Insuring Life's Certainties: Death and Taxes

This piece was written in collaboration with Joseph Bragdon, CFA^® and Ben Kronish of Financial Architects Partners.

Life insurance can serve as a strategic and tax-efficient tool to create liquidity for family estate planning but is often overlooked by high-net-worth families, family offices, and family businesses. Life insurance has the perception of being confusing and lacking transparency as there are a multitude of insurance products and strategies available to sophisticated clientele. The recommendation of products and strategies depend on facts (including assets, ability to pay premiums, and desired coverage) and goals. The best approach is one that integrates income, estate, and gift tax strategies with the proper insurance product to ensure meaningful and tactful estate liquidity planning. This article serves as an overview of life insurance strategies and why high-net-worth and ultra-high-net-worth families, family offices, and family businesses may want to consider adding life insurance to their estate plans and asset allocations.

Basics

Premiums and Death Benefits

At its core, an insurance policy is a contract between a policyholder and a life insurance company. Policyholders, who are the owners of the life insurance policy, pay premiums in exchange for a lump sum death benefit. The death benefit is paid to the beneficiaries when the insured party passes away.¹ The policyholder formally names beneficiaries in the policy and can change them throughout the life of the insured. Beneficiaries, whether they are designated as primary or secondary beneficiaries, can be individuals, organizations (businesses and charities), trusts, and estates. It is advisable to consult with an insurance professional and estate planning attorney when naming beneficiaries. Most estate liquidity strategies will use a trust or business entity as the owner and beneficiary.

Cash Surrender Value

Once a policy is created and funded, it should remain in effect until the intended purpose is fulfilled if possible. When this is not the case, the surrender value is the amount of money a policyholder receives when canceling the policy before it reaches maturity (e.g., in general, the surrender value is the amount of premiums paid plus interest less surrender charges). Additionally, the cash surrender value of the policy can be borrowed against, withdrawn, or used to pay premiums. Withdrawing from the cash value generally affects the amount of future death benefits.

Taxation

Life insurance receives favorable income tax treatment and, when owned properly, is not subject to estate tax. For example, life insurance death benefits are generally excluded from the beneficiary’s gross income for income tax purposes.² Additionally, life insurance cash values grow income tax-free, and the policy’s basis may be withdrawn first, leaving excess accumulated cash in the policy to continue to accumulate tax-free.³ Although tax rates may seem high today, historical U.S. tax rates (income and estate) have been much higher. If tax rates increase, life insurance planning becomes even more valuable.

Planning

In terms of putting this strategy into practice, one option would be to create and fund an irrevocable life insurance trust (“ILIT”). The ILIT can be structured as a generation-skipping transfer (“GST”) tax-exempt dynasty trust and funded with annual exclusion gifts and/or all or a portion of one’s lifetime gift tax exemption.⁴ If properly structured, reported, and maintained, an ILIT can create a pool of liquidity to purchase illiquid assets from the insured’s estate or replace assets lost to the payment of estate tax and potentially benefit multiple generations of the insured’s family, all while keeping the death benefits out of the insured’s gross estate for estate tax purposes.

Underwriting

In order to qualify for a significant life insurance policy, an insured typically must complete a medical underwriting process. This could involve providing the insurance carrier medical records (typically for the last five years), an independent life insurance examination, and details on any dangerous advocations (e.g., SCUBA, skydiving, piloting) so the carrier’s underwriters may assess an underwriting classification (e.g., Standard, Preferred). This underwriting classification will determine the cost of the insurance policy along with the insured’s age, sex, and smoking status.

Product Types

Knowing the different types of insurance products allows an advisor to match product types to goals and risk tolerance. Life insurance product performance can be linked to equity performance (hedged or unhedged), interest rates, or be fully guaranteed by the insurance carrier. While the different types of insurance each have their merits, it is important to understand the nuances of each. The following list includes some of the more common types of life insurance and the accompanying synopses are merely to provide a format for such discussion.

