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Should I Buy Life Insurance To Pay Death Taxes?

Does second-to-die insurance create a tax bonanza? Not exactly.

“I’m thinking about a second-to-die policy that would pay off after my wife and I are both gone.

“Here’s some proposals the agent came up with, based on gifting premium dollars to a trust owned by the two boys. I need to work through all the tax wrinkles, but ultimately it’s a series of bets, most importantly that we both die after one premium and the boys stick it to the insurance company for the full death benefit. After that the payoff diminishes in magnitude.

“Would love to hear your thoughts if you dive into it.”

Dan, Connecticut

Second-to-die: the marvelous insurance policy that magically creates a tax-free payoff to your kids. They can use the money to pay death taxes on the rest of your assets.

Except that the timing of the payoff does not align with what your family needs. Also: The tax-free benefit turns out to be not so magical. Also: Future premiums are a little murky.

These policies, sold to a couple nearing or in retirement, have a death benefit that is activated only when the second parent is deceased. Second-to-die is such a mouthful. Can I just say that what the agent wants you to have is an S.T.D.?

At first blush the S.T.D. tax exemption does look quite powerful. One element of it is that a life insurance policy’s death benefit does not constitute taxable income. Thus, if you take out a $1 million policy and pay one $10,000 premium, and the next day get pushed onto the subway tracks, your heirs make a $990,000 profit but don’t pay income tax on that profit.

The second key fact about life insurance is that the proceeds can be kept out of your estate. The way to do this is to make sure that the policy is owned by the survivors, not by you. This is easy to arrange.

These two tax angles can be spun into quite the sales pitch. There’s no death duty when either you or your spouse dies, because a surviving spouse doesn’t owe estate tax. When you’re both gone, though, the next generation, which potentially owes a bundle in estate taxes, has those covered with the proceeds of an S.T.D. policy. Because the date of the second death is probably a long way off, the premiums are low, much lower than they would be on a single-life policy for either you or your spouse.

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

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

But the federal exemption doesn’t last. Much like a carriage turning back into a pumpkin, the exemption reverts, at the stroke of midnight on Dec. 31, 2025, to the $5 million it was under a previous tax law.

Last year, when the Democrats had firmer control of Congress, there was talk of accelerating the sunsetting date and even of cutting the $5 million amount. And so S.T.D. came back to life.

Your agent has a policy illustration that works like this. You pay $62,000 a year in premiums for a projected ten years, after which the policy is fully paid up. After you and your wife die, the policy pays out $2.1 million. The kids 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 scheme has to be arranged just so. You can’t own the policy. It’s owned by the kids, or more precisely, by a trust on their behalf. They pay the premiums. But you make gifts to reimburse them, taking advantage of the $16,000 annual gift tax exclusion.

This exclusion is per donor, per recipient. There are two of you and two of them, so your family can transfer $64,000 a year without eating into your lifetime gift/estate tax exclusion ($12 million each or $5 million or whatever it is destined to be). Your policy premium skirts just under the $64,000. Clever.

You send the kiddies the money, they ponder for two or three seconds what to do with it, then decide to throw the cash into the trust. With money in hand, the trust can cover the insurance tab. This charade is blessed by ample legal precedent.

Is this a terrific deal? Not quite. I have three objections.

The first has to do with the timing. As you note, the big payoff in annual percentage return occurs if you and your wife both die young. If, on the other hand, you live an actuarially expected dual lifespan, which in your case is about 35 years, the policy has a mediocre investment return.

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

The next thing I object to is the notion that life insurance creates a tax bonanza. If you want to slip $62,000 a year tax-free to the youngsters you can do that without involving an insurance company. Just send them money. (I gather they are both unmarried and in their 20s.) Tell them to use it to buy growth stocks—or a house.

Yes, insurance portfolios enjoy an income tax break of sorts. Earnings inside the insurance company that help pay for death benefits (called “inside build-up”) are largely tax-exempt. But the tax advantages of growth stocks and houses are just as good, and the kids are missing out on those if they invest in life insurance.

Last problem is one common to just about any life insurance other than the simplest kind of term policy. What you have in this document about premium levels is not a contract but a “projection.” How long you have to chip in in order to keep a universal policy in force is subject to lots of unknowables—future death rates, overhead costs, portfolio returns.

Just one of these factors can be nailed down, to a degree: If you opt for a fixed-income investment, rather than one of the insanely complicated stock-market-linked choices, the portfolio return is guaranteed to be at least 1%. Well, if you want a guaranteed 1% return, get some U.S. Treasury bonds. They are a lot less uncertain.

What became of Barry Kaye? His firm, now in the hands of his son, is going strong. He lived to be 91, so if he bought life insurance he probably didn’t get a great return on it.

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

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

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