Author: Edison Risk

Undoubtedly, there are clients with enough assets to pay for care should they need it later in life. That said, this may be one of those instances where just because you can, doesn’t mean you should. More often than not the decision to self-fund is due, at least in part, to not wanting to think about the possibility of needing care. It also completely omits the planning component by focusing strictly on the funding.

In terms of funding, simply transferring this risk to an insurance company is going to provide a significant discount. What is often not factored into the decision to self-fund, however, is the impact of taxes. Unless paying with cash from a checking account that doesn’t accumulate interest, every time the client liquidates an asset to pay for their care, they are creating a taxable event. At either capital gains or ordinary income rates, the tax burden this creates can grow quickly.

There are additional factors that can make this a more significant problem:

• The majority of Americans’ wealth is tied up in their qualified plan assets. Withdrawals from these accounts to pay for care are 100% taxable at the prevailing ordinary income rates at both the state and federal level.
• Consumers holding annuity assets often have these “earmarked” as the asset they will use to pay for care. The last in, first out tax treatment of these assets again results in a 100% taxable amount at ordinary income rates until such time as all gains are exhausted.
• The resulting increased income can also push the client into a higher tax bracket

Some might think that the taxes can be offset by deducting the cost of care. Maybe, but maybe not. There are two complicating factors here:

• Not all costs are deductible. Only the actual cost of care. In the case of an assisted living facility, that can exclude rent, as an example, which is the majority of the actual cost. If full time memory care is needed, then all costs, including things like rent, may be deductible.
• Even if the cost is fully deductible, there is the 7.5% of AGI threshold that needs to be met before any deductions can be taken. This also assumes the client is itemizing, and for the high net worth that is likely the case. For those of more modest net worth and a simpler financial life, the current standard deduction is high enough that they may not itemize their deductions.

So, what’s the moral of the story? Self-funding only makes sense if the real cost of the approach is superior to an insured solution. That determination needs to include all contributing factors to the cost of both self-funding and an insurance solution. Fortunately, there are ways to mitigate the taxes that may be triggered by either approach. In the case of an insurance solution, things like the Pension Protection Act and case designs with extended premium payment durations can be used to minimize or even eliminate taxes at the time of purchase. In the case of self-funding, finding loss harvesting and other strategies can reduce the net taxes due.

The crux of the matter is asking a very simple question of those who plan to self-fund: Have you thought about which assets you will use to fund care, and did you consider the tax ramifications of your strategy? The subsequent conversation may point to an insurance solution more often than you think.

Two factors, one already in place, the other on the horizon, will combine to erode assets left to IRA beneficiaries at an unprecedented rate. This “one-two punch” can be avoided with a straightforward planning approach designed to minimize the tax by shielding IRA assets from taxation.

Most are well aware of the massive amount of wealth held in retirement accounts. What may not be as well known outside the financial planning community is how significantly those assets will be eroded as they pass to the next generation. Simply considering the income tax implications points to the SECURE Act of 2019 as an accelerant of sorts. Most IRA beneficiaries no longer have the ability to “stretch” the distribution of the inherited IRA over their lifetime. Instead, the IRA has to be distributed over a ten-year period.

The second element of this planning challenge is on the horizon: The sunset of the Tax Cuts and Jobs Act (TCJA) at the end of 2025. While much of the discussion of the sunset focuses on changes to estate tax laws, for IRA beneficiaries the changes to income tax rates may be more important. Why? Just as they are being forced to take large, taxable distributions form their inherited IRA, the rate at which those distributions are taxed is due to increase when the TCJA sunsets.

This has major implications for both those who are in the ten-year distribution phase as well as those anticipating inheriting an IRA.

For those already in the process of distributing an inherited IRA, a quick look at the potential increase in income tax rates based on the TCJA sunset as shown in Table 1 indicates an increase of anywhere from 0% to 4% in marginal tax rates for taxpayers filing jointly as rates revert to 2017 levels. Depending on the rest of the client’s income tax planning, it may make sense to accelerate distributions of the IRA prior to the TCJA sunset to avoid these higher rates.

Those anticipating an IRA inheritance, further accelerating those distributions likely doesn’t help, as it would have to be on such a short timeline that the increased would undoubtedly result in the client jumping up to a higher income tax bracket. For these clients, the panning work has to happen before the inheritance is received.

