One of the many impacts COVID-19 has had on us is a sharp awakening to the need to create a plan for what will happen in the event of one’s death. We’ve heard from many advisors with clients who are working on their wills and are reaching out to discuss securing life insurance protection, and their legacies. For the right client, life insurance can be an efficient way to pass money from one generation to the next.
It all starts with the client conversation. The process should be built around making sure for the client that the right people get the right things in the right way. The conversation may include, in addition to Saybrus and the client’s financial advisor, select family members, attorneys and tax professionals.
For a lot of clients — and these are clients generally between the ages of 65 and 80 who are already retired — a big part of that discussion is understanding what their goals are and their overall financial picture. The discussion should also seek to identify assets that aren’t needed specifically for retirement and could be legacy assets. There are four common places advisors can find assets that might not be needed and can be earmarked for an inheritance.
Legacy assets may be found as annuities that were originally bought for retirement purposes but once the client is in retirement, are not needed for income. IRAs are another common place where we can find legacy money that won’t be used for retirement. Other typical sources include general non-qualified investment accounts and Roth IRAs.
There are advantages and disadvantages to using those assets both in retirement planning and for wealth transfer purposes. For example, when an annuity is passed to a beneficiary, the gains inside the annuity can be taxed as ordinary income.
An IRA has, just like an annuity, tax-deferred growth throughout earning years and retirement years until you begin taking distributions from the IRA. But, upon inheritance, that IRA is going to be taxable to the heirs, who in many cases may be in their peak earning years and subject to a higher tax bracket.
With non-qualified accounts like a brokerage account, taxes are paid as gains are realized. Ultimately, when the asset is inherited there is a step-up in basis.
A Roth IRA is an excellent place for a client to have money when they pass away. That said, a Roth IRA is still a relatively new financial instrument, so many clients haven’t had the length of time in the work force with a Roth IRA available to build up a large balance, or they may be hesitant to do a Roth conversion with existing assets because of the potential tax hit.
While no one vehicle is the answer for legacy planning, life insurance can be an additional piece of the puzzle to help make wealth transfer more efficient.
The number one benefit to using life insurance as a wealth transfer vehicle is that it can provide a predictable death benefit for the beneficiary, even in a market downturn.
If a client has a $500,000 life insurance death benefit and we come to a dramatic sustained drop in the market, the client’s other assets may be impacted, but if structured in the right way, a life insurance death benefit will remain fixed at $500,000.
Tax benefits associated with life insurance are another win for beneficiaries. As a general rule, a life insurance death benefit will pass to heirs 100% income tax free. That could become even more appealing if tax rates rise in the future.
A third benefit is that the rate of return compared to premiums paid can be very competitive. The rate of return on the death benefit will depend upon when the client ultimately passes away, but as an example, at life expectancy a rate of return for the life insurance can be somewhere in the neighborhood of 6% to 8%.
Clients also have complete control over beneficiaries listed for life insurance and it’s easy for them to change beneficiaries, if necessary.
Lastly, the death benefit itself is 100% liquid. If a client has assets like a vacation home or a business, they may need to be sold to properly distribute the value of the assets among heirs. Life insurance, because it’s 100% liquid, can be an effective way to facilitate a buyout.
When considering life insurance for wealth transfer, there are three things that have to be present for it to be appropriate for a certain client.
First, of course, is the client’s desire to leave legacy assets to an heir. “The client has to want to leave more, to proactively plan their legacy for their family or a church or charity. Most clients do have that desire as long as it won’t affect their retirement lifestyle.
Obviously if a client doesn’t have legacy assets that aren’t needed for retirement, they can’t pass them on to their heirs, so an advisor has to take a close look at their client’s full financial picture. Clients should have a stable retirement picture in terms of income and a plan for funding for long term care needs. The clients must also be healthy enough to qualify for the life insurance. Most insurers will underwrite a client up to age 90, but it’s better to start when the client is between 65 and 80.
Establishing a legacy plan may be easy for clients to put off, but time is of the essence. With markets at all-time highs, now is a great time to reposition some of the market gains over the last couple of years into a legacy plan.