Only When Pigs Fly-Part 3: The
In recent columns, I told the "tail" of an imaginary client named Jim who, in my humble opinion, was being sold a pig in a poke--an unnecessary and overly expensive insurance policy. I'll conclude this series (yeah!) by debunking a common sales ploy, highlighting some tax issues and listing practical buying considerations.
Jim's agent prepared financial calculations that showed how much Jim's kids would inherit after estate tax with no planning versus with the insurance policy held by an irrevocable insurance trust. That is like comparing apples and oranges. It's no surprise that Jim's estate tax goes down when he shells out $125,000 per year for insurance. He might have no estate left at that rate!
The fallacy in the comparison is that, by doing nothing, Jim's estate ultimately is taxed on the money not spent on insurance, plus the earnings on those funds. On the other hand, the insurance purchase calculation assumes that Jim makes annual gifts (depleting his estate) to a trust, which buys the insurance policy. The earnings within the trust, which ultimately are evidenced by the insurance proceeds, escape estate tax.
The better way to make the comparison is to assume that, rather than doing nothing, Jim puts $125,000 annually into a trust. Then, compare what happens if the trust uses the money to buy insurance versus what happens if it buys something else. The trust investments are protected from estate tax whether the funds are used to buy insurance or pork belly futures.
In fact, if the trust earns the same after-income-tax rate as the policy earns pre-income tax (but after all of the expenses taken from the premiums), and if Jim lives to his actuarial life expectancy, the trust will have about the same amount in it as the insurance proceeds. His kids would come out the same. Of course, Jim might get run over by a truck before these investments can grow. Certainly, insurance is a great investment if you die quickly, but it is not too exciting over the long term.
Gift and GST Implications
One other consideration merits mention. Gift tax and generation skipping tax (GST) must be considered. The annual premium payments to the trust (or the annual gifts to the trust for the apples-to-apples comparison) are taxable gifts. They may qualify for the $10,000 annual gift exclusion if the trust is properly designed. In Jim's case, since he only has five kids, the $125,000 annual premiums also would rapidly deplete his $675,000 lifetime gift exemption. The agent did not mention that. Furthermore, if the trust is designed to potentially benefit Jim's grandchildren, there are GST considerations. As reported in my February 1993 column, you must annually elect to allocate your $1 million GST exemption to most trusts to shelter them from future GST tax, whether or not the gifts qualify for the $10,000 annual gift exclusion.
Carefully consider whether the combination of annual exclusions, lifetime gift exemption and GST exemptions will be sufficient to cover projected premiums. That becomes more difficult if the premium amounts are not guaranteed. For example, in a variable policy that is dependent upon how the insurance company invests premiums over a long time period, poor investment performance can require increased premiums. Increased premiums can mean potentially huge, unexpected gift and/or GST tax costs.
So, how can you save your bacon when considering life insurance? Here is a list of things to consider:
Don't be rushed into a major purchase by a salesman's pushiness or sizzling sales pitches.
Carefully consider your reasons for buying insurance. Will those reasons change or go away over time? Consider alternative ways to address those needs. Examples? Your kids might grow up and be able to support themselves some day. The estate tax law may permit a long-term payout of estate tax to avoid sacrificial asset sales for that purpose.
Treat insurance as an investment and analyze it accordingly. Investigate the strength and prior performance of the insurance company. All insurance companies are not equal. *
Recognize that there are an infinite number of types and ways to design insurance policies. You need to carefully consider the tradeoffs in assuming investment and other risks to reduce the premium cost versus shifting those risks to the insurance company, with a resulting increase in premiums.
Determine the duration over which you will need insurance. If the need is relatively short term (e.g., for 10 years to cover kids' support until they leave the nest), consider term insurance rather than some form of permanent insurance. Perhaps the premium savings relative to permanent insurance can be invested to provide financial security for both you and your dependents.
Require your agent to run numerous "policy illustrations" to show what happens to the policy over time with varying assumptions as to policy dividend rates, mortality costs and the other elements used to determine premiums and internal cash build-up over time. Project the policy's performance to at least age 95.
Carefully address the gift and GST considerations involved in premium payments. Tie this analysis to the policy illustrations to determine whether you can tolerate these tax costs if premiums must be increased to offset poor policy investment performance.
Avoid apples-to-oranges comparisons of estate tax savings by using a life insurance trust versus doing no estate planning. Consider using the premium dollars in alternative investments within an estate-tax-sheltered trust.
One last point. If pigs try to fly for you, seek shelter! If you are considering a significant insurance commitment, get input from an advisor who does not profit from selling the policy. Most insurance agents are reputable, but they ultimately make money when you buy a policy. And, the amount that they earn is very dependent upon what you buy. There is an inherent conflict of interest.
So, that is the end of the story. Jim wound up with an amount ($5 million, rather than $10 million) and type (term, rather than variable) of insurance that is more suited to his needs. He will invest the $100,000 annual savings to rebuild his post-divorce personal financial security and save for his retirement. As for me, I've got to get back to work bringing home the bacon for my family.