Tax Benefits of Life Insurance Trusts End Soon

The tax plan taking shape in Congress will erase the long-standing benefit of keeping life insurance in certain trusts, by making its value subject to the 40% estate tax when the policy owner passes away. This is a tremendous change since the trusts and their assets are not currently subject to the levy. Many advisors are still suggesting that their clients splurge on life insurance. This is because advisors believe that by pre-paying a lifetime’s worth of annual premiums by January 1st, before the new curb would go into effect if approved, individuals may be able to preserve the trust’s lucrative tax benefits.

Crisis Stage. The blow to life insurance in trusts, a bread-and-butter wealth preservation strategy for decades, is one of many proposals in the emerging tax bill that takes aim at the wealthy to finance President Joe Biden’s $3.5 trillion social spending plan. The draft bill plans to raise the top individual rate to 39.8% and bump up the top capital gains rate to 28.8%. It will tax capital gains at the top ordinary rate once income hits $1 million as well as crack down on large retirement accounts and end backdoor Roth conversions. The Bill will also kill the use of grantor trusts, whether they do or do not contain life insurance. Currently, if an individual owned a $3 million home, had $7 million in retirement accounts, and had $4 million not in a trust, $2.3 million of that $14 million estate would incur the 40% estate tax, which is about $920,000. Now if it is assumed that the insurance policy is in a grantor trust, the $920,000 would instead be left to heirs. These types of savings will no longer be possible if the proposal passes.

A major impediment. Financial advisors and estate lawyers are upset with the proposal because it is common for life insurance to be held in a widely used type of trust called a grantor trust, in which the grantor retains control and pays income tax on its gains. Many benefits of these trusts include intentionally defective grantor trusts, or IDGTs, and grantor retained annuity trusts, or GRATs. Advisors say that most irrevocable life insurance trusts, or ILITs, are set up as grantor trusts, so they would be hit by the curb, too.

In obscure language, the proposal states that any assets contributed to grantor trusts come 2022 would become part of the grantor’s estate for estate tax purposes. The issue with this is that under the plan, a policyholder who pays their annual premiums for a policy that is held in a trust would be “contributing assets,” thus making the trust subject to the 40% estate levy. Wealthy individuals who want to create a future trust for their life insurance could not make their spouse a beneficiary without subjecting the trust to estate tax as well. This is due to it automatically being a grantor trust and thus would have to pay estate tax under the proposal.

The solution becomes the problem. The proposal has the potential to upend retirement planning. The idea of pre-paying premiums revolves around using outside funds, not the money inside the trust, as the latter would get caught by the proposed curb. Many are advising clients to pre-fund their premiums now by contributing cash or other assets before the new law passes so that no additional outlays are required to pay future premiums.

Flying blind. The proposed curb would hit not just the very wealthy. Many families have a life insurance policy that is often their trust’s single largest asset. For example, a person might have a net worth under the estate tax threshold but also a large life insurance policy to care for their family if they die prematurely and their income grinds to a halt. This means that when the insurance death benefit is paid, the decedent’s total assets can exceed the estate tax exemption.

One solution might involve “decanting” a grantor trust. This strategy involves “pouring” a trust’s assets into a new trust. Or a trust could pay the insurance premiums through so-called split dollar arrangements, which are common with wealthy executives. It could be set up so that beneficiaries other than a spouse would have to approve any distributions out of the trust to the spouse, but some fear that it could cause family rifts and may have gift tax implications for kids.

Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.