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| Risk & Reward |
Financing the Future
Laurence Neville
09/01/2004
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According to Wuensch,
these gifting issues were the original motivation behind the development of
premium financing. Under current tax law, an individual may give a total of $1
million tax free over the course of his or her entire financial life. Any gifts
beyond that amount are subject to tax. Furthermore, an individual may give
only $11,000 annually per person. For most of us, our estate plans already
surpass the $1 million limit, leaving no room for additional tax-free gifting of
wealth. Since gift taxes run up to 55 percent, depending on the size of the
gift, this is a considerable problem.
Questions to Ask Your Financial Advisor about Premium Financing
1. At what rate of interest would the transaction no longer work? What
happens if rates breach that level?
2. What are my alternatives if my
bank declines to refinance my loan? How much time would I have to secure other
financing?
3. Should I consider personal financing to fund the
premium?
4. How much control do I maintain over the collateral I put up
for the loan?
5. Given my age and the size of my estate, what
alternatives to premium financing can accomplish my financial goals? |
“Understandably, clients are not
enthralled by the prospect of paying such taxes,” says Douglas Moore, national
director of estate and charitable planning at Citigroup Private Bank in New
York. He relates the experience of a client who established an insurance policy
with a $3.5 million premium cost. “If he gifted funds to the trust [to pay the
premium], he would be gift-taxed for $2.5 million at a 48 percent rate and the
following year, the entire $3.5 million would be subject to gift tax. This
significant additional cost provides no benefit to beneficiaries.”
Wuensch
says premium financing offers us a way around these taxes. “The gift is
considered to be the interest paid on the loan, not the premium,” he explains.
This means that in funding a trust, the only money taxed is the amount of the
interest itself.
But leverage comes with a health warning, especially when
used in premium financing: Investors should only borrow money that they can
afford to do without. Remember that borrowing costs, the performance of the
insurance policy and the performances of other assets will constantly change.
Experts agree that before pursuing a premium financing strategy, investors
should stress test their finances under high interest rate and low stock market
conditions. “[Inves-tors] should never get into a situation where they might be
forced to sell an asset they don’t want to,” says Pamela Hendrickson, managing director and global head of lending and liquidity products at JP Morgan Private
Bank in New York, “especially one where the loss would be as great as letting a
life insurance policy lapse.”
Credit Options
The terms of loans used to finance insurance premiums are often as short as one
year and rarely over five years. Banks, unfortunately, do not guarantee that
they will renew the loans, so we must choose our lenders with care. Since life
insurance policies typically last well over five years, if our lender decides
not to renew our loan (say, its parent company sells the lending arm, or it
changes its lending policies), we may have to repay the loan, obviating the
strategy’s cash management and tax benefits.
Therefore, it is important to
have alternative sources of financing available. We should also obtain quotes on
loans from more than one lender, whenever possible. These can come from a
variety of institutions, including our private banks. These institutions often
structure premium finance transactions themselves, and can either source third
party insurance for their clients seeking to finance premiums, or offer their
own policies. However, as Kevin Warner, director of New York-based premium
financing intermediary Isthmus Capital notes, not all banks understand life
insurance, and many insurance companies do not understand premium financing. We
should ascertain how much expertise and experience our bank has in this field
before signing up.
Another somewhat novel option is to become our own lender.
“A privately financed life insurance plan, also known as personal financing, is
the funding of life insurance premiums through a personal loan between an
insured or a family member and an irrevocable life insurance trust,” explains
Richard Wuensch, first vice president and estate planning specialist at Merrill
Lynch. The benefits of such an arrangement are that the loan does not count as a
gift (since it must be repaid) and the interest payments can be kept within the
family, thus minimizing costs. Typically, in private financing, we lend at the
applicable federal rate, which the IRS publishes each month, so the arrangement
is considered a fair market loan.
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