Use dividends to pay premiums

Charles Blair, DDS & John McGill, MBA, CPA, JD

Some time ago, I purchased a $750,000 whole-life insurance policy on my wife for estate-tax protection. The annual premiums of $25,763 are paid by my daughter and two grandchildren out of funds that we have gifted to them from time to time. The policy has now been in existence for approximately five years.

The insurance company claimed that all premiums should cease approximately 14 years from inception, and thereafter all premiums could be paid from policy dividends. One adviser recommended that I use all past and future dividends to pay the policy premiums so as to minimize my out-of-pocket costs. Is this a wise choice? Also, the insurance company is currently assuming a 6.75 percent dividend rate for its calculations. Is this realistic?

Since the stock market decline has reduced our net worth to $3 million and the estate-tax exemptions are increasing, should I cancel this policy altogether? What about the loss in value I would sustain since I have already spent more than $129,000 in premiums, while my cash surrender value is only $80,000?

The first step in the process is to determine your true life insurance needs. Given the fact that you are now retired, it is unlikely that your net worth will continue to grow, especially given the current investment climate. Assuming that your current net worth is sufficient to support your family's standard of living and retirement, it appears that the only legitimate need you would have for life insurance would be to pay potential death taxes. This need has been dramatically reduced — under current law, both you and your spouse have a $1 million exemption. Since the estate-tax exemption is scheduled to rise significantly in future years, the probability that you will need these proceeds for estate taxes is minimal.

I recommend that you terminate this policy and take the cash surrender value of $80,000. Disregard the fact that you have invested $129,000 in premiums but have only $80,000 of cash surrender value; this is a sunk cost attributable to the life insurance coverage and commission expenses incurred.

Should you choose to continue this policy, it is preferable that the policy be owned by an irrevocable life insurance trust to avoid inclusion of the $750,000 of proceeds in your wife's estate upon her demise. Should you choose this route, we recommend that you use past and future dividends to pay the premiums so you can minimize your out-of-pocket costs.

I am getting ready to make a substantial investment in new dental equipment as well as in my computer system. I will be purchasing new computers and software. Furthermore, I plan to install some additional chairs to increase my capacity, along with additional air and water lines for my office. How should I handle this from a tax standpoint? Can I immediately expense these items, or must they be depreciated over time? Also, should I simply pay for these items out of my existing cash or finance it?

From a tax standpoint, these items must be capitalized and depreciated. While, generally, they would have to be written off over several years, you are entitled to immediately expense up to $25,000 of these items under Section 179 of the tax law. Moreover, you would also be entitled to an additional 30 percent first-year "bonus" depreciation on this purchase.

As we write this column, Congress is working on a new tax bill that would substantially increase the expensing election amount. We expect some parts of the legislation to pass later this year, and the expensing election to be substantially increased somewhere in the $35,000 to $75,000 range.

We recommend that you finance 100 percent of the cost of these items, with repayment over a five-to-seven-year term at an interest rate not to exceed prime (currently 4.25 percent). This will conserve your cash in order to generate additional deductions, while spreading out the cost of these items over their estimated useful life.