Over 200 years ago, Benjamin Franklin said, “In this world, nothing can be certain except death and taxes.” Unfortunately, this is as true today as it was in 1789, with the rules governing taxes growing more complex over time. Tax-related questions are amongst the most frequently asked by our estate planning clients.

estate taxes and life insurance

Topping the list of tax questions is this query: “Are life insurance proceeds subject to estate taxes?” The answer depends on many factors, including how an estate is structured and who owns the life insurance policy. Having a trusted and experienced advisor create an estate plan will help ensure that, after your death, the tax burden on your beneficiaries is minimized.

A 2016 survey found that three-quarters of Americans would be more likely to create an estate plan if it helped to lower their families’ taxes. There are some keys to structuring your life insurance to help achieve this goal of having an estate tax-free policy, while also lowering the potential tax bill on the entirety of your estate. Below is a compilation of ideas for how to leverage life insurance tax benefits in a way that will maximize your estate with the help of a trusted financial advisor.

Utilizing Life Insurance as a Tax-Free Investment Alternative

Before looking at life insurance as part of an estate planning strategy, it is important to understand that Life Insurance can, however, compare very favorably to traditional type investments that have risk of loss. A keen analysis of the Taxable Equivalent Internal Rate of Return can be provided to help you determine if life whole life, universal life, or indexed universal life should be part of a strategy to provide tax-free income later in your life, as for example, a source of retirement income.

While the death benefit proceeds from life insurance are always income tax-free, they are not always free from estate taxes. This causes confusion among some people as they hear “tax-free” and believe that there are no taxes associated with life insurance. This is not the case. The death benefit of life insurance, if not properly structured, can be subject to estate taxes and reduce their value by as much as 40 percent or more.

This is why it is critical to have a trusted life insurance advisor provide estate-planning guidance. Tax codes are not only complex, but are constantly changing; structuring your estate to remove the tax burden on life insurance is best left to professionals that understand these rules.

Life Insurance Ownership to Remove Estate Tax Burden

The most important factor in determining whether life insurance proceeds are subject to estate taxes is the ownership of the policy. For the purposes of simplification, all assets above the estate and gift tax exemption that you own at the time of your death are subject to estate taxes. Assets that you do not own, on the other hand, are not subject to estate taxes.   

Here are the general guidelines as they apply to estate taxes and life insurance:

  • You own the policy: If you are the owner of a life insurance policy, the full value of the death benefit may be subject to estate taxes. The first $5.49 million of value in your estate is exempt from taxes, but all assets owned by you at the time of your death—including proceeds from life insuranceabove this amount are subject to estate taxes.
  • A trust owns the policy: An irrevocable life insurance trust (ILIT) can provide a means of passing life insurance policy ownership to a trust, which effectively removes the eventual death benefit from your estate. This means that there are no estate taxes on the policy, and charities and family beneficiaries receive the full face value of the life insurance policy without any estate tax burden.  
  • Your children own the policy: If your children are the owners of a life insurance policy with a death benefit on you, the proceeds are not subject to estate taxes. Why? The policy is not part of your estate, but is an asset owned by your children. When you pass away, the proceeds of this policy are not only income tax-free, but are free from estate taxes.

In order to remove the proceeds of a life insurance policy from your estate, there are some very specific rules related to ownership, which must be satisfied. Only an experienced advisor who knows the ins and outs of these rules should be trusted with structuring a life insurance policy so that it meets all of the requirements needed to pass it on to beneficiaries tax-free.

Strategies for Structuring Life Insurance to Be Free of Estate Tax

There are a number of ways that a life insurance policy can be purchased in order for them to be free of taxes, and establishing a trust can be the most effective. However, trusts are another area where there is often confusion.

If you place a life insurance policy in a standard trust in which you maintain control of the assets, the death benefit may still be subject to estate taxes. Again, any assets that you own at the time of your death are subject to estate taxes, so the structure of the trust must be an asset that you do not own.

An ILIT, as previously mentioned, ensures that the policy is not included in your estate by giving up control of your assets to the trust. The irrevocable trust is a separate entity from your estate, and therefore not subject to estate taxes. This distinction in how your trust and estate are structured could mean the difference in potentially millions of dollars of tax liability.

For these reasons, we highly recommend that you seek only an experienced advisor to help create your estate plan. Life insurance policies can (and should) be part of this plan, as it helps to make the value of your estate is predictable and positions your heirs to receive the face value of the policy.

The advisors at Howard Kaye Insurance have been providing estate planning for over 55 years. We specialize in leveraging life insurance as a means of reducing estate taxes. Contact us today at 800-DIE-RICH to discuss creating an estate planning strategy to help maximize your wealth transfer and minimize your tax exposure.

Image courtesy Yastremska

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