Editor’s note: Howard Sharfman is a columnist with Rethinking65. Read more of his articles here.
Howard Sharfman
Building and maintaining wealth isn’t just about accumulating assets; it’s about protecting them from taxation, market volatility and liquidity challenges. Life insurance can be a strategic tool in this process, providing heirs with an asset uncorrelated with other investments that provides near immediate access to cash. When structured within an irrevocable life insurance trust (ILIT), it can become an even more powerful, tax-efficient tool.
First, let’s look at the role that life insurance plays in addressing a client’s needs. Sometimes our clients ask if life insurance is necessary. The reasoning they often share is, “Couldn’t I keep more money by investing wisely in the market?” The bet they’re making is that they will live long enough for their investments to grow and that the investments they choose will in fact appreciate. Market cycles are unpredictable and if a client passes away during a market downturn, life insurance ensures tax-free liquidity without having to sell assets at a loss.
Additionally, clients who built successful businesses sometimes assume that the business will always be a reliable source of wealth. However, businesses, like the market, go through cycles, and economic downturns can significantly impact their value. A well-structured financial plan — including life insurance — ensures that heirs are not left in a precarious position if the business declines or fails.
Minimize Sequence Risk and Estate-Tax Pressure
When it comes time to draw down assets invested in the stock market, sequencing those withdrawals is an entire strategy unto itself. This execution will depend on the family’s specific needs and the time horizon of the entrusted assets. Additionally, few families want to liquidate a business or other assets under pressure just to pay estate taxes. Life insurance creates the liquidity needed to cover obligations while preserving long-term investments.
However, an insurance payout is normally part of the taxable estate, potentially subject to estate taxes. For example, if a client has $10 million in assets and $5 million in life insurance, their estate would be valued at $15 million upon death. This increase in total value could subject the estate to additional taxes, reducing the amount available for heirs.
This is where the irrevocable life insurance trust (ILIT) comes in. An ILIT removes the life insurance proceeds from the insured’s estate and shields the death benefit from estate taxes. The grantor establishes the ILIT and makes contributions to fund the policy premiums; but the trustee manages the trust, controlling how the proceeds are distributed.
Must-knows for Grantors
While the grantor does not retain control over the trust or assets once they are transferred to an ILIT, there are ways to retain some indirect influence. For example, the grantor can name a trusted individual, like a sibling or close friend, as the trustee. And the grantor’s spouse may be named as a beneficiary, which provides indirect access to the funds. Selecting the right trustee is essential, as the trustee plays a central role in managing the trust and ensuring that its administration aligns with the grantor’s intentions.
Here’s a common example I encounter: A family breadwinner dies after accumulating significant assets and building a successful business. Because their life insurance was held in an ILIT, the policy’s payout was excluded from their taxable estate. This allowed the heirs to cover estate taxes and other obligations without putting a healthy business on the chopping block just to pay estate taxes.
However, a successful family breadwinner who doesn’t properly prepare with an ILIT could be forced to sell their assets — such as a business or investment property — at inopportune times to cover tax liabilities. In such cases, advisors often must help families find alternative sources of liquidity, which may not be ideal or may come with significant consequences.
Weighing the Pros and Cons
The downsides of an ILIT include the administrative and setup responsibilities: establishing a new trust bank account and transferring funds to pay the insurance premiums. Furthermore, once the gift is transferred to the trust, it becomes irrevocable, and the grantor relinquishes access and control. That said, benefits of an ILIT usually outweigh the downsides for clients who are significantly wealthy or concerned about asset protection. In addition to offering critical tax savings, ILITs can protect assets from creditors or spendthrift beneficiaries.
However, ILITs may not be necessary for everyone. If a client’s life insurance is likely to be used during his or her surviving spouse’s lifetime or if the estate is small enough to avoid estate taxes, a revocable trust may be sufficient.
For example, if a couple has modest income and a $2 million policy that is intended to support the surviving spouse and fund his or her lifestyle, the complexity of an ILIT may not be warranted. In these situations, the cost and administrative burden may outweigh the benefits.
The Bottom Line
For families who want to ensure their wealth endures, the goal is to transfer wealth in a way that maximizes its impact and provides security for generations to come. As an advisor, your experience is key in assisting your clients with this. And since estate laws and tax regulations change, a well-structured plan should adapt to those changes.
Despite their complexity, I find the successful use of insurance and ILITs boils down to two factors: How much can they shield a family from tax exposure? And, how effectively can the life insurance policies they hold provide liquidity without forcing heirs to sell assets at a loss?
When used and structured properly, an irrevocable life insurance trust can hold life insurance — an asset uncorrelated to market performance — to provide essential liquidity, protect other investments, and support long-term wealth preservation.
Howard Sharfman, senior managing director of NFP Insurance Solutions, a wealth-transfer consulting and planning firm, has been recognized as an innovative leader in the insurance business for over two decades. His practice focuses on servicing families with multigenerational wealth, family offices, private equity managers and the advisors who serve ultra-high net worth clients. His firm has additional expertise in executive benefits, corporate benefits, general insurance and risk management.
