Before answering the above question, be assured that the information in this article works perfectly if you are worth $3 million or $333 million. Or any amount in between (or even more).
Now the answer: The tax law creates a special tax-free environment just for life insurance. This special law gives everyone, but mostly taken advantage of by the rich who are always in the highest income tax and estate tax brackets -- an easy way to create more wealth. Tax-free wealth.
Your opinion of life insurance, as a tax-advantaged investment, will change when you learn the difference between the math (which follows) in a taxable environment as opposed to a tax-free environment.
Is $1 million a lot of money?
In a taxable environment, more than you think. Can you guess how many dollars you must earn to leave your family $1 million after taxes? Try this:
You must earn $2.78 million
A lousy deal: The tax collector gets $1.78 million, or 64%, and your family gets only $1 million, or 36%.
Less income tax (state/federal) on $2.78 million at 40%: $1.11 million
Balance: $1.67 million
Less estate tax on $1.67 million at 40%: $670,000
Balance to family: $1 million
Now you know why the estate tax is called a "double-tax monster." But the fact is insurance (properly structured) beats the monster at every turn. No theory. Just results. Results best described by two words: TAX MAGIC!
The law that allows you to perform magic tax tricks:
1. Insurance premiums are deductible for estate tax purposes
For example, in a taxable environment the IRS pays 40% of the premium. Suppose you pay $500,000 in premiums (from the day you bought a $2 million dollar policy to the day you die). The $500,000 is gone -- can't be taxed by the estate tax monster. Result: If you had not bought the policy, your family would have received only an additional $300,000 ($500,000 less $200,000 of estate tax).
To sum up: $300,000 cost to get $2 million tax-free (guaranteed), a great tax-advantaged investment.
2. During your life
(a) Your cash surrender value (CSV), as you pay your annual premiums, increases a bit each year. Sometimes your CSV exceeds the total premiums paid. All increases are always tax-free.
(b) You can borrow the CSV (called a "policy loan"). The receipt of such a loan is tax-free. If loans are not repaid during your life, they will be repaid at your death out of policy proceeds, also tax-free.
3. At death
(a) The excess of the death benefit (say $1 million) your heirs receive over the amount of premiums paid (say $250,000) is tax-free. The excess of $750,000 ($1 million minus $250,000) is a clear profit... but every dime is tax-free: no income tax.
(b) The $1 million death benefit, if properly structured, is tax-free: no estate tax. But be warned, if not structured exactly right, the estate tax monster will get $400,000 in tax for every $1 million of death benefit.
4. And even after death
You are married. Say you die with a $10 million policy on your life owned by an irrevocable life insurance trust (ILIT), and your wife is beneficiary, there is no estate tax at your death. (Thank you tax law for the 100% tax-free marital deduction.)
Your wife dies many years later, and the amount in the ILIT has grown to $12 million, then every penny of that $12 million will pass to her heirs -- probably your kids and grandkids -- tax-free. No estate tax. No income tax.
Three little-known strategies to enrich your heirs, while avoiding the estate tax monster.
Now let's use the tax law spelled about above to leverage your wealth. There are actually dozens of insurance strategies, but following are three (actual cases taken from my private client files) strategies used over and over again in real life. Read carefully. Chances are you'll see an opportunity.
1. Funds in a qualified plan (like a 401(k) or IRA)
Sadly, funds in a qualified plan are double taxed (income and estate tax). To avoid this double tax, two strategies rise to the top: (a) Subtrust and (b) Retirement Plan Rescue (RPR).
Joe has $1 million in his 401(k). It is estimated that if Joe and his wife Mary each live to five years beyond life expectancy (ages 91 and 89 respectively), the after-tax amount to their heirs would be only $1.15 million. Using a Subtrust, Joe's and Mary's heirs (via a second-to-die life insurance policy will get) $3.53 million. Of course, tax-free.
(b) Retirement Plan Rescue
Sam, married to Sue, has $900,000 in an IRA. Using a RPR to purchase a $10 million second-to-die policy avoids every penny of the estate tax. Wow! $900,000 (only $324,000 after the double tax) turns into $10 million (tax-free).
If you have a large amount ($400,000 or more) in a qualified plan, you owe it to your family to look at a RPR.
2. Existing life insurance policies with a CSV
Frank had a second-to-die policy (insuring him and his wife Faye and owned by an ILIT), acquired in 1996 with a current CSV of $850,000 and a death benefit of $1.53 million. We did a tax-free exchange raising the death benefit to $3.48 million. No out-of-pocket cost to Frank, Faye or the ILIT. Do you have a CSV policy that is 8 years or older... Take a look at this strategy.
3. The annuity strategy
Very few advisors know how to implement this strategy. This real-life example -- has two steps -- is a jaw dropper.
Step No. 1. Matt (married to May) bought an immediate joint life annuity for $1 million (will pay $43,843 a year for as long as either Matt or May is alive).
Step No. 2. The after-tax amount of the annuity will pay the premium on a $5.68 second-to-die policy on their life. Everything -- the annuity and death benefit -- is guaranteed.
Remember the after-estate tax-value of $1 million is only $600,000. So Matt turned $600,000 into $5.68 million. Smart planning.
And finally, get the tax magic working for you and your family. I twisted the arm of my insurance guru to agree to give you -- the readers of this column -- a free review of your situation to determine just how the above strategies would work for you. To get started call me (Irv) at (847) 674-5295 or email Irv@IrvBlackman.com.
IRVING L. BLACKMAN has been practicing accounting and law more than 50 years, specializing in wealth transfer, business succession and valuation. He was a founding partner of Blackman Kllick Bartelstein LLP, CPAs, one of the largest accounting firms in the country, and is a member of the Illinois Society of CPAs, American Institute of CPAs and the American Speakers Association, among other organizations. Blackman has authored 21 books on taxation and penned hundreds of articles for trade publications. His company, Tax Secrets of the Wealthy, is headquartered in Naples, FL. He may be contacted at (847) 674-5295 or Irv@IrvBlackman.com.