Term Life Insurance Opportunities in Estate Planning

Life insurance is frequently used in estate planning for liquidity. When estate tax is due, the insurance proceeds provide the cash to pay the tax. This means the heirs don't have to sell illiquid assets or tap a retirement plan to come up with the tax money.

Critical: To prevent the insurance from creating estate tax itself, it is essential to hold the policy in an irrevocable life insurance trust or have a third party (children) buy the policy. That way the proceeds will be free of estate and income tax.

Short-term Insurance
Typically, estate planning calls for permanent (cash value) life insurance because this is a need that won't disappear. However, in some short- and medium-term situations inexpensive term insurance makes sense.

Example: Gift tax restoration. Jean Walker, 74, makes a $2 million gift to her children. Because Jean already has used up her exemption amount she pays a $1.1 million (55%) gift tax. Trap: If Jean dies within three years, the $1.1 million paid in gift tax will be included in her taxable estate. At a 55% rate, her estate would owe another $605,000 in estate tax.

Solution: Jean buys a three-year $605,000 term policy. If she dies within this period, the death benefit will cover the extra estate tax obligation. After three years, the threat will vanish and the policy can lapse.

Cost: Assuming she is in good health, Jean will pay around $30,000 in premiums over three years, 5% of the insurance she's buying. Generally, younger people will pay less as a percentage of insurance coverage, while older people will pay more.

Key: In some situations, not only the amount of the gift tax but the gift itself will be subject to estate tax if the donor dies within three years. Example: Gifts of life insurance policies. In such cases, term insurance can provide valuable coverage.

Trust Reversions
In some types of trusts, tax benefits will be lost if the grantor doesn't live out the term.

Example: Betty Porter, age 75 owns a house worth $400,000. She transfers it to a qualified personal residence trust (QPRT) with a 10 year term, naming her children as trust beneficiaries. Betty can stay in the house for 10 years, after which the children will become the owners.

With current interest rates, the present value of a $400,000 gift in 10 years is now about $220,00. Moreover, IRS actuarial tables state that Betty has only a 49% chance of surviving for 10 years. Strategy: Betty adds a "reversion" feature to the QPRT, providing the the house will go back into her taxable estate if she fails to live out the term. Because of this reversion provision, the value of the gift made through the QPRT ($220,000) is multiplied by the 49% probability factor, further reducing the value of the taxable gift to about $108,000.

Loophole: Now a $400,00 house, plus any future appreciation, is out of Betty's estate while she has incurred a taxable gift of only $108,000 (and used $108,000 of her lifetime gift/estate tax exemption). Over the 10-year term the house might appreciate 50% to $600,000.

Trap: If Betty dies within the l0- year term, the house perhaps worth $600,000--will be returned to her taxable estate. Even though the $108,000 portion of her lifetime exemption will be restored, her estate will be increased by $600,000 and the estate tax bill might jump by more than $250,000.

Solution: Betty can buy a 10-year $250,000 term Life insurance policy to cover her estate.

GRAT Solution
The same principles that applies to QPRTs also apply to grantor retained annuity trusts (GRATs). These trusts pay an annuity to the grantor during the trust term, after which the assets go to the trust beneficiary. Again, the tax benefit: may be lost if the grantor dies before the term ends.

Example: John Jones, the sole owner of ABC, an S corporation, gives $1 million worth of his shares to a 15-year GRAT, of which his son Henry is the beneficiary. Five years later, ABC goes public and the value of the shares in the GRAT appreciates to $5 million.

Now, if John dies during the trust term, his taxable estate will be increased by $5 million and the estate tax bill will rise by more than $2.5 million.

Strategy: John insures his life for $2.5 million, using a 10-year term policy to match the remaining term of the trust.

Installment Sale Acceleration
Suppose George Smith sells an apartment building he owns to his daughter Diane for $3 million. Payments are to be spread over six years, with most of the money for the purchase coming from the building's cash flow.

Trap: If George dies before the six years are up, the note that he holds will be included in his taxable estate. The amount of the unpaid principal will be subject to estate tax.

Example: If three of the six payments are outstanding at the time of George's death, the unpaid principal on the note will be $1.5 million, resulting in extra estate tax up to $825,000.

Strategy: George might take out a six-year policy when he sells Diane the building. The policy could start out with a death benefit equal to the estate tax obligation that would arise if George were to die immediately. Each year, after another installment payment is made, the amount of the coverage can be cut down, reducing the premiums to be paid.

Tactic: Work with a savvy insurance professional to see if you're better off with the type of insurance described above or a "declining benefit" term policy.

Choice of Coverage
When you buy term insurance you can choose between level- premium policies and annual renewable term (ART), where the premiums increase as you grow older.

• Level-premium term is extremely inexpensive for policies lasting 10 years and up.
• For policies under five years, ART likely will be the better choice.
• In the five- to 10-year range, compare level-premium and ART quotes before deciding.

Good news: Term insurance is widely available to healthy applicants at reasonable prices, even if you're in your 70s or 80s. In one recent case, a 92-year-old woman was able to buy a two-year policy to cover a gift tax obligation. In all likelihood, you'll find a term policy that meets your needs.