Life Insurance: The Only Guaranteed Key to Success in Wealth Transfer Tax Planning

Now more than ever, financial planning requires knowledge and imagination.  Nowhere is this truer than in wealth transfer planning.  A wide variety of tools, some very complex, have emerged in recent years: FLPs, GRITs, GRATs, GRUTs, CRUTs, NIM-CRUTs, among others.  Planners must understand and use these techniques if they are to serve their wealthy clients adequately, let alone if they hope to acquire new ones.  Yet no matter how sophisticated the planner and the tools, the simple fact remains that there is only one asset that guarantees success in wealth transfer tax planning: life insurance.

Can you explain to a client how life insurance can serve his or her wealth transfer tax planning needs and go from there to make a sale?

Wealth Transfer 101: The Importance of Being Post-Gift

Imagine that you’re speaking to a client whom we’ll call Mr. Garcia.  His net worth is $10 million, and he’s been reading up on estate planning.  During your fact finding you’ve learned that he is receptive to transferring up to $1 million to heirs.  The question is: What’s the best asset to effect this transfer?  Your primary job at this point is client education.  To make the right choice, Mr. Garcia needs to understand the mechanics of the wealth transfer tax system.

Wealth transfer tax planning has a simple goal: to minimize or eliminate transfer taxes, i.e. the gift tax, the estate tax, and the generation-skipping transfer (GST) tax. The planner’s tools are the exemptions and exclusions and the opportunity to leverage them:

·         The gift tax is subject to an exemption of $11,000 per year per donee (as indexed) [I.R.C. Section 2503], up to a lifetime exclusion of $1 million for the donor;

·         The estate and GST tax are subject to an exemption of $1.5 million in 2004 and 2005, increasing to $3.5 million in 2009;

A central point should be explained first, since Mr. Garcia is almost certainly unaware of it. This is the importance of using an inter-vivos (life-time) transfer rather than a testamentary (death-time) transfer.  Let’s assume that the transfer vehicle of choice among sophisticated planners, an irrevocable trust, will be employed.  An inter vivos transfer to the trust means that any post-gift appreciation of the transferred assets will be excluded from the gross estate and thus avoid estate and GST taxes, just as the assets themselves are.  Since a testamentary trust does not take effect until the death of the testator, any appreciation between today and Mr. Garcia’s death will not be excluded from estate or GST taxation.  This is crucial because appreciation of Mr. Garcia’s gifted assets will be central to his transfer objective.

How then to maximize Mr. Garcia’s exemptions and exclusions?  The previous paragraph suggests that the best method is to leverage the post-gift appreciation of the transferred assets.  That means the best asset is the one that will appreciate the most .  Which asset offers the most bang for the buck?

It’s easy to show that life insurance has the advantage here.  Would Mr. Garcia like to see his $1 million appreciate to $5 million?  In a rising market and economy, securities and other investment assets such as real estate will likely appreciate.  But there’s no assurance that they will appreciate fast enough.  Suppose that an investment portfolio yields an annual return of 8%. Then, if Mr. Garcia were to fund an irrevocable trust today with $1 million worth of portfolio assets, they would take more than 20 years to appreciate to $5 million. By contrast, if the trust were to purchase a policy on Mr. Garcia’s life with a $5 million death benefit, the full leverage would obtain from the moment of the transfer.  Life insurance wins from this point of view.

Wealth Transfer 102: Why Do You Think They Call It “Insurance”?

Looked at from another angle, the same example proves the larger point that gives this article its title: life insurance is the only asset that guarantees success in leveraging the transfer tax exclusions and exemptions. In this regard, the investment portfolio can’t guarantee success.  Nobody can guarantee that if Mr. Garcia transferred the investment portfolio to his irrevocable trust today, he would live until 2024, the 20 years necessary for the portfolio to appreciate to $5 million in our hypothetical example.  Yet a properly structured life insurance policy will deliver a $5 million death benefit from the moment it became effective.  Mr. Garcia has “locked in” to success in wealth transfer tax planning.  He could die the next day knowing for sure that he eliminated estate and GST taxes on a highly leveraged transfer.  Life insurance is the only asset that can offer this result because it is the only asset whose leverage is effective as soon as it comes into being.  

(Note that the transaction must be structured to avoid the three-year rule of I.R.C. §2035, which takes life insurance proceeds back into the gross estate if the policy was transferred within three years of death.  In this example, that is done by transferring cash to the trust and having the trustee buy the policy.  For further discussion see Section 2, Subdivision B of this Service, “Transfers within 3 Years of Death”)


Service, not sales, is the planner’s reason for being, but when service creates a sales opportunity, so much the better. Effective wealth transfer tax planning is a perfect example, since there is only one way to guarantee success.


Current Comment 04-03, GST Tax Planning: A Powerful Prospecting Tool

Current Comment 03-11, Insurance-Funded Irrevocable Trusts: A Hedge Against Estate Tax Uncertainty

Section 2.1, Subdivision C, The Insurance Funded Family Bank

Section 59, Subdivision G, The Del Boca Vista Widow

(Posted 08/12/2004)

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