Life Insurance for Wealth Transfer

Thang Truong
Thang Truong
Updated on:

Life insurance is a highly useful financial tool for those concerned about afterlife expenses and the costs of living for loved ones they leave behind. The death benefits on life insurance policies are usually enough to cover funeral costs, pay debts, and give family members money to live on for a few years. Life insurance policies can also be used to a way to pass wealth from one generation to the next via very large death benefits.

Passing Wealth Through Life Insurance Policies

Those who have accumulated wealth in life may want to ensure it is passed onto their family members. One of the easiest ways to do this is through a life insurance policy with a large face value. The death benefits are usually tax-free and certain policies, like the guaranteed universal life policy pay out much more than the policyholder invests.

To demonstrate how a life insurance policy can grow and transfer wealth to the next generation, we have pulled two policy illustrations from Penn Mutual and Prudential insurance companies. The policyholder is a 40-year-old male, non-smoker who is looking to pay 20 years of premiums for a $10 million death benefit. Both of the policies are for guaranteed universal life insurance (or GUL).

Life Insurance CompanyPolicy TypeAnnual PremiumTotal Premium OutlayDeath Benefit
Penn MutualGuaranteed Protection UL®$79,451$1,589,020$10,000,000
PrudentialPruLife® Universal Protector$87,500$1,750,000$10,000,000

The Penn Mutual life insurance policy has a total premium outlay of roughly $1.5 million in exchange for a $10 million death benefit. This means the policyholder can get a roughly 6.5X return on their investment. With the Prudential policy, the ROI is similar at 5.5X growth. 

Of course, life insurance policies that are this large can potentially increase the policyholder’s estate to a taxable size. There are also strategies for minimizing the estate taxes that can deplete family wealth and impact a life insurance policy’s death benefit.

>>MORE: Best 5 Companies for Guaranteed Universal Life Insurance

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What are Estate Taxes?

Many people use life insurance as a way of providing liquid assets to pay potential taxes and fees on their estates. This allows your relatives to keep significant property, such as a family home, instead of selling it for the cash to pay an estate tax.

Estate Taxes are federal taxes that are charged to estates with combined gross assets and prior taxable gifts exceeding $11,580,000. The gross assets in an estate may include:

  • Cash and Securities
  • Real Estate
  • Life Insurance
  • Trusts
  • Annuities
  • Business Interests
  • Other Assets

To calculate the value of an estate, the fair market value of these assets are added together and any debts, charitable donations, and allowed deductions are subtracted from that amount. If the final total exceeds the $11.58 million exemption, then estate taxes are applied to the overages. 

>>MORE: How Much does A $10-Million Life Insurance Policy Cost?

Estate Tax Rates

The estate tax rates vary depending on how much taxable value there is in the estate, but it is usually between 18% and 40%. For instance, if your estate’s taxable amount is $10,000 or less the taxed rate is 18%. Also, if your estate’s taxable amount is more than $1,000,001, the tax is a flat fee of $345,800 plus 40% of the amount over $1,000,000.

>>MORE: How Much does A $5 Million Life Insurance Policy Cost?

Using a Trust to Protect Life Insurance

As you can see, life insurance is considered a part of the estate so it can technically be taxed as part of the estate as a whole. It’s also possible for a large life insurance policy to push an estate into taxable territory. However, it’s possible to avoid estate taxes on life insurance by placing it into an irrevocable trust before death. 

An irrevocable trust holds the life insurance policy for the beneficiaires with the death benefit being paid out when you die. Once placed in the trust, the life insurance policy is no longer considered your property or part of the estate. So, the large face value won’t count towards the size of the estate and the death benefits don’t get taxed as part of the estate either. 

>>MORE: What is a Life Insurance Trust? And How to Set It Up?

The Gift Tax on Premium Payments

If you opt for a life insurance policy that requires annual or monthly premium payments, you could run afoul of the Federal Gift Tax, meaning you might have to file a gift tax return every year and potentially pay taxes on the premium payments. Why is this? Since the policy is held in trust for your beneficiaries, it means that the premium payment may be considered ‘gift money’ to the beneficiary for the future. 

Thankfully, there is a gift tax exclusion of $15,000 per recipient per year, with a maximum lifetime cap per recipient of $11.58 million.

In order to qualify for the exclusion each year, you simply need to notify the recipient that you’ll be placing some money into the trust to pay the life insurance premiums. This letter lets the beneficiaries know that they have received gift monies in the trust and have the right to withdraw the funds for the next 30-days. Naturally, you don’t want the money to be taken out, so will need to let the beneficiary know about hte purpose of the funds too. Also known as a Crummey letter, this notification helps you avoid the gift tax by counting the premium payments towards the annual exclusion.

In some cases, the premiums may be higher than the gift tax exclusion. For instance, the two illustrations we pulled for GUL policies have annual premium payments of around $80,000 to $90,000. The premiums on each of these policies is well in excess of the $15,000 gift tax exclusion. However, the policyholder may still be able to avoid paying the gift tax on the premiums, as long as the overage does not exceed the lifetime gift cap for the beneficiary.

>>MORE: Compare Guaranteed Universal Life Insurance with Whole Life Insurance

An Example of the Lifetime Gift Cap in Action

Our policyholder’s $10 million Guaranteed Protection UL® from Penn Mutual has an annual premium of $79,451 for 20 years. He has placed it into an irrevocable trust to protect his estate and sends a Crummey letter to beneficiaries each year when making premium payments. Even with the annual gift tax exclusion, the policy holder is considered as giving $64,451 per year to the beneficiary through the trust. At the end of the premium payment schedule of 20 years, the total amount of gift money given to the trust will be $1,289,020. 

The high premiums do trigger the requirement to file an annual gift tax return. However, the policyholder won’t owe gift taxes because the overall amount given is still less than the lifetime cap of $11.58 million per the recipient.

Since the gift tax cap amount applies to annual gifts and the estate tax applies to property within your estate, it’s possible to set up these massive life insurance policies so beneficiaries won’t owe any taxes on the payout.

Final Thoughts:

  • Large life insurance policies allow people to pass wealth to loved ones.
  • Life insurance death benefits can be used to pay taxes and fees on an estate.
  • An irrevocable trust allows policyholders to protect life insurance policies from being taxed as part of their estate.
  • The gift tax cap may be triggered by premium payments on life insurance policies in trust, but can be avoided.

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Thang Truong

Thang Truong covers small business insurance and small business success at BravoPolicy. He is a licensed P&C insurance agent. Previously, he held product leadership positions at, Capital One, NerdWallet, and Mulberry Technology. He holds a MBA degree from UC Berkeley - Haas School of Business.

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