In this case, the fact that approximately 36% of retirees who withdrew funds from a traditional IRA in 2021 used the money to reinvest or save. The likely cause of these distributions is undoubtedly Required Minimum Distributions that force the IRA owner to liquidate a portion of their IRA each year once they reach a certain age. The question for this discussion is what are these clients doing with the money? Where are they investing it?  From the perspective of the beneficiary anticipating receiving the IRA as an inheritance or the IRA owner concerned about so much of their hard-earned money being lost to taxes, a life insurance policy may be the best vehicle for a few simple reasons:

• Each premium dollar is immediately leveraged, increasing the amount that passes to the next generation.
• Life insurance proceeds pass income tax free and there are no rules around distributions once received
• Life insurance proceeds can also pass estate tax free with proper planning

In short, transforming the tax in efficient IRA into a tax efficient life insurance strategy can avoid the tax double whammy created by the SECURE Act and TCJA sunset by reducing the amount subject to taxation. This tried-and-true planning strategy is more relevant than ever given both current law and the apparent inability of Congress to pass meaningful legislation over the recent past.

1 https://www.wsj.com/articles/retirement-required-minimum-distributions-tips-11668797319 What to Know About RMDs and Retirement Planning, Nov. 27, 2022.

Best practices exist for a reason, as do products that may cost a bit more but offer superior value. In this real-life example, an insurance solution that is built for the business market would have streamlined a key component of buy/sell agreement management that could have prevented multiple days in tax and appeals court.

It comes as a surprise to no one that insurance assets need to be reviewed periodically. What may be a surprise is how significant a problem could result if you don’t. Case in point? 2023’s Connelly decision. The details of the case are worth understanding (Follow this link for more on the case), but there’s one element of the decision that is particularly important for anyone working with business owners: The court affirmed the IRS’s position that the proceeds of a life insurance policy that funded a buy/sell agreement were includable in the value of the business, rather than offset by the obligation of the business to redeem the deceased owner’s shares under the terms of their Buy/Sell agreement. This increase in the value of the business led to a $1MM increase in estate taxes.

While there are multiple issues involved, the most fundamental called out by the court in their decision focused on the business not following the terms of the buy/sell agreement. Specifically, the agreement called for a “Certificate of Agreed Value” that set the price of the business by mutual agreement on annual basis. Failing that, the agreement called for two or more appraisals to determine the fair market value of the business. Neither of these were done.

After the owner’s death, they parties involved agreed on a value, executed the sale, and proceeded to file the necessary estate tax return. The audit of the return uncovered the lack of compliance with the terms of the buy/sell agreement, resulting in the inclusion of the proceeds of the life insurance in the value of the business and the increased estate tax. The Connelly decision may not be the last word on this, as the Connelly family appealed, and the Supreme Court has agreed to take up the case.

In this case, the amount of life insurance, $3.5MM, was relatively close to the agreed upon value of $3.89MM the family used. This is rather surprising given that the buy/sell agreement was put in place in 2001 and the owner passed in 2013. Their problem would have been far worse if the policy were for significantly less than the deceased owner’s share of the business. The estate tax implications likely would not have changed, but their ability to execute the sale would have been severely compromised. This is where the danger of “outgrowing your business insurance” comes into play.

These business owners are undoubtedly not unique in their lack of periodic review of their buy/sell agreement, the value of the business and any related insurance policies. To make matters worse, there are both insurance solutions and valuation services available that can make that process as painless as possible. All it takes is using an insurance provider that offers products built for this specific purpose, not only insuring the value of the business today, but having a built-in mechanism for both periodic review and commensurate increases in coverage as the business grows.

The first step is to set the value of the business with a formal valuation. This is followed by implementing the funding with life insurance. In each subsequent year, the business owners execute the increase option, including a renewed formal valuation every third year. See Table 1, below, for a description of how this could play out.

The insurance company offering this product will do the valuation at no cost. The end result is a product and process that prevents the fact pattern of the Connelly case from occurring while ensuring the adequate funding of the buy/sell agreement. In short, preventing the business from outgrowing their insurance.

Splitting the Proceeds of a 1035 Exchange Unlocks Planning Opportunities

We’ve seen strategies for utilizing accumulation-focused insurance policies that have grown significant cash value become an effective repositioning strategy. The result is an updated insurance position that reflects the client’s current needs and leverages today’s modern products.

True insurance planning is far more nuanced than finding the best underwriting offer or the best price. It involves a perspective beyond a simple needs analysis. It requires understanding how insurance needs change over time and how to best manage a policy or portfolio of policies to deliver the most effective risk management strategies to the client. Today, that means insuring against risks beyond survivor income or estate tax liquidity, with the cost of Long-Term Care as the most significant threat to a successful retirement or a source of estate erosion, reducing the legacy left to loved ones.

