With the 2010 Tax Act hanging in the balance, the inertia in our nation’s Capitol created by gridlocked legislative and executive branches has led an increasing number of “experts” to conclude that January 1, 2013 will be a day that will live in fiscal infamy. Those in the know on The Hill affectionately refer it to as Taxmageddon.

For those lucky few who remain blissfully unaware, absent an act of Congress, on January 1st the era of the Bush Tax Cuts will disappear and the previously higher rates will be reinstated. Additionally, 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?”

Certainly, this climate has poured accelerant on two ostensibly inapposite, mutually exclusive objectives: “How do we gift money to our kids and grandkids and still maintain access to those same assets for our needs?” Of course, implicit within that singular query are several subsets of legal and financial planning issues.

Irrespective of whether the notion of a fiscal cliff actually comes to fruition, the need for clients to strike a proper balance between minimizing their taxable estate (through gifting assets away) and retirement income planning (by keeping enough to live on throughout life) will always be a complex and uncertain equation. In addition to variables such as inflation, taxes, and longevity, future health care costs could greatly increase the level of retirement spending for many. In particular, long-term care costs—at $130,000 to $150,000 (in today’s dollars) for custodial care in Massachusetts, for example—would necessitate a large chunk of liquid assets to be accessible as part of a retirement income plan. If these assets were not ultimately consumed, however, they could be ultimately subject to both state and federal estate taxes at the death of the second spouse.

Many clients address this Hobson’s choice by purchasing long-term care insurance (LTCI). Traditional LTCI can be an excellent alternative or most frequently, a supplement to self-insuring. However, there are some obvious downsides to LTCI:

  1. It can be expensive.
  2. The premium can increase in the future.
  3. There is what I call “cost recovery risk.” In other words, it’s a “use it or lose it” proposition. Most LTCI offers a Return of Premium Rider, but if the insured actually uses the long-term care insurance (on claim), he has drastically overpaid for the policy.   

Even those who want to purchase LTCI have often found it difficult to qualify for a policy. Currently, the confluence of low interest rates and the financial damage caused a long-standing mistaken reliance on life insurance underwriting experience has led LTCI underwriters to be extremely selective in extending offers to applicants. 

Simultaneously, life insurance carriers have become more creative. So called “linked benefit” riders on base policies offer the owner the ability to accelerate the policy’s death benefit during life should the insured be unable to perform 2 out of 6 Activities of Daily Living (ADLs) or have severe cognitive impairment. Even though there is less design flexibility with respect to actual coverage for long-term care, the cost of the rider is typically significantly lower than a stand-alone LTCI policy.

Accordingly, from a cost-recovery standpoint, these policies can be attractive to many clients. However, the underwriting for those riders is, in most cases, identical to the underwriting performed on a stand-alone LTCI policy. As such, the LTCI rider would be a non-starter for an applicant who had already been declined for a stand- alone policy. And, for the reasons mentioned above, there are many of these clients.  

Fortunately, one solution could be a life insurance policy with a Critical Illness Rider (CIR). A CIR enables a client who can obtain life insurance to benefit from a contractual provision allowing the owner to accelerate the death benefit during life. There is neither specific underwriting for long-term care risk (morbidity) nor an additional cost for the CIR. Like traditional life insurance, the cost of the policy will be dependent upon how much death benefit the client purchases coupled with the underwriting classification the client receives from the carrier. This ostensibly opens the door to prospects with Parkinson’s, MS, muscular dystrophy and other afflictions (depending on the progression/stage of the disease) that ostensibly do not curtail life expectancy to pursue a life insurance contract with a CIR. Clearly, this is a little-known opportunity for many.    

In contrast to a true “linked benefit” rider that is underwritten for morbidity where there is a dollar-for-dollar reduction of death benefit as money is taken by the owner under the rider, a $500,000 guaranteed universal life insurance policy with a CIR will payout something less than $500,000 of cash that the client can use during life. How much less will be largely dependent upon the insured’s age at the time he or she triggers the benefit. In short, the older the insured is, the more benefit he or she can receive. However, no matter when the insured activates the benefit, there’s still a significant amount of leverage to be gained on premium dollars. Obviously, this risk management dimension makes this strategy attractive to those seeking to transfer some of the morbidity risk to an insurance carrier—without the extra cost or underwriting, of course. 

Finally, from an estate tax planning standpoint, an Irrevocable Life Insurance Trust (ILIT) could own the life insurance policy with a Spousal Access Provision. If structured properly, any assets owned by the Spousal ILIT would not increase the value of the taxable estate. Moreover, if one spouse is the grantor (funder) of the ILIT, the other could have access to assets owned by the ILIT—including the cash value or accelerated death benefit of the insurance—during life as a “spousal beneficiary.” Critically, in the case of a true linked benefit policy, the contract would have to be structured as an indemnity policy (with the benefit paid to the trustee of the ILIT as owner of the policy) as opposed to a reimbursement policy (benefit would be paid directly to the care provider/facility) to ensure that the policy would remain outside of the insured’s taxable estate.

If one spouse predeceases the other and the surviving spouse needs long-term care benefits from the policy, the successor trustees of the surviving spouse’s ILIT could distribute benefits to the children (as successor beneficiaries of the ILIT). The children could then independently decide to pay for expenses related to the insured’s long-term care using the policy proceeds. The only catch is that unless the cost of care is considered a “medical” expense and paid directly to the facility, there could be gift tax implications to children.

Meet with a competent, qualified estate planning attorney and a knowledgeable financial planner to discuss whether any of these strategies make sense for you and your family.