Using Premium Financed Life Insurance To Pay The Estate Taxes

Wealthy people LOVE life insurance, and for good reason.  The three most common ways wealthy people use life insurance policies are to:

1.     Provide liquidity to fund lifestyle expenses for their family in the event of a pre-mature death.

2.     Generate a tax-free supplemental retirement income.

3.     Pay the 40% in estate taxes due when wealth is transferred to the next generation (assuming their net worth would warrant this taxation).

Wealthy people typically want a conservative alternative to a taxable bonds portfolio, and the 0% floor of an IUL provides that conservative alternative.  In addition, the tax-free cash value accumulation inside a life insurance policy is also very appealing to wealthy people. 

But the appeal doesn’t stop there.  They also like the fact that the retirement income drawdowns from the policy can be tax-free as well.  I have an entire chapter in this book devoted to explaining the different ways to take these tax-free income drawdowns (Chapter 5:  Policy Drawdowns).  This benefit can even be enjoyed by non-wealthy people that own an IUL.

In addition, when a wealthy individual passes away, their assets can be passed on to their surviving spouse without tax consequence, however once their surviving spouse passes away and their wealth is transferred to the next generation, their heirs may incur a substantial tax liability in the form of estate taxes (currently 40%) depending on the estate’s value at such time, and depending on the Estate Tax Exemption Limit at such time.

The IRS allows a certain amount of their net worth to be transferred to the next generation tax-free up until a certain dollar amount known as the Estate Tax Exemption Limit. 

This exemption has increased each year since 2017.  Below, we see these increases since 2017 (sourced from https://www.irs.gov/pub/irs-pdf/i706.pdf):

2017:    $5,490,000 ($10,980,000 per married couple)

2018:  $11,180,000 ($22,360,000 per married couple)

2019:  $11,400,000 ($22,800,000 per married couple)

2020:  $11,580,000 ($23,160,000 per married couple)

2021:  $11,700,000 ($23,400,000 per married couple)

2022:  $12,060,000 ($24,120,000 per married couple)

2023:  $12,920,000 ($25,840,000 per married couple)

2024:  $13,610,000 ($27,220,000 per married couple)

Upon death, a spouse can pass their exemption on to their surviving spouse.  However what many feared regarding the Biden Administration’s tax agenda came to pass on September 13, 2021 when the House Ways and Means Committee released a tax change proposal in favor of reducing the estate tax exemption limit back down to the $5,000,000 range per individual in 2026.

However, one thing that has remained constant is the favorable tax treatment of life insurance, which is why it continues to be an incredibly valuable estate planning tool.

Due to Section 101a of the IRS tax code, the death benefit of a life insurance policy is tax-free, giving policy owners a huge advantage when the policy is owned in an Irrevocable Life Insurance Trust (ILIT) outside their taxable estate, despite their net worth being far above the thresholds I mentioned earlier. 

If however, the client’s estate is worth less than the thresholds I mentioned earlier (including the death benefit of the policy), the policy can be individually owned inside their estate and the death benefit is tax-free as well. 

I will discuss comparing life insurance strategies to non-insurance-based alternatives later in this book, however it is important to understand that when a person dies, any excess net worth above the estate tax exemption is currently taxed at a rate of 40.00% when it is transferred to the next generation.  The creates a substantial tax liability for Generation Two (G2).

To clarify how this works, when one spouse passes away, the surviving spouse does not incur any estate tax liability.  However when the second spouse dies and the estate is transferred to the next generation, estate taxes are incurred by the inheriting generation.

As an example, if the surviving spouse is worth $100,000,000 above the exemption limit, at the time of their passing, the inheriting generation will owe $40,000,000 in estate taxes (40.00% of the $100,000,000).  This inheriting generation is only given nine months from the time of their surviving parent’s death to file and pay the estate taxes due, which is not much lead time by any means. 

Even if the estate value is comprised of illiquid assets (e.g., real estate, a company, jewelry, art, automobile collection, etc.), the estate tax is still due on the value of these assets nonetheless, which often results in a necessary fire sale of such assets to come up with the funds required to pay the estate taxes.  This can be both financially and emotionally draining for all parties involved.

Life insurance is an extremely efficient tool in planning for the estate tax liability that the next generation will incur because it removes the need to liquidate the estate’s illiquid assets within this nine-month period. 

If the policy is owned by an Irrevocable Life Insurance Trust (ILIT) – which is outside the taxable estate – the death benefit will pay out tax-free to the ILIT and is not subject to estate taxes.  The ILIT can then pay the estate taxes due once the death benefit is issued.  This is a much easier process to manage than a desperate fire sale of illiquid assets just to come up with the cash needed to pay the estate taxes.

