Leveraging Gifts with Life Insurance

“Rich people will never be poor!” I squealed to my co-worker, half with delight and half with a twinge of guilt.

We were discussing a strategy to use family gifts to fund a permanent life insurance policy. The gifts come from the grandparents. Their adult children would use the money to purchase a second-to-die life insurance policy on themselves, with their children, the donors’ grandchildren, as beneficiaries.

Now I have taken a lot of heat in the past for criticizing permanent life insurance, and I stand by my criticism. The overwhelming majority of these policies are sold to people who do not need them and who would be better off using those premium dollars in a million other ways. But the truth is, wealthy families can get creative with permanent life insurance in ways that ensure their heirs remain wealthy for generations to come. This is just one of those creative solutions.

Who would choose to pursue a strategy like this? First and foremost, these are families with assets above the federal estate tax exemption. The exemption is the amount that can be transferred to heirs free of estate tax. In 2021, the federal estate tax exemption is $11.7 million per individual ($23.4 million for a married couple).  Fewer than 1% of Americans are subject to estate tax. Remember when I said that most permanent life insurance policies are sold to people who don’t need them? This is a big part of my reasoning.

Lest anyone think they can avoid estate tax by giving away gifts during their lifetime, there is also a tax on gifts in excess of $11.7 million. That is the limit on transfers, whether the gifts are given during life or at death. The IRS requires an accounting of lifetime gifts reported on a gift tax return. At death, lifetime gifts are added to the gross estate to calculate estate tax.

In addition to the lifetime $11.7 million exemption, individuals can give up to $15,000 per year ($30,000 for married couples) to as many people as they wish. They can give $15,000 to their children, their children’s spouses, their grandchildren, their neighbor, a friend, their dog walker, or anyone else. The limit is $15,000 per recipient per year. There is no requirement to file a gift tax return to record gifts under this annual exclusion. This means that a married couple with three adult children, all married, and six grandchildren, can give $360,000 per year to their family members while flying under the gift tax radar.

And here is where things get interesting. Imagine the adult child and his wife who are receiving $60,000 per year from his parents.  Assuming they do not need to spend the gift on anything in particular, they instead choose to fund a permanent life insurance policy for the benefit of their children. They purchase a second-to-die life policy, one that pays a death benefit upon the death of the second spouse. This allows them to purchase a larger death benefit, since the insurance company is underwriting two lives instead of one.

Some generic modeling suggests that a couple in their mid 40’s and in good health, could purchase $6,000,000 of death benefit by paying a $60,000 premium for 10 years on a second-to-die insurance policy. That’s a 10-1 ratio of premium paid to death benefit received. By the time the couple’s children finish high school, their estate plan could be funded.

There is a structural nuance to this strategy. The couple does not want the life insurance proceeds to be counted as part of their gross estate for the estate tax calculation. We already know that the grandparents have a taxable estate, so it is likely the adult children will as well as the assets pass through the generations. Remember, the reason that the grandparents are giving the annual gifts in the first place is to chip away at the size of their taxable estate. To remove the assets from their estate, the adult children create an irrevocable trust to own the life insurance policy. The estate planning terminology for this type of trust is an irrevocable life insurance trust (ILIT). The adult children will have no ability to access funds once placed in the irrevocable trust, and they must name a trustee to oversee the assets for the benefit of their children.

If done correctly, the life insurance policy pays out a death benefit that is tax free to their children and passes outside of the estate, avoiding estate tax as well. At no out of pocket expense, this family has leveraged ‘small’ annual gifts to provide a legacy to the grandchildren. No matter what happens in the life of the middle generation – bankruptcy, divorce, poor investments, expensive long-term care – a minimum inheritance is solidified for their children. And this is why I exclaimed to my colleague “Rich people will never be poor!”


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