Till Death Do Us Part; How second-to-die life insurance pol

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February 2009

PRODUCT INSIGHT; Pg. 35 Vol. 17 No. 2

2136 words


Till Death Do Us Part; How second-to-die life insurance policies protect wealthy clients' legacies.

Howard J. Stock



Second-to-die life insurance (also known as survivorship insurance) were mainly intended for one purpose: To pay any estate taxes to non-spouse heirs over and above the estate-tax exemption.

This year the exemption rose to $7 million per couple or $3.5 million per spouse from $4 million per couple and $2 million per spouse in 2008. While it's impossible to say what will happen to estate taxes going forward, it's likely that the current exemption will remain in place for several years (see sidebar on page 37).

Estate-tax liability can be devastating, especially when a family business is involved. Without proper planning, heirs may have to liquidate the family business to raise funds for the tax man. Second-to-die policies can protect the legacy of married clients who have-or are likely to amass-significant assets. And they can even help supplement retirement income tax-free, as long as the policy stays in place until death.

"Wealthy couples face significant estate-tax liability, 45% federal and another 5% in some states," says Jeff Cullen, manager of estate and business planning at The Hartford in Simsbury, Conn. "So for a couple with an estate that is $10 million more than the exemption, when the second spouse dies, $5 million in taxes would be due nine months after the date of death."

The decision starts with the client's needs. If they want to pass money on to heirs, what is their exposure to estate tax today and what is it likely to be in the future? That future potential liability is the number that determines the need. "A couple, both age 60, with $10 million in assets could double their money every 10 years and, given current mortality rates, that could mean an estate of $50 million when the second spouse dies," Cullen says. "At the current estate-tax rate of 45% the couple will need a death benefit of $22.5 million to cover the tax bill in order to pass on that full amount to their heirs."

TWO FOR THE PRICE OF ONE

Advisors should check whether second-to-die premiums would be cheaper than those on an individual universal life policy; they usually are. Second-to-die policies are the same as universal and variable universal policies. The difference is that they cover two people and therefore tend to have lower premiums. That's because at its ghoulish essence, life insurance is a bet that a healthy individual will live a long time and pay lots of money to the insurer in premiums. The insurance company is betting that it will make more money off those premiums than it has to pay out when the policyholder eventually dies.

A worst-case scenario for a life insurer is that a healthy person buys a policy and then promptly dies, in which case the individual has made minimal payments and now the insurer has to pay out a whopping death benefit. The likelihood of that happening is slim but it falls dramatically if the policy covers two people, because the chances of them both dying early are less than the chances of one dying early.

For high-net-worth clients in their twenties and thirties, where one spouse is the principal breadwinner, a single-life policy often makes more sense since the premiums are so low for younger people. Second-to-die policies are usually for people in their fifties to eighties who are looking at a tax hike, but want to get as much of their assets to their heirs as possible. The sooner a client starts paying, the cheaper the premiums.

Consumers can pay for second-to-die insurance with higher fixed premiums or premiums that start out low and rise as the owner ages. A $10 million policy might cost a 30-year-old in good health 0.5% in annual premiums, Cullen says. At age 70, the cost would rise to 3% or 4% of face value, depending on the health of the insured. "Policyholders can choose to overpay when they are younger and premiums are lower. The excess goes into a cash balance account, which grows over time and can cover payment of premiums in the future," he says. "That was the original intent of cash balances within life insurance policies." Like universal life insurance, policies house a "cash balance" component, which was originally intended to pay the premiums in the future, but now can be used for other purposes. Also, like universal life insurance, the cash balance can be invested in a fixed-income vehicle or in mutual funds, which can grow to sizable amounts over the span of the policy.

IRREVOCABLE TRUSTS

Second-to-die policies are commonly used in conjunction with irrevocable trusts. Otherwise the death benefit would stay in the couple's estate upon the death of the second spouse. Therefore advisors usually get clients' attorneys to create an irrevocable trust, which owns the policy outside of the estate and pays its premiums. "A couple can gift up to $12,000 per year each to pay the premiums. The larger the benefit and the older the policyholders, the higher the premium rate, but $24,000 is usually enough in most cases," says Gordon Homes, senior financial planner at Met Life.

Many planners recommend dynasty trusts, irrevocable trusts that hold assets for a wealthy couple's children and grandchildren, which can last for a lifetime plus 21 years. "So if your two-year-old granddaughter lives to 85, the trust can hold the assets for 21 years after her death," Cullen explains. "Some states have repealed this, so the race is to establish the trust in more liberal states." In South Dakota and Florida, both at the liberal extreme of state law, these trusts can stand for 300 years.

Once the money is in an irrevocable trust, the policy owner can't touch the cash balance, but can use the policy to provide limited funds to the other spouse even while the owner is alive via a spousal access trust. "Most tax attorneys agree that this is a permissible strategy," confirms Cullen. But the beneficiary spouse can't control the money either and generally can take no more than 5% per year, says Homes.

TAX-FREE WITHDRAWALS

How cash balances are used has evolved since their inception, and now policyholders who don't wish to use the policy for estate-tax purposes can use the cash balance as an extension of their qualified retirement plans, one that doesn't have the same restrictions (contribution limits, withdrawal penalties and minimal withdrawal requirements).