• Term Life Insurance – life insurance that provides coverage for a set period (generally 10-, 15-, 20-, 25-, or 30-year terms). Premiums must be paid while the policy is active and, if the insured dies during the term, the beneficiaries receive a death benefit. Term life insurance does not have a cash value. It is often used to protect one’s human capital during their working years, protect a company from the loss of a founder or key employee, or protect against a durational liability. Term Life Insurance often has a convertibility feature, allowing the policy to be converted into a permanent insurance policy without renewing underwriting, providing a hedge on a client’s morbidity.
• Permanent Life Insurance – life insurance that provides coverage for an insured’s lifetime, where the policies generally accumulate cash value, which can be withdrawn or borrowed against. There are several types of permanent life insurance:
  
  • Single Life vs. Survivorship – A survivorship policy has two insured (e.g. husband and wife) and pays out the death benefit at second death (often used in estate planning). Single life has one insured and pays out when the insured dies.
  • Whole Life Insurance – Typically offered by mutual insurance carriers, the product performance is tied to the carrier’s declared dividend rate (correlated to long-term interest rates) and provides underlying guarantees for death benefit and cash surrender value. Premiums are fixed and must be paid annually.
  • Universal Life Insurance – Provides adjustable premiums and flexibility of coverage amounts (e.g., the policyholder can decrease, increase, or skip a premium often while maintain the policy).⁵ Each type of Universal Life product has a different underlying performance factor (e.g., equities, fixed income, guarantees).
    • Guaranteed Universal Life – The insurance company takes all investment risk and provides a certain result to the policy owner with no performance assumption.
    • Indexed Universal Life Insurance – The product performance is based on an equity index (e.g. S&P 500) with a cap and floor.
    • Variable Universal Life Insurance – The product performance is based on a basket of underlying mutual funds (similar to a 401(k) account) where the policy owner can choose from the available investment accounts.
      

Goals of Life Insurance Planning

Life insurance can be used by high-net-worth and ultra-high-net-worth families, family offices, and family businesses to (i) provide liquidity for estates with illiquid assets, (ii) minimize the risk in the event of the loss of a key member of a family office or business, (iii) equalize estates without a forced sale of assets, (iv) provide inheritances in blended families, (v) fund business succession and provide liquidity to businesses following the loss of a key member or employee, (vi) fund charitable planning, (vii) compensate and retain key employees in a family office or family business, (viii) hedge against rising income tax rates, and (ix) fund nonqualified deferred compensation.

• A 40% federal estate tax (and potential state estate tax) can cause liquidity problems when settling an estate as the estate tax is due to the IRS within 9 months of passing. Estates with illiquid assets (e.g., private investments, farms/ranches, real estate, family businesses, collectibles, art, and other infrequently traded assets) will want to plan to have liquidity at death. Life insurance is the only asset which matures and becomes fully liquid at a client’s death making it optimal to avoid a forced sale of illiquid assets.⁶
• Life insurance can be used to equalize estates by solving succession and inheritance problems. In many circumstances, this allows heirs to live separate lives while maintaining family assets and harmony. Regarding family businesses, not all heirs may be interested in the family business. Life insurance can be utilized to allow the family business to pass to the heir or heirs who are interested in running the business and insurance proceeds can go to the heirs who are not interested in being a part of the business. In the case of blended families, the strategy allows certain assets to remain separate for the benefit of one side of the family, while using the insurance for the other’s inheritance.
• Life insurance can be used for business succession planning to ensure that a business can continue operations following an owner’s death. Life insurance policies with buy/sell agreements provide liquidity for the other business owners to purchase a deceased owner’s interest. It is advisable to consult with an insurance professional and estate planning attorney when developing a business succession plan as special care must be taken to ensure that unintended estate tax consequences do not occur as a result of certain types of buy/sell agreements.⁷
• Life insurance can be used to reduce the risk of loss caused by the passing of a key employee or founder of a business. By having this strategy in place, it allows other stakeholders time to find and fund suitable go-forward solutions.
• Life insurance can be used in compensation strategies and strategies to retain key employees. See split dollar insurance below.
• Life insurance can be used inside of certain qualified retirement plans to guarantee benefits to the plan beneficiaries even if the plan participant dies prematurely. In this structure, the premium payments are tax deductible as they are considered part of the plan contributions. The pure life insurance proceeds (also called the “net amount at risk”) are the difference between any cash value accumulation in the policy and the coverage amount and are received income tax-free despite being a distribution from an otherwise fully taxable account.
• Life insurance can be used for charitable planning. Donating appreciated property or cash is likely the most fulfilling method because it accomplishes a family’s philanthropic goals, while generating a tax deduction. Life insurance can be used by families with illiquid assets to accomplish charitable goals as premium payments may be more cost-effective than liquidating the assets upon death. For certain families, it may make more sense to donate assets to one or more charities or foundations and equalize heirs with insurance.

