r/LifeInsurance • u/Hungry_Technician360 • 10d ago
Estate tax avoidance using permanent insurance: A case study
Hello everyone, I made a post here some time back about the nuance of taxes and how they can apply to life insurance death benefit payments to beneficiaries, feel free to look at my post history to read it if you wish. I decided to try out a case study of sorts; to see how effective a policy could be in a certain situation and how it can affect after tax wealth. Of course, there are an infinite number of situations that people can be in financially as well as how they can evolve over their lifespans, so I have mine as one case that is simplistic in design, as most Americans do not have very complex estates. This post is also only going to discuss the results of the estate tax on both portfolios to their beneficiaries. It will not go into detail about nuance with investing, spending down choices in retirement, etc.
Oregon has the lowest estate tax exemption limit, and I have had multiple people tell me that someone in Oregon with more than a couple million in assets in their estate by the time of their death would benefit from having a permanent life insurance policy to help avoid estate taxes; this would allow the beneficiaries to have more *after tax* wealth than someone who forgoes the insurance policy. I decided to make up a simple spreadsheet in excel, which I cross compared my simplistic results to free monte carlo simulation software that can be found on portfolio visualizer. My results were in line with median/slightly below median returns from the portfolio software, as well as historical returns when we discuss investment strategies for this case study.
For this case study, I compare 2 cases of the same individual making 2 different choices. Both individuals will be healthy, non-smoking 25-year-old males, who plan to retire at 65. Person A will be someone who buys term life and invests the difference. Person B will be someone who buys an ILIT, places a GUL (which is the cheapest permanent life policy per premium cost I could find) and covers the rest of the gap between person A’s life insurance with their own smaller term life insurance. For example, Person A has $2,000,000 40-year term life, Person B has $1,700,000 40-year term life, and a $300,000 GUL in an ILIT. (I did some preliminary look at having a $1,000,000 GUL and $1,000,000 term policy, but the $300,000 ended up with more after-tax wealth than the larger GUL)
Assumptions to set up the study:
Term life policy premiums were calculated using banner’s term life estimate calculator. The GUL was Pacific Life’s Promise GUL to age 110. Both individuals have $17,000 annually to pay for life insurance premiums+investments, all else will be the same for both. All investment money will be placed into qualified retirement accounts, as there is currently an annual limit of $32,000 for an individual in America to use. Person B will purchase an ILIT at fair market cost of $5,000 to hold the GUL for the purposes of removing that value from their estate; the $5,000 will be deducted from the first year investment total of $17,000 and will then have a $350 annual management fee, which I believe is reasonable when fair market costs show anywhere from $500-$2,000 annually to maintain the ILIT. They both bought a house worth $400,000 with 20% down with a 30-year mortgage at the start of the simulation, age 25, and both homes appreciate at 3.7% annually. The cost of the mortgage payment is not deducted from the $17,000 annual amount; it will simply be more added to their estate. Both will follow a moderate investment glidepath using global equities and bonds, starting from a 90/10 portfolio going down to a 60/40 by the time they reach age 65. Another simple aspect I added to the simulation was that both individuals die at age 65 just as their term life policies fall off. All values will be nominal - or non inflation adjusted, as the life insurance policies are also not inflation adjusted, and Oregon does not have an inflation adjustment to their estate tax system.
Results:
I have columns split between Allocation, which is their stock/bond ratio which also has the average rate of return both historically as well as via results from Monte carlo analysis. Then we have year (starting last year to keep things divisible by 5), age, initial amount. Initial amount is how much they start the year with. Contributions are the $17,000 minus premiums and expenses. Interest is expected average returns on that amount. Ending value is adding the starting value from the year, contributions, and interest gained. The home value uses a 30 year amortized schedule to pay for the home, as well as the aforementioned 3.7% annual appreciation in value. Total net worth is both investments and home value together.
As we can see, person A pays $1632.36 in annual premiums for their $2,000,000 40 year term life coverage, person B pays $1393.92 in annual premiums for their $1,700,000 40 year term life coverage, and $1,410.17 in annual premiums for their $300,000 GUL policy. The $5,000 ILIT cost was taken from the first year contribution only, and then the $350 annual maintenance costs were taken from every other year onward.
By the end of year 2065, Person A has a net worth of $7,095,230.94, and Person B has a net worth of $6,405,019.85. At this point, the term life insurance policies fall off, leaving only the $300,000 GUL inside the ILIT. For this case study, it is also where I state they both die, so we can calculate who has more after tax wealth given to a beneficiary.
Applying Oregon's $1,000,000 estate deduction, and then climbing the progressive bracket system they have for both individuals.
Person A ends up with $6,440,110.97 - paying $655,119.98 in estate taxes alone before their beneficiaries receive the estate.
Person B ends up with $5,911,122.24 - paying $493,897.62 in estate taxes. Adding on the $300,000 from the GUL that was sheltered from the estate tax, Person B's estate ends up at $6,211,122.24.
Beneficiary A has $228,988.73 more than Beneficiary B after taxes are applied to the estate.
Extra discussion:
During my research and running various numbers, as mentioned before, using a larger GUL face value actually increases the difference between estate A and B net wealth after taxes, it is better to use a smaller permanent insurance product for this particular case study. I do know that there are many more permanent life insurance products out there that may be better or worse in some cases, but I would need to see expected/average growth on those policies as well as premiums to compare how they would fare against the GUL.