That statement comes as no surprise to anyone paying attention to developments on multiple fronts in our industry. That said, simply stacking a new Long-Term Care Insurance policy on top of the client’s other insurance assets may not be the answer, particularly if there are existing insurance policies that may no longer match the needs of the client. More specifically, a personally owned life policy that was a great accumulator of cash but is now under-leveraged and lacks the modern features available from today’s insurance products represents a funding source for an updated insurance strategy. The challenge is how to reposition the policy’s cash values efficiently and for maximum benefit.

Those two outcomes, efficiency and maximum benefit, can seem to be competing intentions at times. An efficient update will minimize costs, both in terms of premium outlay as well as taxation. That typically means a 1035 exchange. That immediately limits product choice to single life products on the same insured. Splitting that exchange to fund multiple policies, perhaps one focused on legacy and another on Long-Term Care, can offer superior benefits, but they remain limited to a single insured. The “Goldilocks” approach, however, still utilizes a 1035 exchange, but follows that with a second transaction. One that funds a similar strategy on the other spouse.

That second transaction, a policy loan, allows for the cash-rich source policy to fund an updated strategy for the second spouse that mirrors the one put in place for the original insured. On the surface, this would seem to create a significant risk in the form of the policy loan that could hamper long-term policy performance. That particular issue is addressed by a planned repayment of the loan via a withdrawal. The end result is two policies, one on each insured, that provide both death benefit intended for their heirs as well as a ready source of funds should the need for Long-Term Care arise.

Consider the following fact pattern:

• A 65-year-old couple
• The husband has permanent life insurance with $400K in surrender value
• The wife has no permanent life insurance

The typical solution would involve a 1035 Exchange to a new policy on the husband’s life that includes Long-Term Care or Chronic Illness Benefits. The client would then fund a separate Long-Term Care strategy for the wife, paid for out of other assets. Alternatively, they could surrender the existing policy, pay any taxes due, and then fund a policy on both husband and wife.

In this case, however, a more effective solution may be available that begins with a 1035 exchange as discussed above, but rather than using other assets to fund a new policy on the wife, the existing cash surrender value on the new policy is used as the source of funds via a policy loan. Figure 1, Funding Two Policies from a Single Exchange, shows the flow of funds, including a critical component: The rapid repayment of the policy loan.

In this case, the loan repayment comes from the husband’s new policy itself. Utilizing the carrier’s ability to take a withdrawal, not to exceed cost basis, that is then used to repay the outstanding loan on the policy, effectively eliminates one of the potential downfalls of the strategy: The long-term health of the policy being compromised by a growing loan balance.

If we revisit our objective of minimizing costs and providing maximum benefits, the approach certainly meets the mark. In summary:

Existing Coverage:

• Total Life Coverage: $700K
• Total Living Benefits: $0
• Lives Covered: 1
• Account Value: $400K

Updated Coverage:

• Total Life Coverage: $744K
• Total Living Benefits: $349K
• Lives Covered: 2
• Yr 1 Account Value: $320,631
• Yr 2 Combined Account Value: $291,228
• Additional Outlay: $0

Admittedly, the account values are lower immediately after this transaction is executed. That said, based on current crediting rates, the combined account value exceeds $400K by policy year ten and continues to grow plus the loan balance is zero beginning in year two. In addition, there is no additional out of pocket for the client, zero taxes due, and a significant upgrade to the coverage is achieved by the addition of living benefits. In an environment where most clients are concerned on some level about the economy, finding creative ways to fund planning objectives is critical. This approach is perfectly suited to today’s economy and truly does deliver more value than a single life solution without living benefits.

With the cost of capital increasing dramatically as interest rates have risen, many commercial loans now have terms that are far less favorable, if not punitive. Fortunately, clients with life insurance assets have access to a “refinancing” strategy that can provide relief from higher rates in the near term and a long-term management plan.

With the current higher interest rate environment appearing to be more than a short-term phenomenon, clients with significant commercial loans are seeking relief from the interest burden they now bear. While shopping for a more favorable rate can certainly help, the reality is that today’s rates are so much higher than when many existing loans were originated, a slightly lower rate provides remains far in excess of the original loan terms.

Paying down these loan balances would certainly provide the interest rate relief clients are seeking, but these loans are often used to fund business expansion or other planning objectives that remain important to the client. Attempting to unwind a strategy designed to capitalize on a business opportunity to pay back a loan will often simply trade one pain for another: The pain of higher rates for the pain of missing out on the business opportunity they were pursuing. Some clients, however, may already own an asset that is perfectly suited to “refinancing” these loans at terms that are far more favorable than even the most well-qualified client can find in the market.

