Life Insurance
Life insurance, largely because of its tax benefits, can also be used as an investment. And it’s not just because of the cash value associated with permanent insurance. Consider how the death benefit of a policy can generate millions in tax savings for a wealthy family. Rich families often use dynasty trusts to move their millions down through the generations. In this case, the family is the investor, not the individual. The challenge for these family dynasties are the three federal transfer taxes that charge a flat 40% rate on transfers: the gift, estate and generation skipping transfer taxes (GST). While these taxes can quickly deplete a wealthy estate, current law allows an exemption of $11.4 million before they apply. So, Generation 1 can set up a trust that uses $11.4 million to skip a generation, landing the wealth in the hands of Generation 3, transfer tax-free.
Generation 2 doesn’t suffer for wealth because they live off the income in the trust. The question is what investment to use to maximize the efficiency of the $11.4 million exemption in moving money through the generations. A popular solution in GST tax exemption planning is life insurance. This product has the advantage of paying exactly when needed, i.e. at the insured’s death, and it pays a benefit that is income tax-free. Let’s take an extreme example to demonstrate the leverage. wealthy individual, Gen 1, uses her entire $11.4 million generation-skipping tax exemption to pay a one-time premium for life insurance. Assume the policy’s death benefit is $25 million and it resides in a dynasty trust. The trust is structured so that after Gen 1’s death, it collects the insurance proceeds income tax-free, and begins paying interest income to her children, Gen 2. The $25 million principal in the trust will eventually go to the grandchildren, Gen 3, after Gen 2’s death. Life insurance has maximized the leverage of this transaction. When Gen 1 died, the trust received $25 million income tax-free, and neither Gen 1 nor Gen 2 pay gift, estate or GST taxes on the death benefit. In the end, Gen 3 has $25 million in trust and the dynasty continues. Even accounting for inflation, the family experiences little, if any, diminution in the value of their wealth through three generations.
FORBES Magazine.