With the 2010 Tax Act hanging in the balance, the inertia in our Nation’s Capitol created by a gridlocked Legislative Branch has lead an increasing number of ‘experts’ to conclude that January 1st 2013 could be a day that will live in fiscal infamy.
For those lucky few who are blissfully unaware, absent an act of Congress, on 1/1/13 the era of the Bush Tax cuts will toll and the previous higher rates—both for income and estate taxes—will be reinstated. Significantly, the Lifetime Gift Tax Exemption (i.e., the most an individual can give away during his or her lifetime) will revert to $1 million from the current $5 million figure. This has many of our estate and financial planning clients asking the obvious question: “How much should we give away now?!”
In that context, we’ve encountered a myriad of different situations that all revolve around two ostensibly inapposite, mutually exclusive objectives: “How do we give it away (i.e., take advantage of the waning hours of the $5 million Lifetime Gift Exemption) and still maintain access to it for our needs?” Of course, implicit within that question are concerns within several different areas of legal and financial planning that many of our physician clients have.
Accordingly, in my previous article for Today’s Practice, ‘Killing a Flock of Birds With One Stone’, I addressed the confluence of three of those areas: retirement, tax and estate liquidity planning. Specifically, we demonstrated how Mike, our 45-year old orthopedic surgeon, could protect his family with life insurance owned by a specially-drafted Irrevocable Life Insurance Trust (ILIT) and simultaneously access the policy’s cash value to supplement his retirement or provide funds for his children’s college. In this article, we’ll discuss how asset protection planning—in particular, long-term care planning—can be integrated into a similar legal and financial structure.
Below is a brief excerpt from my conversation with Jim, a 55 year-old Radiologist from Massachusetts who is looking at gifting to his ‘Access’ ILIT prior to 1/1/13. Of note: his wife Jill is also 55 and has been recently diagnosed with Parkinson’s disease:
Me: So, how are you doing?
Jim: Well, I’m simultaneously concerned and motivated. I feel like this is an opportunity to transfer a lot of wealth to my kids and grandkids that I don’t want to miss. So, I’m motivated to do something. I’m also concerned that Jill and I won’t have enough to live on should one or both of us encounter a major health issue in retirement—especially given her prognosis. I know you’ve always told us that the best financial plan is to die with a dollar left in our names while transferring the entire current value of our estate to our heirs. Problem is—I don’t know how we account for the risk that we could be spending an additional $130,000 annually—in today’s dollars—to pay for long-term health care costs.
Me: Well, generally, there are 3 ways to handle any kind of risk: 1. Assume all of it; 2. Assume some of it; or 3. Assume none of it. These rules apply to long-term care as well. Based upon the retirement income planning we’ve done, I don’t feel confident that you can self-insure the risk. How do you feel about traditional long-term care insurance?
Jim: Well, in light of her health, Jill doesn’t qualify for it so I guess we’re stuck with option #1 for her. For me, I think it would be great to have but, based on the numbers I’ve seen, it’s really expensive. I’m also concerned that, if I don’t use it, that’s a lot of money wasted that could have gone into my retirement plan or to Jill or the kids that I can never recapture. I know I can pay for a Return of Premium Rider on the policy but if I actually use the long-term care insurance, then I’ve drastically overpaid for the policy haven’t I? And, there’s no guarantee that the premium won’t increase during my lifetime so there’s a lot of uncertainty there.
Me: Well, let’s focus on Jill’s situation for the purposes of today’s meeting. Now, more than ever, there are a LOT of clients who are being turned down for long-term care insurance—not just those with diseases that make them more likely to file a claim and collect on a policy. Clearly, from a morbidity underwriting standpoint, Jill is the very definition of adverse selection—there is a high probability that she will be unable to perform 2 out of 6 Activities of Daily Living (ADLs) and as such, she would love to have long-term care insurance. The essence of long-term care insurance is leverage: you want to pay a relatively small amount of money into an insurance contract that will pay you out a much larger benefit. Here, because of the probability that a claim will be paid is high, she won’t qualify for a contract that has morbidity underwriting.
Jim: I’m following you. I think you just restated my point that we’re at option #1 for her, no?
Me: Fair enough; I’ll get to the point: from a mortality underwriting standpoint, Jill is insurable. Actuarially speaking, Parkinson’s (at least at the stage she is at now) does not significantly curtail life expectancy. So, we should be able to obtain life insurance for her at or near standard rates.
Jim: But how does that address my concerns regarding long-term care costs?
Me: Great question. There are actually several highly-rated life insurance carriers who will issue life insurance policies that contain a contractual provision that enables the owner to accelerate the death benefit of the policy during life if the insured is ever unable to perform 2 out of 6 ADLs or has a severe cognitive impairment. This is where you can still gain leverage with a carrier even with a textbook case of adverse selection.
Jim: And there’s no underwriting for this?
Me: Not for morbidity; just for mortality.
Jim: How much of the death benefit can we get during life? What is the cost?
Me: Well, the cost will be dependent upon how much death benefit we decide makes sense for you. It’s just like any other permanent life insurance contract. Most of the carriers that we use will allow you to accelerate up to 24% of the death benefit annually (2% per month). For example, a $400,000 life insurance policy would give you $8,000 monthly. In most cases, that payment is income-tax free.
Jim: Sounds amazing. What’s the catch?
Me: There are 2 major downsides: 1. There is no inflation protection in the typical life insurance policy that we use; 2. When you take your payment under the rider, it is not a dollar-for-dollar reduction of the death benefit. Instead, the reduction of the death benefit is based upon a net present value calculation that combines an interest rate and the life expectancy of a chronically ill insured.
Me: A $400,000 guaranteed policy will give you something less than $400,000 of cash that you can use during life. How much less will be largely dependent upon your age at the time you trigger the benefit. The older you are, the more benefit you will receive.
Jim: OK. I’d like to see some examples of how the numbers look. In the meantime, how does this fit into my estate plan? Can I have this insurance owned outside of my estate and still have access to benefits?
Me: Glad you brought me back Jim. The policy could be owned by an ILIT where Jill is the grantor (funder) and you would have access to assets owned by the ILIT—including the insurance—during your life as a spousal beneficiary. If prudent, you could decide to accelerate the death benefit during Jill’s life should you be faced with long-term care costs. If you don’t need to accelerate the death benefit during life, the policy will not add to the value of your estate for estate tax purposes and as such, would provide your family with a source of income and estate tax-free cash. In that way, there is a recapture—or rate of return if you will—on the premium dollars you have paid into the policy.
Jim: What if I predecease Jill? Can the kids have access to the accelerated death benefit?
Me: Yes. As successor trustees of Jill’s ILIT, because the policy is not considered to be a ‘reimbursement’ long-term care policy (technically, it’s not even considered a long-term care policy at all), your children could decide to accelerate the death benefit during Jill’s life should she be unable to perform 2 out of 6 ADLs. Subsequently, they could decide to pay for expenses related to their Mom’s long-term care using the policy proceeds. The only catch is that unless the expenses they are paying are considered to be medical expenses that they pay directly to the facility, there could be gift tax implications to them.
Jim: So, in terms of our planning, we could maintain less assets outside of our ILITs to address long-term care costs.
by Christopher A. Hynes, JD, CFP®