The asset? Cash value life insurance. In fact, this very same life insurance policy may have been the actual collateral used to secure the commercial loan in the first place. The available interest rates were far lower than those available on loans from some insurance policies. As rates have risen, however, the best use of the policy cash value may no longer be as collateral. It may be paying off the bank loan. There are two variables that have to be considered when considering the loan repayment:

Is the loan interest rate in the life policy more favorable than the bank loan? Even as bank loan rates have risen, they may remain lower than the rate available on the policy loan. The net cost of the policy loan, however, is likely to be lower based on the policy also receiving some sort of credit on the loan balance.
What’s the long-term performance impact of the policy loan? Larger loan balances can seriously impair the future performance of the policy.

For some, the answers to these questions will be favorable and a loan from the policy is a clearly superior option when compared to the terms now available from the bank. Unfortunately, that will not always be the case. Whole Life policies in particular frequently have much higher loan interest rates and large loan balances create a drag on policy performance that results in a risk of lapse in the future.

There is, fortunately, a potential remedy to the scenario described above. That remedy involves sourcing a new life insurance policy, funded by a 1035 exchange, that offers the low loan interest rate we are seeking and a strategy for maintaining long-term policy performance. In some instances, the client can extinguish the loan balance without having to pay out of pocket, leaving them out from under the bank loan they are currently struggling with and with an adequately funded policy.

To execute this strategy, there is a proper order of operations, so to speak, that needs to be followed if the life policy was, in fact, used as collateral for the bank loan. Trying to execute a 1035 exchange with the existing policy encumbered by a collateral assignment will typically not work. Instead, the following steps need to be followed:

1. Take a loan from the existing policy first. That loan is used to bay off the bank loan, allowing the bank to release their interest in the policy.
2. Once that is complete, a 1035 exchange to the new policy with more favorable terms can be completed.
3. With the new policy in force, the repayment strategy begins, using annual withdrawals up to cost basis to make loan payments until either the cost basis is exhausted, or the loan is extinguished.

See Figure 1: The Bank Loan Refinancing Strategy for additional details on how this strategy plays out.

As mentioned previously, in a perfect world this loan is completely paid off without the client having to make any out-of-pocket payments. Extremely high loan-to-value ratios or a lower cost basis may not allow for a complete repayment. In those instances, the client can pay off the balance of the loan from other assets. That said, they may not have to. By minimizing the loan balance, existing policy values and projected crediting may be enough to support the policy long-term. In either case, the client’s primary objective is met: They are no longer subject to today’s higher rates on their outstanding bank loan.

Varying economic conditions cause permanent life insurance products to fall in and out of favor. That’s not much of a problem for new insurance policies, but for in force policies it presents a major issue: Actual performance that does not meet expectations set at the time of sale. When that happens, a policy owner may not have great choices as they see to make the best of a bad situation. Unless, of course, their policy was purchased with just this possibility in mind.

Dealing with actual performance that does not meet the sales illustration or client expectations is all too familiar to those who have sold many types of life insurance. Declining dividend rates in Whole Life (WL). Market performance that didn’t materialize in Variable Universal Life (VUL). Index Cap and Participation rates that were unsustainable in Indexed UL (IUL). That doesn’t make any of these products inherently inferior or inappropriate. It does, however, point out that they can lack the flexibility needed to manage varying economic conditions. The exception? It may be Variable Life, but with a twist.

The rise of downside protected insurance products that also offer market-based returns has resonated with many consumers for easily understandable reasons. Primary among them is loss aversion. Once that is in place, however, the other side of the coin in the form of performance enters the conversation. In the case of IUL, actual performance can be severely limited by both the Cap and Participation rates, particularly as a segment matures and is subject to a renewal Cap or Participation rate. This is where performance can start to lag, and policy owners start to look for alternatives. Typically, that means either stay the course, or pivot to a new vehicle. Even if they are insurable and outside the surrender period, they are likely to be hesitant to commit to a similar strategy with a new product that is more well suited to the current economic environment.

A more graceful solution would avoid the need for underwriting and surrender charge considerations if it were already present in the very policy the client already owns.

