A New Administration
The lifetime gift tax exemption is currently the largest it has ever been. In 2021, an individual can exclude $11.7 million from his estate, and a married couple can exclude $23.4 million.
President Biden has indicated that he wants to increase income taxes and lower the estate/gift tax exemption. Democrats now control the Senate and House, making it more likely that these changes will be enacted.
The gift tax exemption may be reduced quickly and dramatically. In 2016, Democrats favored a lifetime gift/estate tax exemption of $3.5 million, a reduction of over $8 million from current exemption amounts. That possibility creates a limited window of opportunity for individuals to take advantage of the current exemptions. There are strategies that can be employed to maximize use of the exemption in 2021 and preserve its advantages in future years.
Make Large Gifts
High-net-worth individuals ($30 million and above in most cases) may consider making large gifts that utilize their lifetime gift exemption. Such gifting may require creating new trusts, transferring assets, and—in some cases—appraising assets such as real estate or business interests. These activities take time, so individuals who are considering large gifts should begin the process now before any changes occur.
There are two primary gift strategies that facilitate life insurance planning—prefunding life insurance trusts and making additional gifts to existing trusts.
Pre-fund life insurance trusts.
A large gift can be made into an insurance trust today to pay premiums in the future. This action ensures that even in the event of changes to the tax law, the gift has been made and the funds are available.
Example: Client could purchase a $10 million life insurance policy with annual premiums of $100,000, payable for 30 years. To lock in the current gift exemption, the client can make a lump sum gift to an irrevocable life insurance trust in early 2021. Factoring in the discount for investment earnings, a gift of $2 million could be used to make all premium payments for the duration of the policy.
When funding insurance policy premiums upfront, planners should be aware of the modified endowment contract (MEC) rules. If a life insurance policy is funded with a large single premium, it will become a MEC. Lifetime distributions from the policy will be taxable if the policy has any built-in gain, which is a significant disadvantage.
To avoid MEC status, large gifts should be made to the trust rather than directly to the policy. Each year, the trust can pay the premiums from its invested assets. This strategy not only reduces tax liability—it also allows the policy beneficiaries to retain more funds in the event of an insured’s unexpected early death.
Example: Client has an insurance policy with a $10 million death benefit, with premiums of $100,000 per year. Assume the premiums are prepaid in one advance lump sum by the insurance trust to the insurance company; in this case, assume a gift of $2 million could prepay the insurance premiums. If the client dies unexpectedly in year 2, the beneficiaries will get the death benefit of $10 million.
If, however, the trust had retained the lump sum amount, distributed as a gift to the trust under the gift tax exemption, it could instead pay the premium of $100,000 each year. If Client dies unexpectedly in year 2, the trust would have only paid $200,000 to the insurance company instead of $2 million. The trust would retain $1.8 million and the beneficiaries would also receive the $10 million death benefit—the trust would have a total of $11.8 million.
Review funding of existing policies.
Interest-sensitive policies, such as universal and whole-life policies, may currently be underfunded due to low interest rates. Low interest rates have resulted in decreased interest crediting rates for universal life policies and lower dividends for whole life policies. Further decreases in interest crediting rates and dividends are expected over the next two years.
Therefore, it is important to obtain updated in-force illustrations of these policies to see if they are adequately funded. Inadequate funding is a common problem, but the dramatic recent reduction in interest rates has amplified this issue considerably.
Example. Client is a 67-year-old male who has a $5 million face amount universal life policy that was purchased 20 years ago. The current annual premium for the policy is $50,000.
An updated in force illustration shows that, based on current interest and mortality rates, the policy will lapse at age 79. If a policy is under-funded, the insured can choose one of several possible solutions:
- Increase the premium payments by making additional gifts to the trust in early 2021 (this is usually the most attractive option)
- Lower the policy’s death benefit (if Client’s budget is limited)
- Consider replacing the policy with a new policy if better pricing is available. (This may be more difficult due to low interest rates.)
Making additional gifts to an existing life insurance trust.
The most straightforward option for additional gifting to a life insurance trust is a lump sum gift that uses the $11.7 million gift exemption in 2021.
Another option is to create a Grantor Retained Annuity Trust (GRAT) and name the insurance trust as a remainder beneficiary. GRATs typically have a short duration of two to ten years. When the GRAT terminates, the life insurance trust, as remainder beneficiary, will receive the assets from the GRAT. The GRAT would be created in early 2021 to take advantage of the current large gift exemption: GRATs are another planning tool that might be constrained or eliminated by tax law changes in 2021.
Taking Advantage of Low Interest Rates
Interest rates are at historically low levels: the IRS 7520 rate, which is used for certain estate planning techniques, was at 0.6% as of January 2021. In a low-interest environment, split-dollar loan and premium financing strategies are advantageous and should be considered:
Private split dollar loan.
In a private split-dollar loan arrangement, the insured lends money to the insurance trust. The loan is set up as a long-term note at the applicable federal rate (currently 1.35%), and each year, the trust pays interest to the insured.
The trust uses some combination of the loan principal and the interest earned on the loan to purchase life insurance. Assuming the trust can earn more than the loan interest rate, the excess earnings can be invested and used to repay the loan in the future.
Premium financing.
Under a premium financing arrangement, a bank lends money to a client’s insurance trust each year. The trust uses the loan to buy life insurance, and the insured makes gifts to the trust to pay interest on the loan. A whole life policy that accumulates substantial cash value can provide some or all of the funds to repay the loan in the future.
Impact of the COVID-19 Pandemic
Life insurance companies have faced increased mortality claims during the COVID-19 pandemic. But lower interest rates have had a much greater impact on life insurance companies than the increased mortality claims. Lower interest rates cause lower investment earnings on an insurance company’s portfolio, which is typically composed of 60%–70% government and corporate bonds. When interest rates on new bonds are reduced, insurers have lower income but still retain the liability of guaranteed interest rates of 4% or higher on existing life insurance and annuity policies. The Consolidated Appropriations Act of 2021 has provided important relief for life insurance companies by lowering the required minimum guaranteed interest for whole life insurance policies from 4% to 2% in 2021 (Division EE, Section 205). The act also amended other interest provisions in IRC section 7702. These provisions will favorably impact funding of whole life and universal life policies.
Low interest rates create significant strain on the financial strength of an insurance company, which is the most important factor an individual should consider when choosing an insurer. Advisors play an important role in knowing and evaluating the current financial strength of these companies. The most reliable indicator of a company’s financial strength are the ratings it receives from the four major rating agencies: AM Best, Fitch, Moody’s, and Standard & Poor’s. A useful measure of the company’s strength is its composite Comdex score. The highest possible score is 100; the author recommends that advisors look for companies with a score of 90 or higher. The Comdex score is not a substitute for looking at the individual ratings, but it is a helpful screening tool.
Act Quickly
Although one can’t know for certain how the tax landscape may change in 2021, advisors and their clients should closely evaluate current opportunities. Taking swift action in 2021 could allow individuals to maximize these benefits while they are still available.
