The events of the past several years have made life insurance a key tool for wealth planning once again. The American Taxpayer Relief Act of 2013 made it permanent that the estate tax exemption amount (the amount a person can pass to someone other than a spouse) is $5 million (indexed for inflation annually). Before that, permanent life insurance was used as a tool to help replace dollars lost to estate taxes at one’s passing.
The Tax Cut and Jobs Act followed in 2017, further increasing the estate tax exemption to $11.2 million. Given these large exemption amounts, many estates that would have been taxable in the past no longer exceeded the exemption amount and owed no estate tax. Thus, the use of permanent life insurance no longer played an important role in wealth protection planning.
Flashforward to 2019 and the passing of the SECURE Act, and then to 2021 with a new administration, and permanent life insurance is once again an important part of wealth protection planning.
How the SECURE Act Impacts Retirement Accounts
First, the SECURE Act changed how beneficiaries of retirement accounts are taxed over the long-term.
Before the SECURE Act, when a beneficiary inherited a Traditional IRA or 401(k), that person was able to minimize the tax burden by “stretching” (or spreading) the tax payments over their lifetime. This benefit existed because beneficiaries were only required to take a minimum distribution annually, starting in the year after the year of death (which is taxed as ordinary income).
The SECURE Act removed the “stretch” provision, although there are some exceptions. Now, non-spouse beneficiaries of retirement accounts must distribute the entire account by the end of the tenth year, following the year of death. For example, if someone died in 2020, distributions must be made by 2030. This acceleration of tax payments reduces the after-tax inheritance since taxes are due sooner and could also be higher due to paying tax at a higher marginal tax bracket.
This could also create less flexibility in one’s financial plan. For example, before the SECURE Act, if a beneficiary received the inheritance before retirement, they could delay taking a large portion of the IRA until after they retire (due to taking the distribution over their life expectancy, rather than ten years). This would possibly allow them to pay tax inside of a lower tax bracket. For many beneficiaries, that option is no longer available.
This law change also impacts Inherited Roth IRA and Roth 401(k)s. Distributions from Roth accounts are not taxable. Before the SECURE Act, the balances in these accounts would grow tax-free over the beneficiary’s lifetime. Now, however, those accounts must also be fully distributed within ten years. Therefore, you are only getting a potential maximum of ten years of tax-free benefits. Once distributed, the proceeds would be added to a non-retirement account and subject to capital gains tax in the future.
How the New Administration May Impact Estate Planning
It is expected that income tax rates will increase under the new administration. There is also talk that the current estate tax exemption amount of $11.7 million will be reduced through legislation to $5 million, or maybe even $3.5 million. Both scenarios will increase taxes. If these two expectations come to fruition, the amount an heir receives from an estate will be less than it would have been before the law change.
How Can Permanent Life Insurance Help?
Permanent life insurance has been an important wealth protection planning tool for years. It can lessen the estate tax or future income tax burden for individuals and their designated beneficiaries. Life insurance is income-tax-free and can also be estate-tax-free. For the last decade, the use of permanent life insurance as a wealth replacement tool has mainly been used by ultra-high-net-worth families. Given the recent law changes, permanent life insurance policies as wealth replacement tools are likely to be more applicable to more people. The right life insurance policy could counter the higher taxes discussed above and optimize the amount beneficiaries receive.
For example, you could purchase a permanent life insurance policy with a death benefit similar to the estate and income tax expected to be owed over time on the amount your heirs would have inherited. For this example, let’s assume that one has an estate value of $5 million, and the estate exemption is lowered to $2 million. Therefore, $3 million is subject to a tax of 40%, or $1.2 million. The amount passing to the heirs is $3.8 million, not $5 million. However, if you were to purchase a $1.2 million life insurance policy, then the amount passing to heirs would increase to $5 million. Structuring the life insurance policy so it is owned in an Irrevocable Trust would exclude the value of the policy from your estate upon your death, making the policy proceeds estate and income tax-free. The benefit of life insurance is that the premium is usually much smaller than the death benefit, so that you can replace lost dollars due to estate tax at a modest cost. Of course, to implement this strategy, you must be insurable.
Using permanent life insurance as a wealth protection planning tool is nuanced and should be discussed with your financial planning team before implementation. It does make sense to explore it, given the law changes that we already know about and the expected increase in estate and income taxes.