How Life Insurance may help you escape the Death Tax

By Cathy DeWitt Dunn

An inside look at a wealth-transfer strategy your financial advisor may not know exists

A tired old cliché says the two things you can’t avoid in life are death and taxes. It may be uninspired and a little depressing but, unfortunately, it’s mostly true. Americans are taxed for just about everything. And, if you have been fortunate enough to accumulate some wealth over your lifetime, you are even taxed for dying…the ultimate double whammy of the seemingly unavoidable.

Luckily, exposure to the “death tax” doesn’t have to be completely terminal. If you have built up a good amount of assets in your Individual Retirement Account (IRA), you may be able use a little understood life insurance product to help ease the death tax burn.

It’s called Fixed Universal Indexed Life Insurance. But, before we show how it could help you, it’s important to understand what the death tax means for high net worth families.

The death tax, also known as the inheritance tax, is defined by the Internal Revenue Service as “a tax on your right to transfer property at your death.” Let that sink in for a moment.

Since 1916, there has been only one year––2010––that beneficiaries to an estate weren’t subject to this morbidly unavoidable (everyone is going to die eventually) tax. Otherwise, the heirs of the dearly departed have paid dearly as property and assets are transferred from one generation to the next. Death tax rates and exemption amounts have fluctuated wildly over the years, creating a constant state of uncertainty that has complicated estate planning, especially when possible state death taxes are factored in.

Now, at least, you have a fighting chance of figuring out a way to escape some––if not all––of the death tax burden. We’ll get to ‘the how’ in a moment. First, we need to see what factors are at play in the death tax equation.

As part of the fiscal cliff tax deal (the American Taxpayer Relief Act), the federal estate tax exemption has been made permanent…at least for now. This is the government at work, after all. As of January 1, 2013, estates are now exempt from the first $5 million, indexed for inflation, with a 40% tax rate applied to any excess over the exemption amount.

Knowing the current tax rates and exemptions, we can show a good example of how the death tax affects an estate.

Let’s take a look at John, a widowed, 70-year retired doctor with an approximate $10 million net worth. He has worked hard over his lifetime to save $4 Million in an IRA. He has certain retirement income planning strategies in place that provide an annual sum that meets his lifestyle needs. His main objective now is passing on as much fruit of his labor to his children and grandchildren as possible. He earned it after all.

If the good doctor passed away today, his simplified (and approximate) tax situation would look this:

$10 Million (Estate) – $5 Million (Exemption) = $5 Million (Taxable Estate)

$5 Million (Taxable Estate) x 40% (Tax Rate) = $2 Million (Estate Taxes Due)

$2 Million (Taxes Due) + $1.6 Million (Income Taxes on $4 Million IRA) = $3.6 Million (Total Taxes Due)

$10 Million (Estate) – $3.6 Million (Total Taxes Due) = $6.4 Million Net to family

In this scenario, John’s heirs would owe approximately $3.6 million in taxes.  They would receive $6.4 Million of his original $10 Million estate. Basically, they would have to liquidate his entire IRA to pay taxes.

Now, let’s take a look at John’s (simplified) tax situation with Fixed Universal Indexed Life Insurance added into the mix.

We helped John enact a wealth-transfer strategy that withdraws $800,000 per year from his IRA for five years––therefore liquidating his account and ‘reducing’ his net worth to $6 Million. After paying $320,000 per year in income taxes, the net amount of $580,000 is applied each year towards the purchase of a $6 Million Fixed Universal Indexed Life Insurance policy.

Here is how the numbers would look at John’s passing:

$6 Million (Estate Value after IRA liquidation) – $5 Million (Exemption) = $1 Million (Taxable Estate)

$1 Million (Taxable Estate) x 40% (Tax Rate) = $400,000 (Estate Taxes Due)

$6 Million (Estate) + $6 Million (Insurance Payout) – $400,000 (Estate Taxes Due) = $11.6 Million Net to family

Upon John’s death, the full $6 Million will be bestowed upon his heirs, 100% tax-free––because it’s an insurance payout, not part of the estate. Instead of owing $3.6 Million in taxes, John’s family would receive $5 Million (the exemption) PLUS $6 Million (tax free) from his Fixed Universal Indexed Life Insurance policy. They would have plenty of cash on hand to pay the $400,000 taxes due on the $1 Million over the exemption.

Pretty impressive, right?

This strategy is certainly not appropriate for (or even available to) everyone and we caution you to consult with a tax attorney regarding your specific situation. But, for investors who have earned a lot––and saved a lot––over the course of their lifetimes, a Fixed Universal Indexed Life insurance policy may provide some tax relief…and certain satisfaction. Instead of being “taxed for your right to transfer property at your death,” you can freely choose to purchase an insurance policy that allows you to transfer even more wealth than you have in the bank. If you’re smart, you can effectively use life insurance to escape the death tax.

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