Life Insurance: A Rich Legacy For Children

Life insurance is a powerful tool for the rich to avoid taxes and pass on their wealth to their children. By placing a life insurance policy inside a trust, the death benefit is excluded from estate taxes, and the payout goes to the trust, protecting the remaining assets from lawsuits. This allows the rich to pass on stocks, yachts, and other assets to their children without incurring hefty taxes. Private-placement life insurance (PPLI) is one such tool, enabling ultra-rich Americans to shelter billions of dollars. While PPLI is currently legal, there are efforts to close this loophole and treat PPLI policies as investment funds, which would eliminate their tax benefits.

Private-placement life insurance (PPLI)

PPLI is designed for very wealthy people with a net worth of $20 million or more, or an annual income in the millions. It helps them pay less tax on their investments. It is promoted as a tax-efficient strategy and is becoming a tool for estate planning. It differs from standard life insurance policies in terms of investment flexibility, tax benefits, and customisation.

PPLI policyholders can invest in a diverse array of assets, including hedge funds, private equity, and other alternative investments not typically available in standard insurance products. They benefit from compound interest as investment gains within a PPLI policy are not subject to income tax until the money is withdrawn. Policyholders can also tailor their portfolios to meet their unique financial goals and specific risk tolerances.

PPLI policies can be placed in a trust to facilitate the transfer of wealth to beneficiaries. The death benefit from the policy can be used to provide liquidity for estate taxes, debts, or other expenses, or it can be distributed according to the terms of the trust.

Irrevocable life insurance trust (ILIT)

Irrevocable life insurance trusts (ILITs) are a type of trust that holds one or more life insurance policies, providing certain advantages to individuals, families, and business owners. ILITs are irrevocable, meaning the insured cannot change or undo the trust after its creation. This allows the premiums from the life insurance policy to avoid estate taxes.

ILITs are structured between three legal parties: the grantor, the trustee, and the beneficiary(ies). The grantor creates and funds the trust, the trustee manages it and pays the annual insurance premiums, and the beneficiary(ies) receive the trust assets upon the grantor's death. By creating an ILIT, the grantor removes taxable assets from their estate and transfers them to a separate legal entity, the trust. The trustee uses these assets to purchase a life insurance policy in the grantor's name and continues to pay the premiums. When the grantor dies, the policy's death benefit is paid directly to the trust, which then distributes the proceeds to the named beneficiaries.

ILITs offer several benefits, including tax advantages, asset protection, and government benefit protection. By removing taxable assets from the grantor's portfolio, an ILIT can help lower their current tax burden and avoid estate taxes on the insurance payout. ILITs also protect insurance benefits from divorce, creditors, and legal action against the grantor and beneficiaries. Additionally, for those seeking to provide lifetime care for a family member with special needs, an ILIT ensures that inherited assets don't interfere with the beneficiary's eligibility for government benefits such as Social Security Disability Income or Medicaid.

However, there are also drawbacks to consider. Establishing an ILIT requires the grantor to give up all rights to the property in the trust, including control over who the beneficiaries are and how they receive the assets. Additionally, the cost of setting up and maintaining an ILIT may include professional fees and gift tax returns.

Tax-free benefits

Life insurance is a powerful tool for the wealthy to avoid taxes and protect their children's inheritance. One way to do this is by using private-placement life insurance (PPLI), which is a little-known tax-avoidance tactic. PPLI allows the rich to pass down assets, from stocks to yachts, to their children without incurring estate tax. This is achieved by setting up a trust that owns the life insurance policy, which is created offshore. The policy premiums are funded with diversified assets, and the benefit and assets in the policy are passed to the children tax-free.

Another strategy employed by the wealthy to minimise taxes is to use an irrevocable life insurance trust (ILIT). By placing the life insurance policy inside the trust, the death benefit is excluded from estate taxes. The ILIT collects the death benefit, pays any taxes, and distributes the remaining assets according to the insured's wishes. This also protects the payout from lawsuits, creditors, and divorcing spouses.

In addition to these trust-based strategies, life insurance itself offers tax-free benefits. The death benefit received by beneficiaries is generally not considered taxable income, providing a tax-effective inheritance. This is in contrast to other financial accounts such as individual retirement accounts (IRAs), tax-deferred annuities, and qualified retirement plans, where beneficiaries may face taxes. While estate taxes can apply to life insurance death benefits, the exemption is high and rarely impacts most individuals.

Permanent life insurance also provides tax-free benefits during the policyholder's lifetime. It allows policyholders to build cash value that can be accessed tax-free through withdrawals or loans. The cash value grows tax-deferred, and withdrawals up to the amount of premiums paid are typically tax-free. This enables policyholders to supplement their retirement income or pay for unexpected expenses without incurring additional taxes.

High-cost permanent policies

Permanent life insurance policies are a type of insurance that never expires and covers the policyholder for their entire life, provided that the premiums are paid. This type of insurance is much more expensive than term policies and can carry hefty premiums. However, it also offers a cash value component and indefinite coverage, making it a popular choice for the ultra-rich who want to avoid taxes and protect their children's inheritance.

Permanent life insurance typically includes a cash value component that allows policyholders to borrow against their policy or withdraw funds later in life. This feature, along with the potentially longer coverage period, contributes to the high cost of permanent policies. Multimillion-dollar permanent policies, for example, can come with very high premiums, which can be a financial drain.

One way the wealthy use permanent life insurance to their advantage is by placing the policy inside a trust, such as an irrevocable life insurance trust (ILIT). This strategy allows them to exclude the death benefit from estate taxes. The trust receives the payout, which can then be used to pay any tax bills, with the remainder distributed according to the insured's wishes. This way, the rich can protect their children's inheritance from taxes and creditors.

The flexibility of permanent life insurance policies also makes them attractive to the wealthy. For example, universal life insurance, a type of permanent policy, allows for adjustable premium payments. Policyholders can scale down payments or skip them altogether if they need to pay for other large expenses, such as college tuition or a mortgage. This flexibility can be beneficial for high-net-worth individuals with complex financial needs.

In addition to the financial benefits, permanent life insurance policies offer strong legal protections. Trusts and life insurance are both protected by state laws, providing an extra layer of security for the insured's assets. This can be especially important for individuals concerned about protecting their wealth from creditors or divorcing spouses.

While permanent life insurance policies come with a high price tag, they can be a valuable tool for the wealthy to protect and pass on their assets to their children while minimising tax liabilities. However, it is important to note that tax policies can change over time, potentially impacting the advantages of these strategies.

Whole life insurance

The cash value in a whole life insurance policy grows at a fixed rate, usually between 1% and 3.5%. This growth rate is set by the insurer and distinguishes whole life insurance from other permanent policies that don't guarantee returns. Policyholders can borrow against the cash value or withdraw funds, but such actions reduce the death benefit. Additionally, unpaid loans, including accrued interest, decrease the death benefit dollar for dollar.

Frequently asked questions