The majority of trust-owned life insurance policies are managed by unskilled trustees. Even professionals such as accountants and attorneys who may serve as trustees are unaware of the numerous risks that life insurance policies carry.
As a result, most policy owners are unknowingly overpaying every year, letting their policies edge closer to lapsing, and even potentially gathering interest on a loan they did not know they had. Accountants and other professionals serving as trustees of irrevocable life insurance trusts for their clients should be aware that not adequately managing these trust assets may subject them to future liability. As such, they should be aware of new tools available to monetize life insurance as liquid investments that also prevent policies from lapsing.
Most of the issues associated with life insurance arise due to trustee negligence and the widespread mistaken belief that life insurance is a “buy-and-hold” asset. Life insurance should be viewed as a liquid investment that policy owners can actually benefit from, rather than a burden on which they have to pay premiums every year. With this mindset, policy owners should be aware there is a better alternative to surrendering or selling their policies if they are in need of additional liquidity. Policy owners should also understand how a policy sale (a life settlement) is often double-taxed.
Currently, when the owner of a life insurance policy seeks to sell the policy, whether for additional liquidity or other financial reasons, they face two options. The first option is to surrender the policy to the life insurance company that issued it in exchange for its cash surrender value, or CSV, which is much less than the total premiums paid up to date and reflects the enormous cost of commissions, surrender charges, cost-of-insurance charges and many other fees charged by insurance companies. The CSV has no correlation to the face value of the policy and, in the majority of universal life policies, amounts to less than 5% of the death benefit. The second option is to sell it on the life settlement market, in which the seller typically receives a price higher than the CSV. In a classic life settlement transaction, the seller of a policy engages a life insurance agent, a life settlement broker, and/or a licensed life settlement provider. This inevitably results in multiple intermediaries’ fees that substantially reduce the seller’s return.
Policy owners now have a third option, which their CPAs and advisors should be aware of. Policy owners can monetize their policies by treating them as assets on which they can obtain credit, similar to home mortgages. Now policy owners can receive cash advances, premium financing and credit for relevant legal and accounting fees — all without outside collateral. This allows policy owners greater financial flexibility and ensures they keep their policies for their families’ benefits and for their tax-planning needs.
The most significant risk facing policy owners today is the longevity risk, or the risk of outliving one’s policy. With medical advances and lifestyle changes, many insured people are outliving their policies’ termination dates. Managing life insurance like a liquid asset mitigates this risk. Just as investors in real estate often transfer risks to external lenders, policy owners should transfer the longevity risk to a third party. By obtaining credit secured only by the future death benefit of their policies, policy owners can eliminate or reduce their out-of-pocket premium payments while still maintaining their policies for their beneficiaries and tax-planning needs.
Policy owners lose the tax advantages of life insurance when they sell their policies. The payout of a policy’s death benefit is not subject to income taxes. Most trust-owned life insurance policies are placed in an ILIT, which also excludes the death benefit from the decedent’s gross estate.
Accountants should be aware that policy owners often have to pay both ordinary income tax and capital gains tax on their policy sales depending on the policy’s “cost basis.” A life insurance policy’s “cost basis” is primarily determined by the amount of premiums paid into the policy. During a sale, if a policy’s CSV is greater than its cost basis, then the policy owner has to pay ordinary income tax on the difference between the CSV and the cost basis. In addition, if a policy owner sells a policy for more than its cost basis, then that policy owner must also pay capital tax on the difference between the sale price and the cost basis.
For example, a policy owner who sells a $2 million policy with a $400,000 CSV and $300,000 cost basis has to pay ordinary income tax on the difference between the CSV and the cost basis, as well as capital gains tax on the difference between the sale price and the cost basis. The policy owner’s minimal return is further reduced by the multiple intermediaries’ fees.
The simplest way for policy owners to avoid losing the tax and investment advantages of life insurance is to keep their policies and to manage them as liquid investments that can provide immediate liquidity.