Fortunately, that product exists. Numerous offerings in the VUL segment include “indexed subaccounts” based on the very downside protected indexing strategies found in IUL. In addition, buffered strategies that have become widely available in the Variable Annuity market have now made their way into the VUL market, offering a different balance of downside protection and upside potential than an IUL or indexed subaccount. Clients who own a VUL with these strategies are in an enviable position: Their solution to falling Cap rates, as an example, is built into the product they own.

If Cap rates, as an example, fall to the point that the upside potential of the strategy is no longer acceptable to the policy owner, they can simply change their allocation to a more suitable or attractive alternative from the menu of subaccounts available in their product. While it is tempting to think about this only in the context of wanting more upside potential, it could very well be predictability that the client is seeking in some instances. In that case, perhaps an allocation to the fixed account makes the most sense. Perhaps a bond fund allocation? Further, this is not an “all or nothing” decision and allocating a portion of their cash values across multiple subaccounts, each with its own unique risk/reward profile, may be the most appropriate course of action.

See Figure 1, below, for additional details on the difference between an IUL and VUL in these circumstances.

Figure 1: Strategies for a Falling Cap Rate

The point? There is never an empirically superior product type. The one that happens to be in favor today may very well be out of favor or perhaps significantly impacted by changing economic conditions within a few years. Rather than try to “time” the insurance market, perhaps it’s time to simply use a more flexible strategy that gives the clients a way to pivot when conditions change?

It’s a fact: Most business owners will execute a living buyout rather than have a business owner die prematurely. That singular fact makes it critical to have a buy/sell agreement in place that can provide protection from a premature death while simultaneously position the business owner for their eventual retirement.

In one of our industry’s more delicious ironies, the type life insurance typically used to fund Buy/Sell Agreements (BSAs), term insurance, is probably the least appropriate funding solution. The truth of the matter is that a permanent solution, with properly structured ownership, places a powerful financial planning tool in the hands of each business owner. A permanent life insurance solution can not only fund their BSA, but also provide supplemental, tax-favored retirement income, long-term care benefits and more.

The reasons for this trend can obviously be attributed to price in some instances, but there are other factors at play. A significant one is the perceived lack of control in most cases stemming from either another owner or the business itself controlling the policy. In most instances this can be traced back to a knowledge gap relative to the types of agreements beyond those two basis structures. Fortunately, in this particular instance, the solution not only addresses the fundamental issue outlined above, but it does so without having to increase the complexity of the agreement to the point it becomes unwieldy, if not prohibitive to administer.

If step one in this process of designing a more effective BSA is simply moving from term insurance to permanent, the next step is addressing ownership. In too many cases, the simplicity and ease of implementation that comes with a stock redemption plan, with the business owing the policies, receiving any death proceeds, and “redeeming” the shares of the deceased owner is too tempting. This not only eliminates the possibility of significant tax savings for the surviving owner, a topic for another discussion, but stilll places the business owner at a disadvantage relative to controlling all of their insurance assets as the company remains the owner and beneficiary of the surviving owner’s policy. Traditional cross purchase designs, while more advantageous from a tax perspective, still present the issue of lack of control: The other owner owns the insurance! While these two approaches can accomplish the ultimate goal of providing funding for the BSA when it is needed, it is far from an optimized solution.

That leaves the obvious question: If both of these types of BSA are less than ideal, what’s the answer? While each planning scenario is different and should be evaluated on its own merit, the “Cross Endorsement” structure checks man of the boxes discussed here:

Each business owner is the owner of the policy on their own life.
As a result, they control the death benefit, cash values and any living benefits the policy may provide.
A simple assignment form the secures the portion of the death proceeds needed to buy out the other business owner at their death.
More importantly, this also allows each owner to make full use of the policy as part of their retirement, long-term care and perhaps even estate planning if they, like most business owners, execute a living buyout.
Finally, at retirement this all happens without some sort of taxable event or an esoteric exemption to the transfer for value rules most do not understand, let alone plan for effectively.

Figure 1, below, shows the basic mechanics of this approach in terms of the flow of funds if one of the owners pass away. What it doesn’t do, is address how each owner can make the “highest and best use” of their policy. To do that, it is critical to move the owner beyond viewing this premium associated with their BSA funding strategy as an expense to something that creates an asset on their personal balance sheet. That effectively eliminates term insurance from the conversation.

The key subject matter areas to discuss with the owner as they consider how to structure their funding strategy with permanent insurance include:

• Their protection needs beyond the BSA. Specifically, is their personal insurance adequate? If not, simply increase the amount of coverage on the policy to an amount that covers both the business and personal need.
• Have the planned for the potential need for care as they age? If not, consider the use of a Chronic Illness or Long-Term Care Rider on the policy.
• Is their retirement plan adequately funded? If not, consider a policy designed to accumulate cash value while also providing a death benefit. This could also solve challenges like limitations on qualified plan contributions.