It is also worth mentioning that another reason to acquire life insurance is that it can be a diversifying asset class. Products with lifetime guarantees are non-correlated to other assets and produce guaranteed returns. Life insurance represents a conservative, defensive, principal protected asset class, with equity-like returns. Certain products can be designed to accumulate cash value (tax free). The cash value and death benefit will grow each year and income tax free distributions are available during life.

Funding

There are several ways to fund (e.g., pay premiums for) life insurance policies. Strategies range from simple to complex and carry different tax consequences and contribution limitations. The simplest way to fund life insurance is for the policyholder to be the insured party (or spouse to the insured party) and to directly pay the premiums. Such a strategy results in the life insurance’s inclusion in one’s gross estate. As discussed above, most high-net-worth clients create an ILIT and fund it with enough cash or assets to pay the premiums. While a properly structured ILIT will remove the death benefit of the policy from the insured’s taxable estate, it is important to note that the funding of an ILIT can have estate and gift tax consequences. Funding strategies for ILITs include annual exclusion gifts, lifetime exemption gifts, split dollar, and premium finance.

Annual Exclusions

The amount of money or property each spouse can gift to an individual annually ($19,000 for 2025) without incurring gift tax. When funding an ILIT, each spouse can gift the exclusion amount for each beneficiary of the trust. The insurance premium will frequently be based on the amount the client can gift to the trust each year.

Lifetime Exemption

The amount of money or property each spouse can gift during their lifetime above the annual exclusion amount ($13.99M for 2025). A client can make large gifts to his or her ILIT to fund premiums without incurring gift tax up to this limit. This strategy leverages the Lifetime Exemption amount for heirs through the insurance death benefit.

Split Dollar Life Insurance⁸

When the estate loans or advances money to the ILIT under a split dollar agreement, the estate can claim the gift as being the economic benefit of the future death benefit or the loan interest on the cumulative premium amounts. Both options present a tax efficient option to funding ILITs when premiums are large and/or the annual exclusion and lifetime exemption options are unavailable due to other planning.

Premium Finance

When the ILIT borrows money from a third party to fund life insurance premiums. This strategy provides multiple points of leverage. First, there is a gift leverage as no gifting is required since the trust is borrowing money on its own volition to fund premiums with no maximum limit. Second, there is financial leverage as borrowing money to fund the policy increases both the risk and return potential. Premium finance programs should only be considered for sophisticated clients or advisors and with the guidance of an expert insurance consultant/broker. Performance and program management should be tracked at least annually.

Reviewing Existing Policies and Coverage

It is important to review and evaluate existing policies. The carrier and product landscapes are dynamic, and old policies may not perform as originally intended.

