreck?

(L): Precisely. The point I am trying to make is that just because it is appropriate to get rid of the life insurance trust, does not necessarily mean that you should cash in the life insurance policy in a knee-jerk reaction. That may be the right course, but only after you have considered and rejected the other options.

(C): It’s more complicated than I thought.

(L): I’d like to think that it is not so much more complicated, but rather a situation where there are more options—some of which may be very attractive and income tax efficient.

(C): Like maybe I could save enough money to pay for this consultation?

(L): That’s why we’re talking!

(C): So, to sum up:

• It is OK to get rid of my life insurance trust if I am comfortable that my assets are not likely to exceed the estate tax threshold, admitting that no one is safe while Congress is in session.
• I could continue the policy as is if I have the funds to pay the premiums and like the fixed income death benefit rates of return as part of a diversified asset allocation model. (You tell me my life insurance agent would only be too happy to illustrate this for me.)
• If I don’t want to pay the premiums, I take the paid-up policy or reduce my universal life death benefit to a level the cash value will support.
• If I want income, I take the dividends in cash (or make withdrawals from my universal life policy) until the withdrawals become taxable, or even continue them after that if I can accept the fact that cash received in excess of basis will be taxable.
• I could just make it easier and annuitize the cash value creating retirement income which, if there was a gain in the policy, would be taxable over the annuity period.
• If long-term care expenses are keeping me up at night, I could repurpose the cash values to tax-free exchanges to purchase a new policy (I would need to be insurable) with an advanced benefit rider for long-term care expenses, or do partial tax-free exchanges to finance a traditional non-life insurance long-term care policy.
• If that was too complicated, I could just do tax-free exchanges of all the policies to a deferred annuity, and simply do an additional tax-free exchange each year from the annuity to pay long-term care premiums (either on the life insurance advanced benefit policy or a traditional long-term care policy) as the premiums come due.

(L): You got it!

(C): I learned something today.

(L): Then it was a good day. And the day is not even over yet!

If you have questions about insurance trusts or insurance policies, please contact John Bannen at (414)-277-5859/  john.bannen@quarles.com, or your Quarles & Brady attorney.