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How can leverage be strategically used to protect your estate?

Life insurance can be an essential estate-planning tool for wealthy individuals and their families. In fact, for those who lack liquidity, a properly designed and funded life insurance policy can be an efficient way to generate enhanced cash flow to cover future estate-tax obligations.

Illiquid assets come in a variety of forms. They include: real estate; tax-deferred retirement assets; business or partnership interests; private equity and hedge fund investments; art and jewelry collections; and luxury vehicles, including marine vessels, private aircraft, etc.

Life insurance proceeds may circumvent the need for premature, unfavorable or otherwise untimely sales or withdrawals of assets by heirs. To ensure that the death benefit avoids estate taxes, policies may be held in an irrevocable life insurance trust (ILIT).

Permanent life insurance policies typically require sizable premium payments, and finding liquid assets to fund the payment is not always a simple matter. Therein lies a core estate-planning challenge: If a trust owns the policy, technically it is the trustee that must pay the policy premiums on an ongoing basis.

The insured may make gifts to the trust to cover the premiums. The insured must, however, be mindful of annual gift tax exclusions and lifetime exemptions, which may or may not permit donors to transfer assets to cover the entire premium tax-free.

One solution to this planning dilemma is the use of premium financing to fund the premiums on a life insurance policy. In the case of an ILIT, the trustee will borrow money from a third-party lender to pay the premiums. The loan will not be considered a gift to the trust and will not create a gift-tax obligation. Loan interest may be considered a gift depending on how it is paid. Interest payments are, however, remarkably lower in the early stages of a loan compared to the scheduled premium. This reduced outlay may create the opportunity for gift-tax leverage and increased long-term internal rate of return (IRR).

Premium financing is at times a viable alternative for high net worth individuals.

Premium financing is at times a viable alternative for high net worth individuals. With proper structuring, it offers possible gift and estate-tax benefits. Additionally, the use of leverage allows investors to retain capital in long-term or higher-yielding investment strategies; and at times it also helps them avoid taxes on liquidated assets used to pay premiums.

When entering into a premium financing arrangement, you will be wise to have a definitive plan on when and how the loan will be repaid. If your intent is to use the cash value or death benefit from the policy to retire the loan, the policy should be carefully monitored to ensure that it is performing as projected. A contingency plan should always be developed, which may involve planned liquidation of other assets to repay the loan.

Like using borrowed funds for financing real estate or the expansion of a business, utilizing leverage to fund life insurance should dovetail with one’s financial plan. It is essential to evaluate how premium financing may fit within the context of the client’s overall estate plan, as well as to weigh the potential benefits against relevant risks.

Stephen A. Schwartz offers advisory services as a representative of Northwestern Mutual Wealth Management Company (WMC), a limited purpose federal savings bank, and a wholly owned subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, Wis., (NM). Northwestern Mutual is the fleet name for NM, its subsidiaries and affiliates. Investments held with or managed by WMC are not insured by the FDIC, are not deposits or other obligations of, or guaranteed by, WMC or its affiliates and are subject to investment risks, including loss of the principal.

Stephen A. Schwartz is an insurance agent of NM (life insurance, annuities and disability income insurance), and Northwestern Long Term Care Insurance Company, a subsidiary of NM, and a registered representative of Northwestern Mutual Investment Services, LLC (NMIS), an NM subsidiary, broker-dealer, investment advisor, member FINRA, SIPC.

Pioneer Financial is a marketing name used by a group of Northwestern Mutual representatives (not all of whom are affiliated with WMC) including Stephen A. Schwartz (referred to as the “firm”), and is not a legal entity, partnership, investment advisor, broker-dealer or affiliate of NM. The views expressed herein are those of the author and may not necessarily reflect the views of Northwestern Mutual.

Certified Financial Planner Board of Standards, Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNERTM and federally registered CFP (with flame logo), which it awards to individuals who successfully complete initial and ongoing certification requirements.

This article was originally published in the August/September 2016 issue of Worth.


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