When it comes to estate tax planning, wealthy clients essentially have two options:

1. Do nothing and give away 40% of their wealth to the government in the form of estate taxes, or…

2. Use life insurance to pay the estate taxes for them.

Making the decision to buy life insurance should be based on one simple mathematical equation:

If the money you would have spent on life insurance can be invested in an alternative asset, and that asset value (after 40.00% estate taxes) becomes greater than the tax-free death benefit of the life insurance policy, then you should NOT buy the life insurance policy.  But if 60% of that alternative asset value is less valuable than the net death benefit, then you SHOULD buy the life insurance.  It really is that simple.

There is certainly an emotionally-driven population that feels like they are leaving enough assets behind for Generation Two (G2) and don’t feel the need to purchase life insurance.  Perhaps they have even said, “No one ever left me an inheritance.  My kids are lucky to get whatever I leave them.”

The reality is, wealthy parents are either going to leave the money to their kids, a charity, or Uncle Sam.  Even if they don’t want to make their kids overly wealthy, I have yet to meet a wealthy individual that prefers the IRS over their favorite charity.

The problem that many wealthy families face is that if the majority of the estate’s value is not liquid (e.g. real estate value, business valuation, etc.), Generation Two (G2) would have to sell the estate’s assets to come up with the cash to pay the estate taxes due, and they only have nine months to make this payment. 

The IRS does however have an option to finance the estate taxes due.  According to IRC Section 6166, G2 may defer payment of estate taxes if 35%+ of the deceased person’s estate is a closely held business.  G2 can pay interest-only in years 1-5 on the estate taxes due, then they can pay principle plus interest amortized over years 6-15.  If G2 defaults on this IRS loan, the IRS can seize and sell the asset. 

An advisor once told me about one of his clients wherein the estate was worth $114,000,000 at the time of the second parent’s death in 2006.  At that time, the estate tax exemption for a married couple was only $4,000,000 (instead of the current $27,220,000 per couple in 2024) and the estate tax rate was 46% (instead of the current 40%).  The family’s business was in the real estate industry.  G2 elected the 6166 option because they didn’t have the liquidity to pay the $50 million in estate taxes due. 

Two years later in 2008, the estate/business value plummeted from $114,000,000 to only $54,000,000.  G2’s income plummeted as well, and they defaulted on the 6166 loan. 

The IRS seized the estate’s assets and sold them for their new fair market value of $54,000,000.  However this reduction in estate valuation did not affect the $50,000,000 in estate taxes still due.  You see, the estate taxes were calculated based on the value of the estate at the time of death, regardless of the plummeted value two years later. 

Ultimately, G2 was left with only $4,000,000 after they inherited a $114 million estate from their parents.

In this scenario, had there been a $50,000,000 life insurance policy in an ILIT (Irrevocable Life Insurance Trust) outside the estate to pay the future estate tax liability, G2 could have inherited the entire estate, undiluted by estate taxes.  Over time, the family’s real estate values and business valuation would have recovered.

In addition, when wealthy parents pass away, it can drive huge wedges between siblings if the estate plan is not well designed and/or clearly delineated.  When siblings argue over who gets to keep certain sentimental assets (like the family home and the family business) , versus what assets need to be sold in order to pay the estate taxes, it can absolutely destroy a family.

This is why providing liquidity in their time of need is so important, and typically, life insurance – specifically Premium Financed Life Insurance – is the most prudent and tax-efficient way to provide such liquidity.

Though it is clearly important to understand the client’s financial position when developing an estate plan, the single-most important thing for an advisor to understand is how to identify the difference between what a client says they want today, versus how they will feel in the future if their personal financial situation does not meet their aspirations.

This can be a challenging truth to uncover – one that takes a tremendous amount of psychological, sociological, and emotional intuitiveness on behalf of the advisor.  It also takes a high level of understanding the inter-family relationship dynamics and family governance (or lack thereof).

Here's an example to illustrate what I mean by this.

Let’s say you have a wealthy family with a taxable estate value of $100 million.  When the patriarch and matriarch both pass away, as of 2024, their heirs will owe $40 million in estate taxes within nine months of their passing.  If the majority of the estate value is held in illiquid assets (e.g., Real Estate, Company Valuation, etc.), the adult kids will be forced to sell assets to come up with the cash to pay the 40% in estate taxes. 

In this hypothetical example, the eldest son is running the family business and does not want to sell any shares of the business to pay the estate taxes – the family business is his baby.  The youngest son is living on the family yacht in Miami, living the playboy lifestyle, and certainly doesn’t want to sell the yacht and the penthouse to pay the estate taxes.  The daughter is resentful that she was not chosen to run the family business, and she has a sentimental attachment to the family vacation house in the Hamptons where they spent their summers growing up, and she doesn’t want to sell it to pay the estate taxes.  Of course, each respective sibling could care less about the assets their other siblings care about, and these disagreements over which assets to liquidate in order to pay the $40 million in estate taxes can absolutely destroy the relationships between siblings.

