MKA Executive Planners Blog

Summary

The purpose of this article is to discuss the “living benefit” aspect of life insurance.  By “living benefits” I mean its use as an alternative, non-correlated, investment component of an overall investment portfolio.  My premise is that life insurance may provide a greater total lifetime return with less market risk than a portfolio that does not include life insurance, with particular emphasis on its use by Dynasty Trusts.

What is a Dynasty Trust, and is it Tax-Efficient?

Typically, a dynasty trust is structured to last the maximum term permitted by law, which in some states is forever.  Trust assets may be distributed to multiple generations of beneficiaries, and the asset (to the extent not distributed) left to accumulate.   As long as assets remain in the trust, regardless of how great the value may become, they will not be subject to estate tax upon the death of any beneficiary.  Additional benefits include creditor protection, including claims of spouses in divorce proceedings, and providing financial assistance to multiple generations of beneficiaries through trust distributions.  The maximum gift and estate tax advantages are realized when the trust is funded with assets equal to the grantors generation skipping tax exemption—currently $5,430,000 for individuals and double that for a married couple.  These trusts do have one major problem, and that is the Income Tax Problem.

The Income Tax Problem

In 2013 we saw a significant increase in trust income tax rates.  The American Taxpayer Relief Act of 2012, (“ATRA”) raised the highest marginal income tax rate to 39.6% (up from 35%).  Trusts have a very compressed tax bracket, and the top marginal income tax rate commences when trust taxable income exceeds $12,300.  ATRA also increased the tax on qualifying dividends and long-term capital gains taxes to 20% (up from 15%), and added a new 3.8% tax on “unearned” net investment income above $12,400.    This means that except for the first $12,300 of income, the trust ordinary income tax rate, when coupled with the 3.8% surtax rate, has increased by 24% since 2012, and the top marginal qualifying dividend and capital gain tax rate, when coupled with the 3.8% surtax rate,  has increased by a whopping  59% since 2012.

Simply put, this means that for all practical purposes, trusts that accumulate income and/or capital gains for later distribution, which is what Dynasty Trusts are designed to do, pay a tax of 43.4% on ordinary income, and a tax of 23.8% on qualifying dividends and capital gains.  And, that is just the federal tax; state income taxes impose an additional tax burden.

How has this increased income and capital gains tax impacted the investment strategy of Dynasty Trusts?

There are a numerous strategies suggested to ameliorate the compressed trust tax brackets.  Some of these involve distributions to beneficiaries.  That strategy may fly in the face of the purpose of the trust if it is designed to accumulate income over multiple generations.  In some cases, tax planning is designed to avoid the 3.8% additional tax, but that is cumbersome and requires that the trust own, and the trustee material participate in, a pass through business entity.  It is possible to invest the entire trust principal in double tax-free bonds, but that is contrary to Modern Portfolio Theory.  It is possible to buy and hold forever, but that will not necessarily mean maximize growth, or accommodate distributions to beneficiaries.

Modern Portfolio Theory and the Uniform Prudent Investor Act

Because a Dynasty Trust is designed for multiple generations, the trust’s investment objective would most likely be weighted in favor of long-term growth, and provide enough liquidity to meet the trust’s distribution objectives through an appropriately-diversified portfolio. 

The main asset classes of a diversified portfolio are equities (stock), bonds, cash (money market), property (real estate), and alternative investments (private equity, hedge funds, life insurance).  Modern Portfolio Theory is based upon the premise that different asset classes tend to behave differently under different economic conditions, and their performance will tend to be uncorrelated to one another.  The assumption here is that, given an investor’s level of risk, a portfolio of diversified (“ uncorrelated”) assets can be constructed that maximizes the probability of the expected return, and minimizes unsystematic (or market) risk of the portfolio as a whole.   In this context, performance and risk are inextricably linked.  Greater potential reward requires greater risk.  In the context of Dynasty Trusts, the appropriate levels of expected performance, and the accompanying level of risk, depend on expected return, an associated risk tolerance.

Life Insurance as an Asset Class

Life insurance is unlike any other assets.  Consider its major attributes, which include:

• Cash value growth is income tax deferred, and, with proper planning, totally income tax free;
• Withdrawals and loans from policy value are tax-free if the policy is held until death;
• The death benefit is income tax-free, and with proper planning, estate tax-free;
• The death benefit  is the obligation of the insurance carrier, and, as long as sufficient premiums are paid, is not  related to market  performance;
• It can mirror the portfolio allocation determined to be appropriate for the trust through a blend of the various types of insurance police offered such Whole Life, Universal Life, Equity Indexed Universal Life, and Variable Universal Life. 

Permanent Life insurance has a death benefit component and an investment component.  It can be designed to maximize one or the other of these two components.  This discussion looks at a policy that is designed to maximize the investment component.

A simple example of the lifetime tax efficiency of life insurance can be explained by looking at the internal rate of return (“IRR”) on the projected tax-free policy distributions.  For example, if—and  this is a big if, because cash value returns are not guaranteed, but then neither are the investment returns of a similar investment outside of the policy—projected distributions  generate a  5.50% net investment return, and the tax rate is 43.8%, the equivalent pre-tax rate of return is 9.8%. 

Given the fact that life insurance is a non-correlated asset, consideration should be given to using some of the trust assets to invest in one or more life insurance policies.  The precise policy type and mix of policies should be based upon the trust’s overall investment philosophy and risk profile.   The insurance, as a non-correlated asset class, would be an additional investment class for the trust and incorporated into the trust’s overall investment diversification strategy.

An in-depth analysis of life insurance as an asset class done by Richard M. Webber, MBA, CLU and Christopher House, FSA, MAAA concluded that funding a life insurance policy from an income stream of a component fixed portfolio produces a more favorable result than if the policy were not part of the portfolio, and the return is higher and the risk lower for the existence of needed life insurance.[1]

If you would like more information on this subject, or have a client who might benefit from a discussion about it, please contact Barry Koslow at bkoslow@mkaplanners.com or (781) 939-6050.

Securities offered through Advisory Group Equity Services, Ltd., Member FINRA/SIPC.  444 Washington Street, Woburn, MA 01801 (781) 933-6100. 

This article should not be considered as providing accounting, business, financial, investment, legal, tax, or other professional advice or services.  It is not a substitute for such professional advice or services, nor should it be used as the basis for any decisions or actions that may affect your business or you personally.  This should only be one part of your research.  You should seek authoritative guidance from a qualified accountant or attorney before taking any action.

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