Estate planning professionals have been poring over details in the Tax Cuts and Jobs Act of 2017 and assessing the potential implications for their clients. While the lower rates for corporations and most individuals grabbed the headlines, two less publicized aspects of this new tax law could have an effect on your senior clients.
Doubling The Estate Tax Exclusion
The most dramatic component of the new tax law for estate planners was the doubling of the current exclusion for estate tax calculations. Effective Jan. 1, the lifetime exclusion from estate tax, gift tax and generation-skipping tax increased to approximately $11.2 million per person, or $22.4 million for a married couple. The tax rate on any wealth transfer in excess of those new exclusions is a flat 40 percent rate.
This dramatic increase has widespread implications for the advice you give your clients, but one specific area of impact is related to the way you assess life insurance policies as investment vehicles within estate plans.
For decades, estate planning professionals have worked with high-net-worth clients — primarily those who are already retired and in their senior years — to purchase life insurance policies as a funding mechanism for paying estate taxes after their deaths. This typically involved buying large policies with hefty premiums, keeping those policies in force every year, and then using the death benefit to pay the estate tax bill served to the client’s heirs.
However, the passage of the tax law means that a large number of high-net-worth estates will now fall within the amount that is excluded from estate tax calculations. That means your clients may no longer need those life insurance policies as a vehicle for paying estate taxes. In those circumstances, you have a unique opportunity to help those senior clients obtain maximum value from policies they no longer need, as opposed to simply lapsing or surrendering the policies back to the insurance companies from whom they bought those policies.
Fixing An IRS Revenue Ruling
For more than 100 years, Americans have had an established legal right to sell their life insurance policies. The courts have consistently held that a life insurance policy is considered your client’s personal property, and thus your client has the right to sell that policy just like any asset your client owns, such as a house or a stock.
This is an important option for your senior clients to know about, especially if they own a life insurance policy they no longer need or can afford. Rather than simply lapsing or surrendering that policy back to the insurance company, they can sell it to a third party for immediate cash in a life settlement transaction. This is an option for seniors, especially those who are struggling with unexpected health care bills or a shortfall in retirement income needs.
However, for the past several years, many estate planning professionals have been hesitant to recommend the sale of a client’s life insurance policy because of a confusing revenue ruling in 2009 from the IRS. This rule required policyholders to deduct the “Cost of Insurance” charges from their policy in order to determine an accurate tax basis.
Unfortunately, since it’s very difficult to obtain that precise data, many estate planners concluded it was too much of a hassle for their clients — and the tax consequences would be too great — to go forward with selling their policy. Instead, many of those clients simply surrendered their policies and walked away from an asset of potentially greater value to them.
The new tax law reverses the effects of that 2009 IRS revenue ruling and eliminates the need for taxpayers to obtain Cost of Insurance charges on their policies if they have opted for a life settlement. This reform takes away an obstacle that stood in the way of many seniors who wished to sell their life insurance policies.
To be clear, there are still likely to be tax consequences for your clients who sell a life insurance policy, so it’s always a good idea to consult with an accountant or other financial advisor before entering into a life settlement transaction. Generally speaking, any taxable gain realized by the original owner of a life insurance policy will be regarded as long-term capital gain. The receipt of the death benefit is not subject to federal income tax unless there has been a sale of the policy (a transfer for value).
But this important change to the tax code regarding life settlements will eliminate a lot of confusion that haunted many advisors in recent years, and will make it much easier to determine whether it’s in your client’s best interest to sell a life insurance policy the client no longer needs or can afford.
Here is a case comparison.
The bottom line is that life insurance policies should be evaluated like any other client asset. Is this holding in their portfolio serving a valuable purpose, or would it be better to liquidate and reallocate? The answer will depend on the client’s life circumstances, personal objectives, overall estate holdings and, of course, the specific market value of the client’s life insurance policy. However, the new tax law includes two major reasons to have the discussion.