If there are spouses, children, and grandchildren involved, this can make these family disputes even more volatile.  You see, it’s not just the financial elements that are important.  The emotional/relationship dynamics are also important – perhaps even more important.

This is where a properly structured life insurance policy can be such a valuable tool in regards to estate planning and family governance.  Assets can be split amongst the surviving siblings based on their preference and emotional attachments, and the life insurance death benefit can take care of the estate taxes due, keeping the peace.

When people ask me what I do for a living, I now say, “When wealth is transferred from one generation to the next, I make sure the adult kids don’t kill each other.”

This response often times leads to some pretty interesting cocktail party discussions without me even trying to solicit my services.  You would be amazed that despite how much I try to avoid talking about what I do for a living in social settings, people are fascinated by this topic of inter-family relationship dynamics, especially amongst uber-wealthy families.

There are many benefits of using life insurance as both an estate tax planning tool, as well as a tax-advantaged asset for wealth accumulation and supplemental retirement income.  Even if your net worth is not at the level wherein your heirs would be subject to estate taxes, life insurance can still be a valuable asset for you to own.

But this is an industry wherein the explanations of how these insurance-based instruments actually work is opaque at best.  One of the biggest criticisms of the life insurance industry is that many of the products lack transparency, and quite frankly, I would have to agree with that accusation… sort of, but not completely.

The reality is that many of these life insurance products do not lack transparency in their construction.  The lack of transparency is in how their construction is communicated to the client – both from the carriers and the agents.  It is a problem I experienced as a life insurance client back before I got into this line of work, and it is a problem that still exists today. 

The key is to understand how different types of life insurance policies are built and how they work mechanically.  This is the foundation I built my practice on.  Everything I do is rooted in education and granular understanding. 

In this book, I will open up the black box so you can see what’s actually inside the box, which will change your perspective from looking through opaque lenses to looking through a high-powered microscope.  The strong stance I have taken on opening up this black box has at times felt like I was opening Pandora’s Box, but as I stated earlier, I am an industry disruptor – a beacon of transparency – and my goal is to teach you the truth about these products, where the risks are, how to mitigate these risks, and to show you the best way to utilize these products in the most effective way possible.

If you are not familiar with the details of the Greek mythological story of Pandora’s Box, indulge me for just a moment to share with you how analogous this story is to Indexed Universal Life Insurance (IUL).

In Greek mythology, Pandora was the first woman on Earth.  She was given a box that the gods told her contained special gifts, but she was also told that she was not allowed to open it and see what was inside. 

Eventually, Pandora could not contain her curiosity and she opened the box.  When she did, all the illnesses and hardships that the gods had hidden in the box started coming out.  She tried to close the box once she saw the evil coming out of it, but in doing so, hope got trapped inside the box.

Many people feel the same way about certain life insurance products.  They are told that the black box contains all kinds of special gifts (e.g., tax-free benefits, 0% floor, etc.), but they are told not to open the box and dissect its components at the granular level.  In fact, I’ve even heard advisors say, “My clients don’t want to know all the details.”

Personally, I think that statement greatly underestimates the curiosity of high-net worth clients.  To say that a person worth $100 million doesn’t want to understand how an IUL works is an incredibly naïve thing to say, and from my own personal experience, a very inaccurate thing to say.

So far, I have only talked about why wealthy people love life insurance.  But perhaps you are not worth $100 million.  What if your net worth is far below this amount.  In fact, what if your net worth is less than $1 million, and you make less than $100,000 per year?  Is an IUL still an effective financial tool you should have in your retirement portfolio?

Each person’s unique circumstance would dictate my answer to this question, however ask yourself these questions:

1.     If you were die unexpectedly early, your family would no longer have your income to pay the bills (mortgage, car payments, etc.).  Could they maintain their lifestyle and pay for living expenses without your income?  If the answer is no, perhaps you need some life insurance coverage.

2.     Do you think income taxes are going to go up or down?  If you think taxes are going up in the future, perhaps you might enjoy the tax-free retirement income an IUL could provide you with.

3.     Are you concerned about market crashes during your retirement years?  If you are, perhaps you might enjoy the 0% protective floor than an IUL provides.

4.     When you die, do you want your adult kids to fight over which assets to sell and which assets to keep?  If the answer is no, you might want to use life insurance to provide the liquidity needed so your kids don’t kill each other fighting over assets.

When I started teaching advisors and their clients how IULs work at the granular level, my result was much different than Pandora’s because when I opened up the black box of IULs, not only did the evils of the life insurance industry come out, but so did hope.  Sure, I exposed certain products and their design flaws, but I have also been able to uncover the truth about how a well-designed IUL can be one of the most valuable assets in legacy planning AND retirement planning that exists – assuming it is designed properly and used with the right client.

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