Large Estates Need the Liquidity That Life Insurance Can Provide
It has long been known that life insurance is a valuable tool in estate planning. For every person who has accumulated or inherited a substantial estate, there is the inevitable discussion about dealing with the estate tax issue. It is very real to those who have accumulated estates of $10 million or more, and the tax can be a deal destroyer if not dealt with. That is why many planners will utilize any and all available strategies to avoid paying high taxes. But ultimately, there must be a plan to pay the tax that must be paid.
The first choices really have to do with how much tax will need to be paid. And, given enough time, the client can utilize a number of tools, which will lessen the impact of required taxes. Additionally, there are also the issues of which heir gets what asset. For example, if a client has four children and only one of them in actively involved in the family business which is private, it will be difficult for the inactive children to see eye to eye with their sibling who is attempting to maintain and grow the business.
Inevitably, these issues can and do cause procrastination and indecision. A good friend of mine with whom I work calls the process “herding cats” and that description is pretty close to what is experienced when going through an engagement of this type. Many times, the client is so confused by the process that they throw up their hands when considering the strategies that can be used to reduce their exposure.
Enter the use of life insurance to provide liquidity.
A fairly simple solution to the wealth client’s estate tax problem is to purchase a large enough policy so that it will provide the necessary liquidity to pay the estate tax bill. This will allow for the maintenance of the current assets without having to liquidate them, and do so in a tax efficient manner. Life insurance placed in a grantor trust can be one of the most effective tools to provide the needed liquidity to the wealthy client.
The benefit of a grantor trust is simple.
All of the assets inside the trust are outside the estate tax system for the beneficiaries and the grantor. By using a trust, clients can do something for their children (as the grantor) they cannot do for themselves. They can help remove family heirlooms (their most precious assets) from the tax system for multiple generations. A trust also enables them to protect these assets from creditors and divorce.
In addition to those benefits, the grantor trust can be the owner and beneficiary of life insurance which will be kept out of the taxable estate of the client, but available to the estate for the payment of taxes.
Money is never worth more than the wage it can earn.
What we are really talking about is the cost of liquidity, which is expensive. There is an opportunity cost associated with liquidity. The investor must forego growth and income in order to obtain liquidity. This is because the money is not being used at its highest and best use.
One dollar of liquidity obtained from the liquidation of a family heirloom can cost $2 or more, depending on timing and investment assumptions. So, not only is it expensive to convert a dollar to cash; there is also the prospect of losing the heirloom for posterity. A dollar of life insurance will almost never cost more than 75 cents, even if you assume death at life expectancy or beyond. In many cases, that same dollar could be delivered for significantly less.
So, whose money is less expensive to deliver? Even if you engage the client’s advisors in this discussion, you still have to answer the question, Why life insurance? Life insurance always has been about need. People don’t object to owning life insurance; they just don’t want to pay for it. In the uber market the same is true. The needs are there. But, unless clients can see the economic advantages of owning a policy, they are likely to take a pass.
So why would the ultra-wealthy want life insurance? Consider the following reasons:
- To provide cash at a lower cost than is possible through borrowing or liquidation. Remember, life insurance is the delivery of money in the future at a discounted cost based on the internal earnings, less the expenses. There is no magic here. It is only a matter of risk.
- To move assets from the client’s estate to heirs at the low tax cost. Gifts of premiums are less expensive than gifts of assets, especially appreciated assets.
- To provide liquidity to pay debts or taxes. Providing an automatic repayment plan using insurance is often more advantageous than liquidating assets to pay off the debt.