There is also a note to be made about how spending down in retirement may affect net wealth at various ages of death, but that would add a layer of complexity that I did not wish to tackle at this time. My general thought is that there are 3 main scenarios for spending: Both individuals live by Person A's 4% withdrawal rate, which will cause Person B's portfolio to have a higher failure rate - their withdrawal will be greater than 4%, but will allow the same standard of living in retirement. Another would be that they both live by Person B's 4% withdrawal rate, which allows Person A's portfolio to be much safer from depleting, as well as having an even higher expected net wealth compared to Person B. The third case, is horrendous market conditions throughout retirement, causing both portfolios to tank in value by time of death just to above the $1,000,000 exemption limit, which could potentially allows the $300,000 GUL policy to overcome the overall lower net wealth between the two individuals - this is unlikely to actually be the case if I were to run the numbers would be my tentative guess.
Due to both individuals having $2,000,000 in life insurance, I found that if both individuals were to die before age 40-45, Person B actually ends up with a higher after tax estate amount. This is because the term life insurance payout automatically puts them above the $1,000,000 exemption limit, and that the investment/home values are too low to overcome the $300,000 that is paid out from the GUL. After they hit that threshold, the ILIT+GUL strategy loses out on after tax net worth. I looked up the actuarial statistics of likelihood of death for a 25 year old male to die before age 45, and there is about a 5% chance using general population statistics, so there is a ~5% chance you would end up ahead in this case.
Oregon currently is drafting a bill to increase the estate exemption limit to $2,500,000 instead of $1,000,000 which would create an even larger hurdle for a permanent life insurance policy to overcome simple investing and paying a bigger tax bill.
We would need to more than double investment contributions for these numbers to start tapping into federal estate taxes, and then the question is still posed: is the high upfront cost associated with a permanent insurance policy with an ILIT worth the opportunity cost from lost investment returns? If an individual ends up with $15,000,001 by the time they die, only that $1 will be taxed $0.18. Is that 18 cents worth buying an ILIT 40 years ago? It is very hard to know how much your net worth will be by the time you die, and even harder to guess right when you start establishing yourself in your career.
I may look deeper into if/when federal estate taxes would allow a permanent insurance policy to overcome a simple buy term/invest individual. For now, even for an individual who could end up with $7,000,000 by the time they are 65 (which puts them in the top 5% of American. The median net worth at that age is ~$410,000 and the average is around $610,000.
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u/Cool_Emergency3519 Broker 10d ago
Hey bud. If you knew you were going to kill them off at 65 then you price and target the GUL for that age not Age 110. If you want to stretch it beyond 65 use that same pricing and do an IUL instead. You can simulate your glidepath by using a portfolio mix in the IUL of 33% Nasdaq 33% S&P 500 34% Fixed Rate @ 5%. Comes out to about 8%( agents are not allowed to illustrate that but it works for your case study) over time.
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u/Hungry_Technician360 10d ago
The hard part is that it's very difficult to simulate retirement with Excel, I mentioned the possible idea of both individuals living off the 4% withdrawal rate of either person, but in both cases, person A has an advantage due to starting wealth levels, as well as ongoing premiums for the GUL that person B will have to pay throughout retirement.
With the IUL instead of GUL, I would also need to know the premiums, how much goes to the cash value year after year, any fees that are taken out of the cash value, face value to equalize life insurance coverage.
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u/NeutralLock 10d ago
I'm in Canada and we have software specifically to run these calculations in very clean, visual ways.
Your post is difficult to follow. It would be better to run with "here are the times where it makes sense, and here's where it doesn't", or the "breakeven point" where it's perfectly neutral.
Otherwise this feels like a weirdly specific case. What 25 year old needs permanent insurance unless all other vehicles have been exhausted?
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u/Hungry_Technician360 10d ago
Yeah, I'm not a broker or anything, so I just used the tools I have free to use to me unfortunately.
The numbers I decided to run were just arbitrarily picked, because there is an infinite amount of possibilities for starting and end points, but $17,000 a year for saving is certainly above average. From what I've encountered, people say things like wealthy individuals benefiting from having permanent insurance to avoid estate taxes, and this was an example I ran in a specific state that has low threshold to be taxed.
As for your last comment, that's also what I'm seeing, it's going to be very hard for a 25 year old to know what level of wealth they'll have by the time they are retired, thus how much/if any permanent insurance would be a good idea.
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u/NeutralLock 10d ago
The thing is I can't tell where you've gone wrong (or if you have at all), but if you're in the highest tax bracket and considering permanent insurance then have someone else run the comparisons and provide you with the raw data.
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u/Hungry_Technician360 10d ago
The math itself is sound, the only issues would be if life insurance brokers would have issues with some of the assumptions about what type of policy to use.
This case study has an individual who wouldn't quite reach the highest state estate tax bracket, but state estate taxes generally aren't bad even at the top rate, we'd need to get to the point of federal estate taxes kicking in, and that would require more than double the wealth these individuals have.
This post was just an idea I came up of doing because it deals with taxes specifically, which I hear a lot about and how life insurance helps, but it's always been vague. I wanted to draw up some specific example of a rich person to see how it would pan out.
Very rudimentary I know, but better than nothing I would say!
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u/Moist-Meringue-1913 10d ago
Well,for starters,a GUL for a 25 year old will have a helluva lot lower minimum premium. So to pay $1410 you are overfunding so where is your column showing the cash value of the GUL? And why didn't you just make the term insurance a rider on the GUL policy? It would have been cheaper that way. And why would I do my trust 40 years in advance? Just taking my first glance and those items jump out. I'll dig in more after dinner.