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Building Wealth Outside of the Estate

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Previously, we briefly outlined the three basic types of life insurance, tax treatment and uses of cash value. Today we will look at one of the most important and powerful estate planning strategies one can use – The Irrevocable Life Insurance Trust (ILIT).

The ILIT is one of the most commonly used tools in estate planning. ILITs are designed to take ownership of the life policy outside of a person’s gross estate. By removing policy ownership from the insured’s gross estate, policy proceeds avoid estate taxation. This means that for every dollar of insurance proceeds received, a dollar will be available to meet post death financial needs. By contrast, personally owned insurance is generally includible in the gross estate. A portion of every dollar may be consumed by estate taxation of the policy proceeds themselves. Only a portion will go towards the intended use of the policy proceeds. Owning life insurance in a properly drafted ILIT is one of the most powerful asset leveraging strategies available.

The strategy is not just for the very wealthy. It plays an important role in a variety of estate-planning objectives such as:

  • Equalizing the estate for heirs
  • Protecting assets from liens and creditors
  • Providing for control of assets after the distribution of the estate
  • Bequests to charities
  • Business continuity and succession plans, and
  • Providing cash for the settlement of estate transfer liabilities

How does an ILIT work?

An ILIT is created to take ownership of a life insurance policy. Trustees are established to oversee that it is administered properly. In order for the life insurance death benefit’s proceeds not to be included in the insured’s estate, the trust must be irrevocable. This means the terms of the trust generally cannot be altered, amended or revoked by the insured. The beneficiaries and their shares must be set at the time the trust is established. If there is uncertainty as to who the beneficiaries should be, or what their shares should be, then an irrevocable trust may not be appropriate.

If the grantor wishes to exert control over the trust assets after his or her death then it’s a good idea to make the trust itself the beneficiary of the policy. In this way the terms of the trust dictate the distribution of assets as per the grantor’s wishes. The ILIT also provides asset protection for beneficiaries if they are ever confronted with litigation, creditors or lien holders because the property held in ILITs is not considered to be the property of the beneficiaries.

The ILIT strategy is a worthy consideration for families who want to build, distribute and control the distribution of wealth outside of their estate. It is imperative to work with an advisor who has experience with ILITs to make sure the strategy is set up accurately and administered properly. Please contact me if you want to learn more about the strategy.

 

Dwight Davenport

Principal, Vodia Capital, LLC

 

 

Cash Value in Life Insurance

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In the first installment of my life insurance series, I outlined the primary differences between term, whole, and universal life insurance. Generally, whole and universal life build cash value and term does not. While the primary purpose of life insurance is to provide money to replace income in the event of premature death, it is the existence of cash value that can provide unique planning opportunities to the policy owner. In this piece, I will provide a general overview of how cash value and policy loans against cash value are treated from a tax perspective. In order to get an idea of how cash value insurance can work for you, it’s helpful to familiarize yourself with some general terms and rules associated with it. This overview should not be interpreted or construed as tax advice or specific advice regarding how to best use you own life insurance.

 

Tax Treatment of Cash Values (Non-MEC)

Cash values that accumulate in a life insurance policy grow tax deferred. Additionally, cash withdrawals are treated on a first-in, first-out (FIFO) basis. This means that withdrawals up to your cost basis are tax-free. Your cost basis is the total amount of premiums you paid minus any dividends and any tax-free withdrawals that were made. Amounts in excess of cost basis are taxed as income. This tax treatment allows for opportunities to use the cash accumulations for various financial planning strategies. For example, if you have $200K accumulated in the cash value account of your policy, $100K of which is cost basis, you may be able to take out (depending on your policy) $100K before you use up your basis.  This is tax-free money that can be used to supplement retirement income or contribute to tuition costs.

 

Policy Loans (Non-MEC)

Policy loans use the cash value as collateral for the borrowed amount, and are usually not taxable. This is the case even if you borrow more than the premiums you have paid in. These types of loans are not taxed as long as the policy is in force and are a popular way of leveraging accumulated cash. Interest on policy loans is not tax deductible.

