This doesn't necessarily have to be a trick question. Wealthy people have, in most cases, more to protect.
Why do affluent individuals who are worth $5,000,000 or $10,000,000 or $20,000,000 or even more have life insurance? Does life insurance really make sense for them?
The wealthy, very simply, have a lot more to lose than do others who have been less successful financially. Your estate represents your lifetime. You spend your lifetime building your estate and virtually overnight the IRS tax collector can take away 50% or more of your lifetime of effort in the form of estate taxes. For example, a $10,000,000 estate would have estate taxes and related costs in excess of $5,000,000. Could you write a check today for 50% of everything you own? Some people are concerned that inheriting a lot of money will ruin their children. Malcolm Forbes started with an inheritance and built on that. He then purchased huge insurance policies to help minimize the tax impact on his estate, so that he could pass the inheritance on to his children. There is never too much money ... only too little character. Do you think that paying estate taxes will build character? Do you think the IRS will build a building with your name on it?
Everyone pays the price for success ... not just the breadwinner. You pay the price, your spouse pays the price, your children pay the price, and your employees pay the price. Everyone pays. Why compound the problem by having them pay the price again in the form of estate taxes when you are gone? Why should your dreams die when you die, if there is an option?
Life insurance represents a viable alternative to the liquidation of your lifetime. It normally can be acquired without changing your lifestyle. Most individuals think of buying life insurance out of cash flow, and thus the cost seems to be prohibitive when large amounts of insurance are being considered. In larger estates, insurance is acquired by repositioning capital or using part of the growth. This results in a greater return after income taxes and after estate taxes than would be achieved in any other form of investment.
Doesn't it make more sense to set aside a little bit today during your lifetime rather than transferring a massive problem to your children tomorrow? If you can't handle a small problem today, how can they handle a much larger problem tomorrow? No one likes to buy life insurance. It is simply the lesser of two evils.
Even if you had adequate cash available to pay the estate taxes, it would not seem to make sense to use it if you could discount the estate tax liability by 80-90% by using life insurance. Why pay $1,000,000 if you only need to pay $200,000? Wouldn't you rather pay wholesale than retail? Why be forced to sell a cash cow if you could sell just a little milk instead? Successful people become that way by making logical business decisions. Suddenly when it comes to the subject of life insurance, logic is thrown to the wind and emotion rules. That really does not make sense, does it?
The current tax law enables a decedent to leave his or her entire estate to the surviving spouse without incurring any estate tax. As a result of the "sucker play," as it has been labeled by several top estate planning attorneys, many wealthy individuals have been lulled into a false sense of security. The tax is merely deferred until the death of the surviving spouse. The tax must still be paid. The problem still exists. In many situations it makes sense to pay taxes at the first death.
The best way to determine whether or not life insurance makes sense for you is to look at the numbers and examine your options.
Life insurance can provide real value to a business owner. An insurance policy can address a wide range of business objectives and needs. It may, for example, be a key element in funding a buy-sell arrangement among partners. Insurance can also be used to protect a company from the financial disruption caused by the loss of a key employee. In other situations, it provides a stable source of support for the business owner's family.
The benefits of insurance, however, often shine brightest when it comes to paying estate taxes. Estate taxes can be an acute problem for family businesses. The timing of the estate tax couldn't be worse. It is levied at death, just when the family- business is most vulnerable to competitors, family squabbles and cash pressures.
There are ways to take some of the sting out of estate taxes if some planning is done during the business owner's lifetime. With the right estate planning documents, for example, each spouse can eliminate estate taxes on $600,000 of assets and defer any tax payment until the surviving spouse's death.
If there is still an estate tax due all available deductions have been used, however, it can be a very big number. Under legislation now pending before Congress, the top tax rate likely will increase from 50% to 55% of the decedent's net worth. This is where life insurance to pay estate taxes can play an important role. Four considerations make life insurance an attractive option for paying estate taxes:
Source of liquidity. A business owner's estate can face a big crunch if estate taxes are due.
Usually, the family finances are tied up in the business and funds are not readily available. Without sufficient life insurance or other cash resources, the family may have few viable alternatives to selling the business. One option may be to pay the estate taxes in installments over 15 years under a special tax law for small business owners. This installment plan has the downside, however, of diverting future company earnings to pay taxes. Some family companies are also concerned about having the government as a "business partner" until the estate tax bill is paid in full. Life insurance can provide a ready source of cash to pay estate taxes without putting a burden on the future profitability of the company.
Source of liquidity. Income tax benefits. Life insurance enjoys some favorable income tax features that make it an attractive source of funds.
The timing of the estate tax couldn't be worse. It is levied at death, just when the family business is most vulnerable to competitors, family squabbles and cash pressures.
The accumulated earnings on an insurance policy, for example, build up tax free during lifetime in much the same way that income in a pension plan or individual retirement account is protected from income tax until it is withdrawn.
The key benefit of life insurance, however, is that the insurance proceeds usually are exempt from income tax at death. Tax planners often speak of "after tax dollars," referring to the dollars left to meet cash needs after income taxes are paid. In this sense, 100% of insurance proceeds are "after tax dollars."
Certain tax traps require special caution and planning. Income taxes will arise if a policy is transferred during lifetime without abiding by some very technical tax rules. Policies owned by a corporation are also subject to special income tax laws.
Estate tax benefits. One feature makes insurance unique from any other asset. Its value jumps dramatically at death.
As a result, it often makes sense to transfer an insurance policy during lifetime while the value is low. Typically the policy is transferred to an insurance trust created for the family's benefit. This usually can be done with little or no gift tax by applying available gift tax exemptions.
By getting the policy out of the insured's estate during lifetime, it is not subject to estate tax at death. In this way, the insurance proceeds will be available to meet the family's cash needs without incurring another layer of estate taxes. This type of planning requires some lead time. Under a special tax rule, insurance transferred within three years of death remains subject to estate tax.
Out-of-pocket cost. If the insurance proceeds fully cover the estate taxes due, then the business owner's out-of-pocket estate tax cost has been limited to the dollars spent on insurance premiums. If untimely death occurs after the first insurance premium, for example, the out-of- pocket cost for full estate tax protection would be pennies on the dollar.
The relative merits of insurance, however, should not be based on projections of an early death. A well-designed insurance program should make sense even if the business owner beats the odds and lives well beyond normal life expectancy.
For this reason, it is vital to have realistic illustrations showing when an insurance policy would be "paid up" and no longer require additional premiums to maintain full coverage. In this way, a business owner can reasonably project the actual dollars needed to provide specific insurance coverage years into the future.
Estate taxes are a fundamental problem for many family businesses. If properly orchestrated, life insurance can effectively provide a tax-advantaged way to raise the cash needed to pay taxes and preserve the business as a going concern.