Do I have to take out life insurance to pay taxes on death?

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Does second death insurance create a tax windfall? Not exactly.

“I’m thinking of a second-to-die policy that would pay off after my wife and I leave.

“Here are some proposals the agent made, based on donating premium dollars to a trust owned by the two boys. I have to sort out all the tax issues, but ultimately it’s a series of bets, the more important being that we both die after a premium and the boys defer to the insurance company for the full death benefit, after that the gain diminishes in magnitude.

“I’d love to hear your thoughts if you dive into it.”

Dan, Connecticut

Second-to-die: the wonderful insurance policy that magically creates a tax-free gain for your children. They can use the money to pay death taxes on the rest of your assets.

Except that the timing of the payment doesn’t match your family’s needs. Also: The non-taxable benefit turns out not to be so magical. Also: Future bounties are a bit fuzzy.

These contracts, sold to a couple close to retirement or in retirement, include a death benefit which is activated only on the death of the second parent. Second-to-die is such a mouthful. Can I just say what the agent wants you to have is an STD?

At first glance, the STD tax exemption seems quite powerful. One of the things is that the death benefit from a life insurance policy is not taxable income. So if you take out a million dollar policy and pay a $10,000 premium, and the next day you get pushed onto the subway tracks, your heirs make a profit of $990,000 but pay no tax on this profit.

The second important fact about life insurance is that the proceeds can be kept outside your estate. To do this, make sure that the policy belongs to the survivors and not to you. It’s easy to organize.

These two tax angles can be turned into a sales pitch. There is no inheritance tax when you or your spouse die, as a surviving spouse does not owe inheritance tax. When you’re both gone, however, the next generation, who potentially owes a bundle of estate taxes, have those covered by the proceeds of an MST policy. Because the date of the second death is likely distant, the premiums are low, much lower than they would be on a single life insurance policy for you or your spouse.

A few decades ago, when death taxes weighed heavily on the upper middle class, these policies created a nice business for agents. Notable among them: Barry Kaye. He had books, a big ad campaign, and a thriving insurance agency (call 1-800-DIE-RICH).

Along came a few tax cuts that peeked out of the agents’ veils. The federal estate tax exemption is now $12 million per person, meaning a couple can leave $24 million tax-free to the next generation. Many states have reduced or eliminated death taxes.

But the federal exemption does not last. Much like a horse-drawn carriage turning back into a pumpkin, the exemption reverts, at the stroke of midnight on December 31, 2025, to the $5 million it was under a previous tax law.

Last year, when Democrats had firmer control of Congress, there was talk of accelerating the expiration date and even reducing the $5 million amount. And that’s how STD came back to life.

Your agent has a policy illustration that works like this. You pay $62,000 a year in premiums for ten years, after which the policy is fully paid up. After you and your wife die, the police pay out $2.1 million. The children would use the money to cover death taxes on your other assets. (Do you own a yacht or something?) The policy amount would be totally tax free.

To work, the schema must be arranged like this. You cannot own the policy. It is owned by the children, or more specifically, a trust on their behalf. They pay the premiums. But you make donations to pay them back, taking advantage of the annual $16,000 gift tax exclusion.

This exclusion is per donor, per recipient. You’re two and two of them, so your family can transfer $64,000 a year without impinging on your lifetime gift/estate tax exclusion ($12 million each or $5 million or whatever) that is). Your policy premium is just under $64,000. Clever.

You send the money to the kids, they think for a couple of seconds what to do with it, and then decide to throw the money into the trust. With cash in hand, the trust can cover the insurance tab. This charade is blessed with numerous legal precedents.

Is this a great deal? Not enough. I have three objections.

The first has to do with timing. As you notice, the big percentage gain in annual yield occurs if you and your wife both die young. If, on the other hand, you live an actuarially expected double life, which in your case is around 35 years, the policy has a poor return on investment.

This earning profile is the exact opposite of what your family needs. If you die young, your children won’t need an insurance windfall because you won’t have spent much of your retirement savings. If, on the other hand, you live to be 92 and your wife to be 94, in both cases with big retirement home bills at the end, then your assets will be depleted and the 2.1 million dollars will be too little, too late.

The next thing I take issue with is the idea that life insurance creates a tax windfall. If you want to pay $62,000 a year tax-free to young people, you can do it without involving an insurance company. Just send them money. (I’m guessing they’re both single and in their twenties.) Tell them to use it to buy growth stocks or a house.

Yes, insurance portfolios have some kind of tax relief. Earnings inside the insurance company that help pay death benefits (called “internal accumulation”) are largely exempt from tax. But the tax advantages of growth stocks and houses are just as good, and the kids miss out on them if they invest in life insurance.

The last problem is common to almost all life insurance other than the simplest type of term insurance policy. What you have in this premium level document is not a contract but a “projection”. How long you need to contribute to keep a universal policy in force is subject to many unknowable things: future mortality rates, overhead costs, portfolio returns.

Only one of these factors can be identified, to a certain extent: if you choose a fixed income investment, rather than one of the incredibly complicated choices linked to the stock market, the portfolio return is guaranteed to be at least 1 %. Well, if you want a guaranteed 1% return, get US Treasuries. They are much less uncertain.

What happened to Barry Kaye? His business, now in the hands of his son, is doing well. He lived to be 91, so if he bought life insurance, he probably didn’t get a good return on it.

Do you have a personal finance puzzle that might be worth a look? This could involve, for example, retirement lump sums, Roth accounts, estate planning, employee options or the sale of popular stocks. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Request” in the subject field. Include a first name and state of residence. Include enough detail to generate useful analysis.

Letters will be edited for clarity and conciseness; only some will be selected; the answers are intended to be educational and are not a substitute for professional advice.

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