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Betty's Corner

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Estate Tax Changes Leave Many Over-Insured

You avoided the fiscal cliff, but what to do with all that insurance?
By Stephen Terrell

Immediately after Congress passed the American Taxpayer Relief Tax Act of 2012 (ATRA) - averting the "fiscal cliff" - many wealthy taxpayers found themselves over-insured. Uncertainty has haunted the wealthy for the past dozen years as Congress flip-flopped on raising estate tax thresholds and exemptions. Taxpayers concerned prior to the new law, who prepared for the worst with a generous life insurance policy, must now figure out what to do with unnecessary, unwanted coverage.

Had Congress been unable to reach an agreement by the Jan. 1, 2013, the tax-free amount for estate taxes would have plummeted to $1 million and most estate tax rates would have climbed to 55 percent.

Instead, ATRA kept and made permanent how much one can pass tax-free-during life or at death. On Jan. 11, 2013 the IRS announced this exemption will be $5.25 million in 2013 (adjusted for inflation) and $10.5 million for married couples. Had we not swerved and missed the cliff, estates of individuals passing away this year and in the future would have been heavily taxed.

Permanent life insurance traditionally plays an important role in estate planning as a measure to hedge against estate taxes. Insurance coverage enables wealthy individuals to "pay the taxes in advance" and therefore have their estate (home, money, property, etc.) smoothly pass-on to heirs. Using insurance to pay estate taxes also has a number of tax advantages. Because rates were scheduled to rise this year, many wealthy individuals bought or kept in place large insurance policies for future estate taxes. Such individuals may now be over-insured.

Had we gone over the cliff and the tax exemption lowered to $1 million, a wealthy individual with an estate valued at $10 million would be subject to 55 percent tax on $9 million - nearly $5 million in taxes. A prudent tax planner would suggest that this individual buy a $5 million insurance policy making his estate the beneficiary in order to pay the taxes upon the insured's demise.

Today, with the cliff averted, that same individual (with an estate valued at $10 million) would be subject to 40 percent tax on everything over the first $5.25 million - and only about $2 million in taxes. Had this individual previously bought a $5 million policy, worrying about the worst-case scenario, he would be over-insured by about $3 million.

One way wealthy individuals hedged against changes in the estate tax has been to buy multiple insurance policies; so they could drop one if it was no longer needed. Others may be "stuck" with policies worth more than they need.

Options in this situation include reducing the death benefit, asking for an accelerated death benefit, taking out a loan on the unnecessary policy, surrendering the policy for cash-surrender value, performing a life settlement, or lastly, letting the policy lapse.

Before considering any of these options, agents and financial advisors should confirm that it makes sense for a policyholder to drop his or her policy - even if the benefit is significantly larger than the estate tax costs. Two issues to consider: state-level estate tax rates and policy dividends. Twenty U.S. states enforce estate taxes. If the client's resides in a state that has a lower tax exemption (for example, New Jersey's estate tax exemption is a meager $675,000) than these state taxes will fall to the estate heirs, if not covered by a trust or life insurance policy.

Another important factor in advising whether a policyholder should or shouldn't keep an excessive life insurance policy post-ATRA is the dividend rate on a permanent life insurance policy. If a client has a permanent life insurance policy which collects dividends of at least 4 or 5 percent, then that policy might seriously be worth holding on to. Dividends paid to a life insurance policy are tax-free, not many other investments are.

Estate laws change... scenarios change

However, if a policyholder resides in a state without estate taxes and has a policy accumulating dividends of less than 4 percent, he or she should consider making changes to his or her life insurance coverage.

Reducing the death benefit of a life insurance policy simultaneously lowers premium costs on the policy. Lower premium costs means funds once reserved for paying for the life insurance policy are now free to be used by the policyholder, donated to a non-profit organization or invested in higher-returning investment vehicles.

If a policyholder is suffering from a terminal or chronic illness, he or she might qualify for accelerated death benefits. By receiving some of the death benefit prior to passing away, a sick policyholder can cash the excess benefit no longer needed to cover the estate tax. These funds could be used to cover medical costs or any other financial obligations while the policyholder is still alive.

Another option is to take out a loan on the policy. A policyholder can loan the amount he or she no longer needs sitting in her policy. If not paid back, this amount is subtracted from the death benefit, with enough remaining to cover estate taxes.

Life insurance settlements enable policyholders to sell their life insurance policy for more than the surrender value, less than the face value. In such a transaction, a life settlement provider continues to pay the purchased policy premiums, collecting the full amount when the policy seller passes away. The value of a life settlement varies depending on the life expectancy of the policyholder at the time of sale, and on the written full value of the policy. Often, a life settlement offers seven to eight times more funds than surrendering the policy.

Because of recent changes in life expectancy tables, some individuals may be able to sell a policy or use a policy loan to fund cheaper coverage. The proceeds can be used to purchase a long-term care insurance policy or fill any other financial need.

ATRA may have marked the end of an era of uncertainty in estate tax planning, but the repercussions of a frantic, last-minute swerve to avoid falling off the cliff left many consumers with financial products they don't need and most likely don't want. No doubt certainty is healthy for the taxpayer and for the economy, but it's important that life insurance agents and financial advisors reevaluate their client's tax strategy to gauge if it still makes sense. If it doesn't, agents and advisors have a responsibility to their clients to remain open-minded and to bring all the options to the table when discussing what coverage changes are best for each client.

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