Premium Alternatives: Exploring Options to Pay for Life Insurance
Life insurance can be an important piece of a well-crafted wealth transfer strategy for high-net-worth clients. By removing assets from the client’s taxable estate, permanent life insurance can significantly increase the amount of after-tax wealth parents and/or grandparents can pass on to younger generations.
Often, however, concerns about liquidity, gift taxes and other factors related to paying the premiums cause clients to purchase policies that are smaller than what they actually need for their wealth transfer goals. Fortunately, for many clients, there are alternatives to paying premiums out-of-pocket helping clients fully leverage the benefits of life insurance.
Reasons to Consider Alternative Payment Methods
Traditionally, clients will pay premiums for a permanent life insurance policy by making gifts directly out of the client’s estate. But for some clients, particularly those needing larger policies, issues related to gift taxes, cash flow and investment returns means paying the premiums directly is not the optimal solution.
- Gift taxes: Individuals are allowed to make gifts of up to $14,000 a year (or $28,000 per couple) without incurring any gift tax or using a portion of their lifetime gift tax exemption. For high-net-worth clients, however, the annual premiums on a life insurance policy can easily exceed the annual exclusion amount.
- Liquidity and cash flow: Clients may also be hesitant to purchase a significant life insurance policy because of liquidity or cash flow concerns. Even for affluent clients, the wealth may be tied up in a family business, invested in illiquid assets or held outside of the individual’s estate as a result of preexisting estate-planning strategies.
- Return on investment: For many clients the assets they would use to pay the premiums are represented by investments generating very attractive returns and cash flow. Liquidating these assets to pay life insurance premiums could represent a case of “negative arbitrage.” Furthermore, the assets may be highly appreciated above the tax basis, meaning that liquidating the asset would result in significant capital gains taxes.
Alternative Strategies for Paying Premiums
While the concerns listed above can be significant, in many cases they do not need to limit the client’s ability to purchase an appropriate amount of life insurance. For many clients, there are multiple options available for paying life insurance premiums.
When evaluating the possible payment strategies, it is important to think about the following questions: 1) what are the client’s available sources of liquidity to pay life insurance premiums, 2) what is the return on those assets, 3) what are the client’s cash-flow needs, 4) what are the client’s wealth transfer goals and 5) what estate planning strategies have already been implemented?
The answers to these questions will help determine which of the following strategies makes the most sense for paying life insurance premiums:
- Annual gift-tax exclusions: As noted above, this is the standard approach that most clients take. Individuals can use their $14,000 annual gift tax exclusion to pay for premiums, either directly or through an irrevocable life insurance trust (ILIT). Any payments in a given year above this amount would cut into the individual’s lifetime gift tax exemption, which is $5.43 million in 2015.
- Unused gift tax exemption: The American Taxpayer Relief Act (ATRA), the last-minute law that averted the fiscal cliff at the end of 2012, made many significant changes to the gift and estate taxes. In addition to making the gift and estate tax regimes “permanent,” ATRA also made the exemption amounts indexed for inflation annually. While this provision didn’t make major headlines at the time, the annual inflation adjustments can be very valuable for clients’ wealth transfer strategies.
The lifetime exemption amount for gift taxes has increased from $5.0 million in 2011 to $5.12 million in 2012, $5.25 million in 2013, $5.34 million in 2014, and $5.43 million in 2015. For a couple that instituted a wealth-transfer strategy in 2011 using their entire exemption at the time, they now have an additional $860,000 ($430,000 per spouse) that they can use to pay life insurance premiums or fund other gifts in 2015. In addition to any unused exemption that has accrued since 2011, clients will also be able to use future annual inflation adjustments as opportunities to make tax-free gifts.
- Split-dollar arrangements: A split dollar arrangement is a plan where a life insurance policy’s premiums, cash value and death benefit are split between two parties. These plans can help individuals minimize income and gift taxes connected with funding large premiums and reduce the cash flow required to fund a life insurance policy.
The two parties involved in the split-dollar arrangement can be the insured and the insured’s family. Alternatively, the premiums, cash values and death benefit can be split between the insured and the insured’s employer. Family-owned businesses and other closely held companies often use split-dollar arrangements as a form of deferred compensation for executives.
- Intra-family loans: Many times with high-net-worth clients, the assets available to pay for the premiums are held outside of the individual’s estate in some sort of family entity, such as a trust, a family limited liability company or a family partnership. In these situations, using an intra-family loan may be a very attractive option.
With this strategy, the family entity will loan money to the ILIT or family LLC that is purchasing the life insurance policy. The interest rate on the loan must be equal to or greater than the applicable federal rate (AFR), which is currently about 2.4% for long-term loans (greater than nine years). The ILIT or family LLC will use the loan proceeds to pay the annual premiums on the life insurance policy. This approach is often referred to as private split dollar.
A variation of this approach can be very effective for multi-generational planning. This approach can be structured in a way that allows the grandparents (G1) to use their assets to secure a loan from a third-party lender, and the loan proceeds are used to purchase life insurance on the second generation (G2) for the benefit of the grandchildren (G3).
- Third-party financing: Rather than borrowing money from a family entity, it may make more sense to borrow the funds from a bank or other third party. High-net-worth clients, especially business owners, often have relationships with banks and other financial institutions making premium-financing loans to their clients at attractive interest rates.
When structured and executed properly and under the right circumstances, using a third-party loan to pay the premiums of a life insurance policy can provide a host of benefits for affluent individuals and families, particularly those with illiquid or highly appreciated assets. By paying just the interest on the loan rather than the life insurance policy’s premium, clients can maintain their current cash flow situation and keep their wealth invested in opportunities where the potential rate of return on the assets exceeds the interest rate of the loan.
There is always an element of risk when using leverage, and the client will have to “pay for” that by assuming interest-rate risk and collateral risk. To learn more about the factors to consider with premium financing, see our article, “Premium Financing: 5 Things to Know About Using ‘Other People’s Money’ to Fund Life Insurance.”
It is important to remember that these four strategies are not mutually exclusive. Often, the best solution involves a hybrid approach. For example, a couple may pay the first $28,000 of premiums each year using their annual gift tax exclusions and then use an intra-family loan or a third-party loan to pay for the rest.
At Goldstein Financial Group, we are committed to helping advisors strengthen their clients’ wealth transfer strategies. If you would like to talk with us about payment strategies for your clients, we are always available to answer any questions you have.
This material is intended for informational purposes only and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor or plan provider.