 

Modified Endowment Contract (MEC)

In order to get the favorable treatment described above the policy must qualify as a non – MEC. Prior to the Deficit Reduction Act of 1984 (DEFRA) owners of cash value life insurance could put large amounts of cash in their policies and shelter the growth from taxation. DEFRA established for the first time a legal definition of life insurance. If a policy does not conform to this definition, it is deemed a Modified Endowment Contract (MEC) and technically not a life insurance policy. MEC rules placed limits on the borrowing or withdrawal of cash from policies on a tax-free basis. Also, if the premium payments made into the cash value of the policy exceed certain limits during the first seven years of the policy, it will be reclassified as a MEC. Under MEC rules, policy loans are taxable, and withdrawals may be taxed or even penalized. MEC rules apply to contracts issued after June of 1988 (as there was some grandfathering of existing contracts). These special tax rules are very complex and you should consult with your advisor to best understand how these rules may or may not apply to you.

 

Review Your Policy

The unique tax treatment and relative flexibility of cash value life insurance allow, within limits, for opportunities to use funds for a variety of financial planning objectives. Using accumulated cash to supplement retirement income or fund educational expenses are examples of common strategies. The key is to understand your policy and the details of how it can work for you. The first step is to locate your policy and most recent statement, and have these reviewed by someone who can explain the details and nuances.

Our Next Installment: The role of life insurance as a way of providing protection, liquidity, and leverage for estate planning strategies.

 

Dwight Davenport

Principal, Vodia Capital, LLC

Demystifying Life Insurance

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Life insurance can provide exponential financial leverage to families and individuals in a variety of circumstances and planning scenarios. It can be used to simply replace income in the event of the death of an income earner, to provide cash to an estate for tax settlement, to fund business succession or continuation plans. This précis is the first in a short series that will attempt to demystify the life insurance world and shed light on some powerful strategies.

Very often clients ask us to review, explain, and make recommendations regarding their life insurance. Our clients’ questions run the gamut from how much should be purchased to how it might be used in complicated estate planning scenarios. The place to start is the three basic types of life insurance:

  • Term
  • Universal Life
  • Whole Life

Term insurance operates as the name implies. One pays an annual premium over the course of some term of years to be awarded a certain amount upon the death of the insured. One-year renewable, five, ten and, twenty-year terms are pretty standard term insurance options. Term insurance does not build cash value.

Universal Life (UL) and Variable Universal Life (VUL) are variants of a type of insurance known collectively as “universal life” and is a bit more complicated.

UL has term insurance and cash value features that are bundled together under one policy. It is considered to be a “permanent” policy because excess premiums are paid and credited to the cash value. In a typical UL policy the cash value is credited with a fixed interest rate for a set period (usually one year). UL policies can be flexible in terms of the amount in excess premiums that can be paid into the policy. These excess amounts are subject to limits set by the IRS.

VUL is very similar to UL except the cash value account consists of variable sub-accounts. These “sub-accounts” usually shadow a publicly traded mutual fund. The term “variable” generally refers to the fact that the underlying investment will fluctuate in value. Almost any type of publicly traded mutual fund can be held in a VUL. The idea is that the cash values can build more quickly because they are being invested.

Because cash values grow tax deferred and withdrawals (if they are allowed) may receive favorable tax treatment both ULs and VULs can be used creatively in a variety of financial planning scenarios. Using universal life to help pay educational expenses or provide income in retirement are examples. I will explain more on insurance strategies based on ULs and VULs in my next installment of this series.

The third category is Whole Life insurance. Whole Life is considered to be a true permanent policy as it provides death benefit coverage for the “whole” life of the insured. There are basically two types of whole life policies: “participating” and “non-participating”.

In a non-participating contract all policy values are established at issuance. This means that death benefit, cash values, and premiums are pre-set.

In a participating contract the policy owner shares in any excess profits the company makes or the company may refund any overages in premium and will return these back to the policy. These are called dividends and there are many ways in which they can be used. Choosing the correct dividend option is important because it can affect the long-term performance of the policy.

Life insurance and its uses is a very broad topic. There are many important factors that need to be accounted for when considering using life insurance as a financial strategy. These include the financial strength of the underwriting company, the performance of the underlying assets, the underwriters’ claims experience, and fees to name a few. This brief introduction is designed to help explain some basic insurance types and terminology. In future installments of this series I will dig deeper into some very powerful and interesting strategies and explore how, with careful planning, life insurance can be used to build integral advantages into a family’s financial circumstances. I am always available for questions and/or discussion in the meantime.

 

Dwight Davenport

Principal, Vodia Capital, LLC