The beauty here is in the flexibility. Each owner can design their own strategy based on their needs. Once in force, simply filing the assignment secures the other owner’s interest in the death benefit in an amount equal to their obligation under the BSA.

As simple as this strategy is, there are some places where Business Owners may try to cut corners. Specifically, this arrangement does not eliminate the need for a formal, written BSA. Further, the BSA needs to be reviewed regularly, including updating the value of the business. If they want to pay for the coverage through the business, as most Business Owners do, there will likely be personal income taxes due on those funds, likely treated as compensation. There may also be tax due on the economic value of the assigned coverage. Both of these issues make the Business Owner’s CPA or other tax expert a critical part of the conversation.

There are additional benefits to the Cross Endorsement or “Living Benefits” Buy Sell Agreement, including:

• Personal ownership of your policy — The Business Owner names the primary beneficiary and controls the cash value. Any death benefit not committed to the buy-sell agreement can go to family or other personal beneficiaries.
• Younger and healthier owners aren’t required to pay premiums on older and less healthy business partners as they might be with a cross purchase buy-sell agreement.
• You can fund your own policy at a higher level to build greater cash value for your future use.
• Policy is portable — if the business ends or you retire, you still retain the policy and any cash value.
• As an individually owned policy, it may be protected against business creditors depending upon the laws of your state.

The bottom line? There is far more utility from a Cross Endorsement BSA funded with permanent insurance than is available from other agreement types or agreements funded with term insurance. We would all benefit from taking a moment to consider the rest of the Business Owners planning versus pursuing the path of least resistance.

There’s a lot of potential change on the horizon in the Long-Term Care and Estate Planning markets. Between a potential wave of state level LTC legislation plus the possible sunset of the estate tax exclusion levels embedded in the Tax Cuts and Jobs Act (TCJA), clients are facing a period of uncertainty than can have real consequences over the balance of the decade and beyond.

As important as both of those potential planning challenges are, the largest risk clients are facing is the very real need to have a plan for care in place as they age that includes both how they want to receive care as well as how to pay for it. Many are feeling this rather acutely as they care for their own aging parents.

For clients who may find themselves subject to estate tax if current estate tax exclusion limits expire, their Long-Term Care strategy needs to be flexible enough to not only position them to take advantage of any possible opt-out of state level LTC programs, but also address the potential TCJA sunset. It likely also involves pushing some of this risk off to the experts: Insurance companies. A well-conceived and executed solution will:

• Use the most cost-effective strategy to secure Long-Term Care coverage
• Allow for “ownership optimization” of the coverage in the event of the TCJA sunset that creates an estate tax liability

The primary objective is to provide robust LTC benefits as efficiently as possible. Assuming the client has beneficiaries, a life insurance solution likely offers the best value, with either the client or their loved ones receiving significant benefits. At the same time, the use of a joint life product that accumulates cash provides additional efficiency and flexibility.

• Fund a Survivorship IUL (SIUL) policy with LTC rider:
  • Covers both insureds with an individual pool of LTC
  • Provides Indemnity benefits
  • Offers a potential return on premiums instead of simply return of premium
  • Establishes or enhances a significant legacy if not needed for care
• When/If the client has future estate tax exposure:
  • Transfer ownership of the coverage to the client’s newly established ILIT. This reduces their taxable estate once the look-back period expires
  • Utilize trust language that allows access to LTC benefits during their lifetime. If there is a claim, this could remove additional assets from the client’s estate

For a pair of 55-year-olds, both in Preferred health, a properly-funded $1MM SIUL policy with a total LTC pool of $500K each has an annual premium of $10,890, well within the annual exclusion gift limit. If none of the risks we are seeking to hedge actually come to pass, their beneficiaries receive the proceeds. The tax-equivalent IRR on the proceeds assuming the clients pass at age 90 is 6.06%.*

The other question is what happens if they need care? If both clients exhaust their benefits during their lifetime, the IRR may increase given they would likely receive these benefits earlier in life.

How does the Hedge Play out?

Potential LTC Legislation

In the event the client’s state of residence enacts LTC legislation with an opt-out provision triggered by existing LTC coverage ownership, the clients may be eligible based on the true 7702B LTC benefits included in the policy. While the specifics of any future legislation are obviously unknown, it is possible that Chronic Illness Benefits under section 101(g) may not qualify for opt-out, making 7702B products a safe harbor of sorts.