If there's enough money built up in the cash balance, policyholders can withdraw money tax-free as a preferential loan. "The internal revenue service (IRS) has a long-standing rule that these loans are early payment of death benefit," says Scott Fryklund, senior vice president and national sales manager, life and long term care at Allianz in Minneapolis. Advisors have to ensure that clients don't take out too much-or they may accidentally spend money that would have covered the premium. If that happens, the policy lapses, and "anything you'd taken out would be taxable at that time," Fryklund says. "So you have to be very careful not to do that."

There are several ways to protect the policy from being "overloaned." Product illustration software will help solve for ballpark amounts when the coverage is first designed. Once the coverage is in place, companies typically provide in-force ledger illustrations that can structure loans most effectively to avoid a lapse. Many companies also offer a loan protection rider.

If used this way, the cash balance of a second-to-die policy can serve as an extension of qualified retirement plans for wealthy clients who are looking for incomes of $300,000 or $400,000 a year in retirement. The money goes in without regard to ERISA regulations generally on an after-tax basis. Inside the policy, it can grow tax-free.

Assume that you have a client who is a cardiologist. He and his wife are 45-years-old, in great health and don't use tobacco. He's currently earning $1.5 million a year, and wants to put $10,000 a month into a survivorship policy, which will buy him a death benefit of $2.1 million. For him to set aside enough money to support his future lifestyle, he's going to have to contribute to accounts that are subject to taxation.

Say he wants to pay premiums through age 62 when he plans on retiring. He plans to live on his qualified assets prior to age 71 to reduce his potential tax liability. At 71, he could take out about $285,000 from the cash balance a year for the next 20 years (assuming reasonable policy performance). At age 91 he'd still have about $5 million in cash inside the policy, which would provide excellent coverage over the rest of his life expectancy, so he wouldn't have to worry about the policy lapsing.

Survivorship insurance is the only product available that both offers protection to his family in the event of his early death through the life insurance benefit and a tax-advantaged account he can access tax-free in retirement.

The good news for advisors leery of insurance products is that second-to-die policies are a relatively easy sell. First, the embarrassing risk that a wealthy client couple will be turned down is minimal if one of the pair is in reasonable health. "The policy is unique in that only one of the two spouses need be insurable, so if the husband has cancer they can still buy a life insurance policy if the wife doesn't," Homes says.

Second, it's a fairly natural conversation if you focus on the need, not the product. "Ask clients about how they feel about the loss of the estate they've spent a lifetime building and then talk about how you might approach things differently," Homes says. Just make sure the concept comes first before the specifics. Survivorship life is an outgrowth of the financial planning process, quantifying what an estate will be worth over time. Using that information, you can determine the shrinkage that's likely to occur and what benefit might be appropriate to take care of estate taxes.

"When clients see what could be lost it's discouraging," Homes says. "Most people with a large amount of assets think about their legacy, so to talk about ways to keep that legacy intact is encouraging." BIC

THE STATE OF THE ESTATE TAX

Second-to-die insurance was created in 1981 when President Reagan introduced the unlimited marital deduction, allowing married couples to pass all assets to a surviving spouse at the death of one spouse. But when the second spouse dies, the estate tax hits the couple's combined assets, currently to the tune of 45%.

Back in those days there was more need for such a tax shelter since the lifetime exclusion for estate assets was only about $600,000. This year the exclusion rose to $7 million per couple, or $3.5 million per spouse in 2009, from $4 million per couple and $2 million per spouse. This is generous, but many more people have more than $1 million to pass on these days than in Reagan's time.

The plan going forward was to completely eliminate the estate tax in 2010, making it the perfect time to die from an estate planning perspective! The exemption was slated to return to a meager $1 million at a higher estate tax of 55% in 2011 when the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 will phase out.

But neither one of these two contradictory events-the total estate-tax break in 2010 and the return to a substantially lower $1 million threshold in 2011-is likely to happen, according to John Napolitano, chairman and CEO of U.S. Wealth Management in Braintree, Mass. For starters, neither incentivizing the wealthy to die next year or face punitive estate-tax liabilities the following year makes much sense. Second, and equally pertinent, the nation is strapped for cash and simply can't afford to forfeit billions in lost estate-tax dollars.

At the same time, Napolitano says Washington's legislators won't penalize the wealthy by lowering liability limits either. The likely compromise? President Obama's administration is likely to permanently "fix" EGTRRA this year, locking in the $3.5 million exemption for a long time to come. Interestingly, Napolitano says new tax rules setting the exemption at $3.5 million won't include indexing that amount for inflation. "It just wouldn't be politically correct right now," he says. "I don't expect that to change until times get better or when estate taxes start imposing on the Average Joe next door."

Inflation on this exemption can have a surprisingly fast impact. For example, 1997's $600,000 exemption seemed like a large amount at the time, but by 2001 when EGTRRA raised it to $1 million, estate taxes were hitting the middle classes far more than was initially intended, due to positive market conditions prior to the dot-com crash. Likewise, while a $3.5 million exemption may seem high now, it probably won't seem so lofty in just a few years. For this reason, more people could need second-to-die insurance to protect them from estate taxes.

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