How a life insurance strategy could save some wealthy estates millions

With current estate-tax rules set to expire at the end of next year, life insurance could help heirs to some high net worth clients avoid bigger costs and payments to Uncle Sam in the future.

Purchasing a "whole-life" or "permanent" policy rather than one that runs for a defined term carries much higher premiums — but those and other fees paid by high net worth clients for the insurance product now will go toward tax advantages for their estates' inheriting beneficiaries down the line. 

As financial advisors, tax professionals and their clients try to make sense of a plethora of questions about the future guidelines looming after many provisions of the 2017 Tax Cuts and Jobs Act expire in 2026, life insurance strategies may play a critical role for wealthy estates.

Many registered investment advisory firms are "allergic to life insurance" as a concept, and it's certainly not "the wrench that fits every nut," Jack Elder, the senior vice president of advanced sales with Shakopee, Minnesota-based CBS Brokerage, said in an interview. Regardless, clients will likely hear about the potential tax-planning opportunities of buying life insurance from friends, acquaintances or the inevitable sales agent. And locking in the tax rewards now can bring some relief as life-insurance planning frequently comes up in policy proposals aimed at raising the duties paid by wealthy households by closing the loopholes in the code.

"Your clients are going to be approached, so the conversation should start with you," Elder said. "Somebody's going to talk to them about life insurance, so it should come from you."

READ MORE: With Congress slow to act, financial advisors plan ahead on estate taxes

The case for a wealthy client to buy a whole-life policy and hold the contract in a vehicle such as an irrevocable life insurance trust revolves around the fact that, under the current rules, the asset no longer applies to the value of the estate. If they can afford the premiums, then the clients' heirs will collect the death benefit tax-free in most cases to provide them with liquidity for expenses and give the accompanying cash value of the policy more time to accumulate. 

In a very critical article last year describing whole life policies as often being "sold inappropriately" and "poorly designed for their use," and pointing out that "you get the cash value or the death benefit, but not both," the personal finance website for doctors The White Coat Investor nonetheless cited liquidity and tax strategy as a "pro" in the products' favor.

"An irrevocable trust is a great way to avoid estate taxes," the website's founder, Dr. James Dahle wrote. "By placing an asset into an irrevocable trust, any appreciation after that point occurs outside of the estate. However, trust tax rates are notoriously high, and trust tax returns can be complicated and expensive. What if you could put an asset into the trust that grows in a tax-deferred way until death and then provides an income tax-free lump sum? Voila, a whole life policy can do that."

A strategic gift to heirs using life insurance could reduce the estate's value for tax purposes and boost the amount that beneficiaries will receive upon a wealthy client's death by millions of dollars, according to two illustrations that Elder shares with clients. In one example, a couple living in Washington state who are both 66 years old with an estimated longevity of 20 more years and a current net worth of $12 million will have projected wealth of $34.9 million two decades in the future. If they plan for an estate tax of $10.3 million at that time, they could spend $2.8 million on life insurance held in a trust today rather than spending the much higher amount in the future.

READ MORE: Supreme Court case tests how life insurance affects estate-tax valuations

In Elder's other illustrative example, a couple who are 63 and 64 years old have an estimated net worth of $15.2 million. If they buy a life insurance policy that costs $2 million rather than transferring that directly to an heir, they not only avoid the gift tax, but they could instead pass down $8 million from the proceeds of the death benefits and slash the percentage of their estate that's taxed at that time by hundreds of basis points while hiking up the heirs' inheritances by $4.6 million.

"Strategic gifts before 2026 can save your family millions of dollars in estate taxes," the case study said. "Those who don't proactively use the exemption risk losing the opportunity to shelter their wealth from estate taxes. Life insurance coupled with strategic gifting can reduce estate taxes and substantially increase your net to heirs."

Elder's examples display some of the complexities involved with every individual client. Other complications include the fact that 17 states and the District of Columbia charge their own estate or inheritance taxes. The technical details around the ownership of the policy and a status called the "incidents of ownership," as well as the date of the death, could also affect whether the proceeds of the death benefits wind up adding to the value of the estate, according to a guide to life insurance written by Trusts and Estates Attorney Jennifer Boyer of the Ward and Smith law firm. (The impact of life-insurance death benefits on estate valuations came up in a recent Supreme Court case.)

"While that taxable estate threshold remains high today ($12,920,000 per person for tax year 2023), it looks fairly certain to dip lower in the coming years," Boyer wrote. "Without legislative action, in 2026, anyone with more than roughly $6,000,000 (or $12,000,000 for a married couple with appropriate estate tax planning built into their wills) will find themselves on the undesirable side of that taxable threshold. Insurance policy payouts that seemed perfectly reasonable under our currently-high estate tax thresholds may now push taxpayers over the lower limits set to take effect in 2026. If alternative ownership can be arranged, for instance, by using irrevocable trusts, limited partnerships, limited liability companies or direct ownership by children, taxpayers can realize dramatic estate tax savings."

READ MORE: 26 tips on expiring Tax Cuts and Jobs Act provisions to review before 2026

In other words, any advisors and clients considering the strategy must look closely at the details of their particular estate and any potential policy before making such a costly purchase. Elder and CBS Brokerage advisors use his examples as "a conversation starter" with their clients rather than a method to use in every situation, he noted.

"The responsibility of an RIA is to expose the clients to all of the solutions and tools that can be used to efficiently transfer wealth and then let the clients decide," Elder said.