Additionally, given that the final form of any legislation is yet to be specified, the ability to opt out and the requirements to do so are unknown at this time. This makes it critical to focus on the planning need first, with the goal of opting out of any future legislation as a possibility rather than the sole driver of the purchase of LTC coverage. A review of any proposed legislation in the client’s state of residence as part of the planning process is essential.

Potential Sunset of the Tax Cuts and Jobs Act

The only thing we know about the future of estate taxation, based on history, is that there will be change. In the event the client finds themselves with an unexpected estate tax exposure resulting from future changes, establishing an ILIT and subsequently transferring ownership of the policy to the ILIT removes the death benefit from their taxable estate after the look back period expires. The use of indemnity benefits on the Nationwide policy also unlocks an extremely estate tax friendly way to manage the benefits, that can remove additional assets equivalent to the benefits received plus interest from the client’s taxable estate. Please see Figure 1, below for additional details on this element of the strategy.

Unlocking the “Extra” Estate Tax Exclusion

Client Needs Long-Term Care

• Client buys $1MM life policy with LTC rider in their ILIT using funds earmarked for LTC
• Carrier pays indemnity LTC benefit to the trust ($20K/month for 50 months)
• Client borrows funds from trust to pay for LTC expenses
• Interest is capitalized annually
• The client passes away at exhaustion of benefits
• LTC Benefits Paid: $1,000,000
• Accrued Interest: $220,000
• Estate Debt to Trust: $1,220,000

At Client’s Death

• Estate Repays the Loan
• Total Amount in Trust: $1,220,000

Additional Details

• Trust Language must allow for LTC ownership as well as loans to the Grantor.
• Not all Insurance Companies allow their LTC products to be owned in an ILIT.
• There are very specific technical requirements for the loan to the Grantor.

While the recently passed SECURE Act 2.0 is generating quite a bit of conversation in retirement planning circles, it has not had near the impact in the life insurance segment that the original SECURE Act did when it was passed back in late 2019. The primary impact of SECURE 1.0 in the life insurance space was the significant change to Stretch IRA rules, making inherited IRAs even more of a tax challenge for beneficiaries. Read on to learn more about a strategy to work with both G1 and G2 for a comprehensive solution!

In an ironic twist, planning opportunities stemming from SECURE 1.0 focus not as much on the taxes paid by beneficiaries, but on the “G1” IRA owner who has had the good fortune to accumulate a large qualified plan balance and the ability to fund a traditional IRA Maximization strategy involving current distributions to fund a life insurance policy with far more favorable tax treatment. This presents some planning obstacles for all involved, including:

G1 IRA owners who may not be concerned about the tax implications for their beneficiaries, believing that they are “getting enough” simply by inheriting any assets not consumed during G1’s lifetime net of any taxes.

Even if G1 does care about the tax issue, they may not be insurable, eliminating the viability of the strategy entirely.

For those clients that execute traditional IRA Maximization, there will almost certainly be a remaining qualified plan balance that will be heavily taxed upon passing to G2.

This last issue, the remaining balance inherited by G2, has two components:

Income taxes due on the inherited amount over the ten-year period mandated by SECURE 1.0.

Taxation of any gains on the net proceeds that are then invested.

Fortunately, many of the challenges listed above are easily solved with a life insurance strategy focused on G2. By establishing a permanent life insurance policy as part of G2’s retirement planning approach, there is the possibility of avoiding the taxes that would be due on gains from other asset types. This policy is funded by a portion of the inheritance, and are a number of design elements to consider to render it maximally effective:

Consider using a face amount in excess of the minimum required to accommodate the portion of the inheritance allocated to the strategy.

The “balanced” approach to the design will also increase any amounts available via accelerated benefit provisions included in the base policy or added via rider, strengthening G2’s care planning strategy.

Availability of participating loans early in the policy could allow for higher funding levels, subsequently using a policy loan to pay taxes when due in April of the following year, versus holding a portion of the proceeds back in anticipation of future taxation.

Another consideration is one of timing. While the fact that there is a future inheritance may be known fairly early on, the timing of the event is obviously unknown. This could present a problem if there are insurability issues for G2 that present themselves at the time of the inheritance. The solution to this challenge is to put the insurance in force on G2 early in the process, in anticipation of the future inheritance. Doing so eliminates insurability as a future unknown and would also become part of G2’s overall retirement planning. Having a tax-favored source of retirement income above and beyond the ability to accommodate the inheritance strengthen the resilience of their overall retirement plan. If this approach is pursued, the use of a policy face amount higher than the minimum required for G2’s premium budget at inception creates the capacity to accommodate the future inheritance.

