Let's say you've done very well for yourself and you're going to have an estate tax problem.  Your estate will be more than $5.34 Million ($10.68 Million if married) when you die so you'll have to pay estate taxes of 40% of the amount over the $5.34 Million limit.  What are your options to avoid this tax?

The easiest option is to give your money away before you die.  You (and your spouse) can each give $14K to any person you like every year without incurring the gift/estate tax.  You can also give money to charity at your death, which is then excluded from your estate.  But if you wish to control your money until your death, and then want it to go to your heirs, you'll need a different option.


Option 1: Invest your money and pay the estate tax.

This option can be very attractive, mostly because you can decide to spend the money if you like since it isn't stuck in an irrevocable trust.  It's also attractive because you don't have to go through the time, expense, and hassle of forming a trust and keeping it up to date.  If you invest in a tax-efficient way using investments like municipal bond funds and broad market index funds there is minimal tax drag on your investments.  Let's say you're investing $20,000 a year for twenty years into a total stock market fund.  If you earn an annualized return of 9% on that money, the drag will be something like 2% *15% = 0.30% per year.  So the money will grow at 8.7% a year.  Upon your death, the money will go to your heirs with a stepped up basis.  So estate tax will be owed, but not income tax.  So in our example, the investment will be worth $1.075M before tax, and $645K after tax.


Option 2: Buy a whole life policy inside an irrevocable life insurance trust. 

This is an option often promoted by life insurance agents and estate planning attorneys alike. You make your $20,000 contribution to the irrevocable trust each year and the entire contribution is used to pay the premiums on a whole life insurance policy.  Over 20 years, 3% would be a reasonable estimate of the “return” on the death benefit if you die at your life expectancy.  Your return could be much better if you die early, and perhaps even a little better if you die later.  There would be no tax drag and there are no income taxes due on the death benefit.  So you could expect your heirs to be left with a death benefit of perhaps $553,000, tax-free.


Option 3: Buy index funds inside an irrevocable trust. 

There is nothing that says life insurance is the only thing you can buy in an irrevocable trust.  You (actually your trustee) could buy any type of investment you like.  Of course, the trust would have to pay taxes on any taxable gains at the higher trust tax rates.  For 2014, those rates are:

If Taxable Income Is The Tax Is
Not over $2,500 15% of taxable income
Over $2,500 but not over $5,800 $375.00 plus 25% of the excess over $2,500
Over $5,800 but not over $8,900 $1,200.00 plus 28% of the excess over $5,800
Over $8,900 but not over $12,150 $2,068.00 plus 33% of the excess over $8,900
Over $12,150 $3,140.50 plus 39.6% of the excess over $12,150






Now the qualified dividend/long term capital gains rate is 15% up to $12,150, then 20% above that.  A $500K index fund portfolio kicking out a yield of 2% would provide $10K in yield, which would be taxed at 15%.  So 15% * 2% is probably a reasonable tax drag to apply.  If you get that 9% return, 8.7% after the tax drag, then you end up with $1.075M after 20 years.  Of course, the basis on this is $200K, so the trust will pay 15% * ($1.075M-$200K) = $131,250 in capital gains taxes, distributing an after-tax amount of $944K to the heirs.  No estate tax will be owed.

So to recap,

  • Taxable index fund: $645K
  • Whole life in ILIT: $553K
  • Trust index fund: $944K


Garbage In = Garbage Out

Under these assumptions, there is a pretty clear winner.  The surprise is that 2nd place goes to option 1, where you just pay the estate tax due.  But like anything, garbage in = garbage out.  What happens if we change the return assumptions a little?  What happens if the whole life policy returns 5% and the index fund only makes 7%?

  • Taxable index fund: $508K
  • Whole life in ILIT: $694K
  • Trust Index fund: $750K

The index fund in the trust still wins, although not by nearly as much, and the whole life policy does come out ahead of not using a trust at all.  These projections, of course, are comparing a relatively risky stock fund to a much less risky life insurance policy (which also provides a death benefit in the event of dying sooner than your life expectancy) so it isn't entirely apples to oranges.  But it does reflect the most likely scenario (dying at your life expectancy.)

What About a Variable Universal Life Insurance?

I have had some advisors contend that the insurance and administrative costs of a well-designed VUL only provides a long term drag of 1% on the underlying investments.  I think that's pretty optimistic for a 20 year horizon, so let's double it to 2% and see how it affects things.  You're putting your $20K a year into a irrevocable trust and investing it in a low-cost VUL policy with index fund investments.  Let's return to the 9% estimate for the index fund and the 3% estimate for the whole life policy, and then use 7% for VUL.  Remember there is no tax drag, estate tax, or income tax due at death on the life insurance options.  How do things stack up upon your death at 20 years?

Taxable index fund: $645K
Whole life in ILIT: $553K
Trust index fund: $944K
VUL in ILIT: $877K

The market risk for the VUL is exactly the same as the taxable and trust index fund, so this is a true “apples to apples” comparison, risk-wise.  We see that the VUL comes out in second place, still worse than just investing in index funds inside a trust.

If Risk Shows Up

If stock market returns over this 20 year period turn out to be disappointing and only average 6% (let's say with a 1.5% yield), then the VUL investment only makes 4% and taxes eat up a much smaller portion of the amount in the taxable account.  We'll assume the whole life insurance still somehow manages a 3% return.  We end up with the following:

Taxable index fund: $456K
Whole life in ILIT: $553K
Trust index fund: $676K
VUL in ILIT: $619K

We see that low returns can make the taxable index fund inferior to a whole life policy in an ILIT, but you're still better off with an index fund inside the trust than purchasing any life insurance policy.  The VUL does have the death benefit, which may be worth the $57K in lower expected returns.

There are other factors here to keep in mind.  Estate tax laws change, and they do so frequently.  It is possible that in 20 years there won't be an estate tax at all (like in 2010).  The exemption is currently indexed to inflation, and due to that you may be over the limit at the time of your planning, then under it upon your death.  The exemption could also be raised, or lowered.  Estate income tax rates could also change.  An approach that makes sense under current laws may not under future tax laws.  There are also state income tax rates, state estate tax rates, and state estate tax exemptions to contend with. Clearly this is an area where it makes sense to spend some time and money talking to an experienced estate planning attorney in your state.

However, the fact remains that over long periods of time small differences in return matter a great deal, and that you can buy any investment you want inside an irrevocable trust.  If you start with an index fund investment, either within or without a trust, you can always change your mind later, so long as you remain insurable.  However, surrendering a life insurance policy before death is likely to turn a low returning investment into a financial disaster.  The bottom line?  Permanent life insurance can be considered when designing a high net worth estate plan, but it certainly isn't required and under quite reasonable assumptions, may turn out to be the wrong choice.

What do you think? Do you have an irrevocable trust? What did you put in it and why? Comment below!