Does Life Insurance Still Matter?

Does the scheduled repeal of the estate tax make permanent, cash value life insurance obsolete? Some financial advisers think that if the estate tax’s days are numbered, few people need life insurance. Others say nothing has changed. The truth is somewhere in between.

Let’s review some of the reasons why you don’t want to automatically drop life insurance from the estate planning toolbox.

The estate tax won’t be repealed until 2010. Then, unless the law changes, the tax will be reinstated in 2011. So, repeal is a few years away and might be reinstated.

In addition, when full repeal takes effect, the step-up in basis rules will be repealed. The step-up rules provide that when property is inherited, the tax basis gets increased to the current fair market value. The inheritor can sell the property immediately and recognize no capital gain. All the appreciation during the previous owner’s lifetime escapes capital gains taxes. But after 2009, many inheritors won’t get the benefit of stepped-up basis. Estate taxes might be avoided, but there could be substantial capital gains taxes on property sold by heirs.

While life insurance frequently is used to pay estate taxes, there are reasons other than taxes to consider adding life insurance to your estate plan.

Your estate might need cash to pay debts or expenses, especially if you own illiquid assets such as a business or real estate. Life insurance also can be used to equalize inheritances. You might leave a business or real estate only to the children who are interested in managing it. If so, life insurance is the way to provide for the other children.

You also might want to protect your loved ones from the financial consequences of your premature death by using life insurance to ensure the debts will be paid or your children will have the money to attend college. This function, though, often is best served by term life insurance instead of cash value policies.

Some people buy permanent life insurance to increase an estate. Often the benefit from a life insurance policy will greatly exceed the total lifetime premiums paid. If you have extra income, buying life insurance can increase your estate faster than investing the money.

Insurance also is useful for business buy-out plans if you have co-owners or as part of a deferred compensation plan for executives.

Asset protection from creditors is another use of permanent life insurance. Creditors in most states cannot get access to the cash value of a debtor’s life insurance.

Suppose you aren’t interested in the non-tax reasons for permanent life insurance. In that case, when should you consider purchasing insurance to pay taxes? In the wake of estate tax reform, we have to look at the situation a bit differently than in the past. Consider not only the size of your estate but also both the likelihood of further changes in the estate tax law and your longevity.

• If you don’t expect to live beyond 2009, then you should consider life insurance to pay estate taxes.  Unlike in the past, you might want to consider term life instead of permanent, cash-value life. The term insurance should be much cheaper. The risk of using term is that you might live beyond 2009 and there still might be an estate tax. At that point, you might not be able to get a replacement policy. To hedge your bets, consider purchasing a convertible term policy that can be changed into a permanent policy at your option. Or buy either a variable universal life policy or a flexible premium universal policy. These are permanent policies, but they have flexible premiums, a feature that can be helpful if circumstances change.
• Suppose you expect to live through 2010 and beyond, and you believe that the estate tax repeal will be made permanent. Your initial goal is to ensure that your estate has insurance or other means to pay taxes and debts if you should die before 2010. Don’t cancel any permanent, cash value policies you currently own. You probably have too much invested in them for canceling to make sense, and there still is too much uncertainty about the law to give up that asset. To supply additional cash needs of the estate through 2010, consider buying term life insurance or convertible term life.For years after 2010, you might consider buying flexible premium universal life or variable universal life policies. One reason to buy would be as a hedge against changing tax laws. Another reason is that if the estate tax repeal holds, the stepped-up basis rules also are likely to remain repealed. That means you might want life insurance to cover the capital gains taxes that your children would owe if they sell inherited assets that have appreciated.If you don’t have these other needs for life insurance and are confident that the estate tax won’t be resurrected, then you can consider letting some or all of the life insurance expire or lapse after 2009. But keep in mind that you might not be able to qualify for new policies in the future if a need arises.
• If you expect to live beyond 2010 and believe that some estate tax will exist after 2010, then estate planning essentially is business as usual with some added flexibility. You’ll want to consider permanent life insurance to pay estate taxes. If you are married, second-to-die policies probably are your best value. You’ll want the ability to increase or decrease coverage and other flexible terms to adapt to whatever the law becomes after 2010. The difficulty will be to estimate the future estate tax and your likely insurance needs.Don’t forget the basics. Most life insurance policies should be held in irrevocable trusts, so that they are not included in your estate. Because of the new law, the trustee should have the discretion to distribute assets, including the insurance policies, to your spouse and children. The trustee shouldn’t be required to buy life insurance. You might even want to give the trustee the ability to cash in a policy if the need for it no longer exists and to distribute the cash value to beneficiaries.

Of course, remember life insurance is part of an estate plan, not an estate plan. Most of all, in all your planning remember to retain some flexibility. Much can happen between now and 2010.