While this strategy has been described as a way to solve the issue of not being able to execute a traditional IRA Maximization strategy, the use of these two strategies in concert would be maximally effective in terms of reducing taxation of the IRA and minimizing G2’s tax burden on a forward-looking basis. This “second sale” to G2 in an IRA Maximization strategy can also be used to prospect up or down the family tree, depending on where the original client relationship lies.

The lack of a second business owner does not eliminate the need for effective buy/sell planning. A well thought out, formal agreement with proper funding can still accomplish the owner’s goals for the business upon their retirement, disability or death.

A place where that can break down is the buy/sell agreement. We’ve all heard the stories of businesses without a plan in place, and one of the frequent causes is the lack of a clear successor. That, like so many other things in our business, can be overcome with the right planning. The most effective approaches address both the planned and the unexpected triggering events and can employ the leverage of life insurance to create or augment a funding strategy.

Consider the business owner whose business is their primary asset and is without a clear successor.

Most would likely think about finding an outside buyer. If all goes to plan, that can absolutely work, but the unplanned exit remains a challenge. The “No Sell Buy/Sell” strategy can be part of a solution to this challenge and uses many of the traditional elements of a buy/sell agreement, with one significant exception: The business owner controls both sides of the transaction. More specifically, a trust they establish, and control becomes the buyer of the business, funded by life insurance proceeds.

This No Sell Buy/Sell involves some of the fundamentals seen in a traditional buy/sell agreement between two owners:

• Establishing a fair value for the business
• Funding the plan with a life insurance policy

It also serves as a way to buy the surviving family members time. The family can still control the business through their control of the trust. If, the business is ultimately sold to an outside party, it will be at a time and at terms of their choosing. The infusion of cash from the initial sale of the business to the trust provides the liquidity they need to be patient if that is what is best for the family. Further, if the business is ultimately sold to an outsider for less than the family hoped, those life insurance proceeds serve to make them whole relative to their prior valuation of the business. Depending on the client’s other planning objectives, this strategy can also integrate with their retirement and estate planning. Please see Figure 1, The No Sell Buy/Sell Strategy for an overview of the approach.

Of course, in some cases, there is a Key Employee who would love to take over the business, but they may not see a way to make it happen. This is where effective planning can again overcome a rather common obstacle.

In this situation, there is an opportunity to take a more traditional approach, complicated only by the fact there is not a second owner of the business also seeking to implement a buy/sell agreement. Instead, the designated Key Employee plays the part of the second owner. The key difference is that the Key Employee does not have an ownership position in the company, making this a “one way” buy/sell agreement. Aside from that difference, the mechanics are much the same as they would be in a traditional buy/sell agreement between two owners.

The Key Employee purchases a life insurance policy on the owner of the business. They Key Employee is the policy owner, is responsible for the premium payments and is also the policy beneficiary. At the death of the owner, the life insurance proceeds are used to purchase the business from the owner’s estate per the terms of the buy/sell agreement. If appropriate, the policy can also play a role in a living buyout and may even be funded by the business via deducible bonus payments to the Key Employee. Please see Figure 2, The One Way Buy/Sell Strategy, for an overview of the mechanics.

The approach above, admittedly, relies heavily on life insurance as the primary finding vehicle. The business owner may benefit from an approach that also more directly addresses a living buyout as we see in the Sole Owner Transition Plan. This strategy includes the sale of a small portion of the business at plan inception, and utilizes installments notes and life insurance to protect both the owner and acquiring Key Employee.

Once the Key Employee completes the initial purchase of a small portion of the business, a traditional buy/sell agreement is put in place that serves all the same functions as it would in a multi-owner business. One of the most important elements is the use of life insurance to protect the original business owner in the event the Key Employee passes away or decides to leave the business. The balance of the sale occurs at the typical triggering events, and can be funded via life insurance, installment notes, or a combination of the two. See Figure 3, The Sole-Owner Transition Plan, for additional details.

Regardless of which of the three approaches outlined here is ultimately implemented, the underlying message remains the same: The lack of a second business owner does not eliminate the need for effective buy/sell planning. Further, the owner may have more flexibility in these cases simply based on their control of the decision-making process. Whether they ultimately involve a Key Employee as the buyer or a trust via the No Sell Buy/Sell, the outcome is the same: A well thought out, formal agreement with proper funding that accomplishes their goals for the business upon their retirement, disability or death.