THE BLOG
01/17/2013 11:57 am ET Updated Mar 18, 2013

New Estate Tax Changes Leave Many Over Insured

Estate tax laws didn't fall off the "fiscal cliff," likely leaving many older Americans over-insured. Estate tax planning had been mired in uncertainty in recent years as Congress flip-flopped on raising thresholds and exemptions. Taxpayers who were concerned prior to the new deal, and prepared for the worst with a generous life insurance policy, may now find themselves over-insured.

Had Congress been unable to reach an agreement by the January 1, the tax-free amount for estate taxes would have plummeted to $1 million and most estate rates would have climbed to 55 percent. Instead, Congress kept and made permanent the $5 million exemption (now $5.25 million when raised for inflation in 2013).

Uncertainty was in large supply in recent years. President George W. Bush lowered estate tax rates for 10 years, but as those changes were set to expire, the Obama administration chose to only extend the rates for one year. Had we not swerved and missed the cliff, estates of individuals passing away this year and in the future would have been heavily taxed.

Life insurance traditionally plays an important role in estate planning. When a wealthy individual dies, the value of their estate gets hit with taxes. Some call this the "death tax," as often the burden falls on their heirs. Buying a life insurance policy is one way to hedge against estate taxes. For example, if an 80-year-old expects their estate to be valued above the current $5.25 million threshold, it may be cheaper to buy a life insurance policy for that amount today, pay the premiums now, and have that policy pay the estate taxes upon his demise. It is one way for wealthy individuals to "pay the taxes in advance" and therefore have their estate (home, money, property, etc.) smoothly pass-on to heirs. Using insurance to pay estate taxes also has a number of tax advantages. While the ins and outs of such planning can be very complicated and best left to well-trained attorneys, the overall concept is fairly simple.

The uncertainty of estate taxes has made tax planning for wealthy individuals something of a moving target. Because rates were scheduled to rise this year, many wealthy individuals bought or kept in place large insurance policies for future estate taxes. Such individuals may now be over-insured.

Had we gone over the cliff and the tax rates lowered to $1 million, a wealthy individual with an estate valued at $10 million would be subject to 55 percent tax on $9 million -- nearly $5 million in taxes. A prudent tax planner would suggest that this individual buy a $5 million insurance policy making his estate the beneficiary in order to pay the taxes upon the insured's demise.

Today, with the cliff averted, that same individual (with an estate valued at $10 million) would be subject to 40 percent tax on everything over the first $5.25 million -- and only about paid $2 million in taxes. Had this individual previously bought a $5 million policy, worrying about the worst-case scenario, he would be over-insured by about $3 million.

One way wealthy individuals have hedged against changes in the estate tax has been to buy multiple insurance policies; so they could drop one if it was no longer needed. Others may be "stuck" with policies worth more than they need.

Options in this situation include letting the policy lapse or surrendering for cash-surrender value, if applicable.

Life insurance settlements provide an attractive alternative, enabling policyholders to sell their life insurance policy for more than the surrender value, less than the face value. In such a transaction, a life settlement provider continues to pay the purchased policy premiums, collecting the full amount when the policy seller passes away. The value of a life settlement varies depending on the life expectancy of the policyholder at the time of sale, and on the written full value of the policy. Often, a life settlement offers seven to eight times more funds than surrendering the policy.

Because of recent changes in life expectancy tables, some individuals may be able to sell a policy to a life settlement company and replace it with cheaper coverage. Others can keep one policy to pay estate taxes and sell one for cash. The proceeds can be used to purchase a long-term care insurance policy or fill any other financial need.

Regardless of your financial situation and whether or not the estate tax changes affect you, major tax policy changes should serve as a reminder to evaluate insurance coverage. Individuals may find that coverage is no longer needed, should be converted or can be replaced at a lower cost. Anyone with an estate that is impacted by the legal changes should contact their tax attorney or financial planner.