Life Insurance Fares Well Under New Tax Laws

The American Taxpayer Relief Act of 2012 permanently increases the top income tax rate from 35% to 39.6% for unmarried taxpayers with income over $400,000 and married taxpayers with income over $450,000; permanently increases the top tax rate for capital gains and qualified dividends from 15% to 20%; caps itemized deductions and phases out the personal exemption for unmarried taxpayers earning $250,000 or more and for married couples earning $300,000 or more; and makes permanent the $5 million gift and estate tax exemption (as indexed for inflation). Add to those changes the 3.8% health care tax on investment income under the Patient Protection and Affordable Care Act of 2010, and there will be a shift in focus to income tax planning.

Following are some of the ways that permanent life insurance will play an important role under the new laws:

1. Tax-deferred investments will become increasing popular. Permanent life insurance not only provides tax deferral and tax-free access to cash values (via policy loans and withdrawals up to basis), it also provides an income tax free death benefit. And, if the policy is wrapped inside an irrevocable trust, the death benefit will also be estate tax free. Moreover, particularly for conservative investors, the internal rate of return on life insurance is generally quite competitive.
2. Charitably-inclined individuals will consider donating appreciated securities (rather than cash) to charities to avoid the 23.8% capital gains tax on the appreciation. The donor can then use cash to purchase life insurance, which offers tax-free growth and tax-free access to cash values (via policy loans and withdrawals up to basis); and the charitable deduction can help to offset the cost of purchasing the policy.
3. With the higher capital gains tax, charitable remainder trusts will be more attractive to potential donors. As such, the income tax savings from using a CRT can be used to pay premiums on a life insurance policy as a “wealth replacement” vehicle for the donor’s children.
4. The increase in income taxes will likely increase the demand for non-qualified deferred compensation arrangements. Deferring income for high wage earners until retirement, when they may be in lower tax brackets, may be beneficial. Life insurance remains one of the most popular methods of “informally” funding a non-qualified deferred compensation plan.
5. With fewer decedents being subject to estate taxes because of the $5 million exemption ($5.25 million for 2013), an irrevocable life insurance trust (ILIT) may be viewed as less costly and complex than the other planning acronyms (GRATs, SLATs, IDGTs, QPRTs, CLATs, etc.). An ILIT funded with permanent insurance on the grantor’s life, with the grantor’s spouse as the primary beneficiary, will provide an inflation hedge, estate liquidity (if needed), estate tax savings (if needed), plus income tax benefits and financial/retirement planning options.  The trustee will be able to use the policy’s cash values for the spouse’s benefit (who can then share those distributions with the grantor).
6. The higher gift and estate tax exemption will assist in funding ILITs without the inconvenience of having to use Crummey withdrawal powers. For existing ILITs, consider having the beneficiaries sign a one-time statement waiving the right to future Crummey powers.

In addition to the above, life insurance will continue to provide its traditional uses (e.g., estate liquidity for large estates, buy-sell funding, estate equalization for children not active in a family business, family protection, etc.). But, with the increase in income taxes for the “wealthy”, life insurance now becomes an income tax planning tool as well.

Please feel free to call The Levin Law Firm at (610) 977-2443 to discuss particular client situations and to schedule an appointment for your clients who need to establish and update their estate plans.