How to Build a Better, Cheaper Life Insurance Trust for Estate Planning

You’ve probably seen the promotions for those tax-free “investments” that give a 10 to 1 return on your money. When you get past the initial pitch, you find that the investment is a life insurance policy that pays off for your heirs, not you. As part of the promotions, you’ll learn that the best way to own a life insurance policy for your Estate Planning often is through an Irrevocable Trust so that the insurance proceeds are not taxed in your estate.

But some people don’t understand why they should pay tens of thousands of dollars (or even hundreds of thousands of dollars) to leave a fortune in insurance proceeds for their heirs. An additional problem is the premiums on the permanent insurance policies that are key to estate planning usually are uncertain. The policies start with projections that the premiums will stop after a period of years. After seven to 10 years of high premium payments you are supposed to have built up a large enough cash value in the policy that earnings from the cash value will pay future premiums.

But the premium projections rarely work out as planned. Earnings on the cash value accounts fall with interest rates. The result is that people who expected to pay premiums for seven to 10 years have paid them for 10 to 15 years or longer. That can disrupt both your cash flow and tax planning.

Another disadvantage is that permanent insurance is an expensive way to buy coverage. The policies have high commissions and expenses, and don’t always pay a decent return on the cash value. (In an upcoming issue, I’ll show you how married couples can slash this cost by shopping for a good joint life insurance policy.)

There are exciting, sensible alternatives for those who want to buy life insurance to cover their risks.

One alternative is a low-load or no-load life insurance policy. This allows you to buy permanent insurance at a lower cost, because less of your premium goes to a sales commission. By going this route, of course, you take the risk of buying the wrong amount of coverage or wrong type of policy. But if you are working with an estate planning  professional or financial advisor who is paid a fee, you might find the low-load route is safe and cost effective.

Another alternative is to forget permanent insurance. Instead, buy term insurance through your trust. To refresh your knowledge, term insurance covers the risk of your dying within the term of the policy, which could be five, 10, 15, or 20 years. Some policies last longer. If you die during the policy term, the policy pays your beneficiary. If you outlive the policy term, the policy expires. You don’t pay any more premiums, and you don’t have any coverage.

Why go this route? Term insurance has gotten dramatically cheap in recent years. I’m attracted to anything that is cheap. The fact is people are living longer and longer, so insurance companies just don’t pay off on that many term policies. Another big plus is that insurers developed guaranteed premium policies. In the past your premium would increase every year. Now, you can lock in the same premium for the term of the policy so that your costs are certain. That’s quite an advantage over the projections for permanent policies that frequently turn out to be wrong.

Lower costs mean you can buy a lot more insurance coverage with term. This can be important for estate planning. When an irrevocable life insurance trust is created, the premium dollars you transfer to the trust are gifts. The gifts are tax-free up to $10,000 annually per beneficiary of the trust. (That amount is indexed for inflation.) Additional amounts use up your annual lifetime estate and gift tax exemption or are taxed. Today’s ultra-cheap term life insurance is much less likely to generate taxes than is permanent insurance.

Is the term insurance life insurance trust for everyone? Not at all. The traditional life insurance trust with permanent insurance is appropriate when the insurance proceeds will be used to pay estate taxes. A good example is when your estate consists primarily of a small business or other valuable assets that you want to pass intact to your heirs and your estate doesn’t have enough cash to pay the estate taxes. Permanent insurance also is a good idea when your estate doesn’t have much cash but will have a lot of cash expenses and debt repayments after your death.

Permanent insurance can be a good way to leave an inheritance. Suppose you have a family business in which only one child works. You might decide to avoid conflicts by leaving the entire business to that child and buying life insurance to provide an equal inheritance for other children.

Or your wealth might generate more money than you need to live. Perhaps the best use of that money for your heirs might be to use that excess money to buy permanent insurance that will pay off after your death.

If you need permanent insurance in these situations, consider buying no-load or low-load policies as mentioned earlier. Another option is to fully fund the permanent policy early. Most policies have flexible funding that allows you to pay premiums early. That builds up the cash value faster and might avoid having the premiums last longer than under the initial projections. Your estate planning advisor or insurance broker can help with strategies for fully funding the policy early.

The term insurance option is a good idea for someone who is relatively young and who anticipates the estate growing enough over time to reduce the need for insurance. You might conclude that if you die today, after taxes your estate would be a lot less than you want to leave your spouse and children. But you also might anticipate estate growing enough over 15 or 20 years that even after a big bite in estate taxes your survivors will get generous inheritances. In that case, you don’t need permanent insurance. You only need insurance for the period during which the estate is building up.

The life insurance world constantly is changing. By keeping up with the changes, you can slash costs and increase the wealth of you and your heirs.