• Underperforming policies may lapse early, require additional premiums, or result in an unforeseen taxable event.
• Trustees and advisors should be certain that ownership, funding design, gift reporting, and performance (e.g., duration, death benefit, cash value) are closely monitored like any other financial program.
• Changes in age and health should also be considered so that policies can ultimately be rescued, optimized, or monetized (in the life settlement market).
• Changes in the dynamics of a family (e.g., death, divorce, adoption) may necessitate beneficiary modifications.

Conclusion

A large part of any planning is being proactive. Whether you’re planning for your next business venture or are thinking further ahead towards the inevitable, knowing your options, understanding your strategies, and being prepared is the only way to be certain that you can achieve your desired result. Life insurance can be a valuable planning tool for high-net-worth families, family offices, and family businesses if properly designed, implemented, and managed. At the end of the day (or the end of your life, as the case may have it), you ultimately need the peace of mind and assurance that you have insured your legacy. As outlined above, life insurance is an asset and strategy that can help accomplish this.

1 The death benefit is also known as the face value of the policy (e.g., the lump sum payment made to beneficiaries upon the insured’s death).

2 26 USC section 101(a).

3 If internal rates of return for the death benefit, which are based on the insured’s actuarial age, range from 5%-7% or more, the equivalent pre-tax return for a more traditional investment, which does not grow income tax-free, must exceed 9%-10%. For example, if the rate of return on the funds in the insurance policy is 5% ($100 x 5% = $5), then, depending on one’s tax bracket, the pre-tax rate of return on a traditional investment, which does not grow tax-free, must be approximately 8% ($100 x 8% = $8; $8 x 37% = $2.95; $8 - $2.95 = $5.04).

4 For an ILIT to be eligible to receive annual exclusion gifts, the trust must be structured to include certain beneficiary withdrawal rights, typically referred to as “Crummey powers” after the 9th Circuit case that affirmed their use (Crummey et al. v. Commissioner of Internal Revenue, 397 F.2d 82, (9th Cir.1968)). Note that the use of annual exclusion gifts to fund a dynasty trust may have certain GST tax consequences. It is important to consult with your estate planning counsel prior to beginning a program of annual exclusion giving to an ILIT.

5 Also known as flexible premium adjustable life insurance.

6 The nine-month estate tax payment deadline only applies to those individuals who are subject to the federal estate tax threshold, which, in 2024, is $13.61 million, and, in 2025, is $13.99 million.

7 A recent Supreme Court Case, Estate of Connelly v. US, 602 U.S. _____ (2024), addressed the transfer tax consequences of a buy/sell agreement where a policy on the decedent owner’s life was owned by the business to provide liquidity to fund a potential redemption. In Connelly, two brothers entered into a buy-sell agreement where if either brother died, the surviving brother would have the option to purchase the deceased brother’s shares. If the surviving brother declined the option, then the family business would be contractually required to redeem the shares. Ultimately, the courts ruled that the insurance proceeds were part of the value of the business (the obligation to purchase decedent’s shares was not a liability that decreased the value of the business). Clients with existing buy/sell agreements that involve business ownership of insurance should consult with their estate planning counsel about potential next steps in light of Connelly.

8 Split dollar agreements can also be used as a compensation strategy and to insure key persons to a business. There are two main types of split dollar policies with different income tax consequences – (i) collateral assignment split dollar insurance policies, in which the employee owns the policy, and (ii) endorsement split dollar insurance policies, in which the employer owns the policy. In a collateral split dollar insurance policy, the employee owns the policy, but the employer loans the employee the money to pay all or part of the premiums. When the employee passes away, part of the death benefit is used to pay back the employer for the paid premiums, or some other pre-determined amount, and the remainder is distributed to the beneficiaries. The employee owes interest on the loan from the employer. In an endorsement split dollar insurance policy, the employer owns and pays for the employee’s life insurance policy and endorses a portion of the death benefit to the employee’s beneficiaries. The employer’s payment of the premiums is taxable compensation to the employee and the premium payments are deductible by the employer. The employee has life insurance coverage, and the employer pays the premiums as a bonus as long as the key person is employed with the employer.

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