Life Insurance Proceeds can be Taxed up to 40% if not Structured Properly

Life Insurance is an excellent, asset-protected tool for estate planning. For example, if your estate will contain substantial “hard” assets, such as business interests or real estate, the cash proceeds of a life insurance policy can allow your heirs to pay your estate taxes without having to liquidate any assets. And your beneficiaries can receive the proceeds of your life insurance policy tax free. In fact, in the case of an individual who has not undertaken asset protection planning, life insurance proceeds may be all that is left…

Despite these benefits, few people realize that without advance legal planning their families may wind up owing more estate taxes than they would without the insurance. This is so because life insurance proceeds, while not subject to federal income tax, are considered part of your taxable estate and are subject to federal estate tax. The federal estate tax is assessed at up to 40% of an individual’s net worth in excess of $5 million (adjusted for inflation), including your business, homestead, retirement accounts and life insurance. As such, without taking advantage of a multitude of techniques provided by the tax law, for every $1.00 of net worth over $5 million, $0.40 will go to your favorite Uncle Sam! For example, an individual with a home worth $1 million, a business worth $6 million, $2 million in investments and retirement accounts and a $3 million life insurance policy (total $12 million), might have to pay almost $3 million in estate taxes (12 – 5 X 40%).

One technique to minimize this individual’s estate tax liability is to create an Irrevocable Life Insurance Trust (ILIT) that will own the policy and receive the payment upon death. A properly drafted life insurance trust keeps these insurance proceeds from being taxed in your estate or the estate of your spouse. It can also protect the trust beneficiaries from their own “excesses”, their creditors, and in the event of divorce.

Here’s how the Irrevocable Life Insurance Trust works:

You create an ILIT to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make purchase and make premium payments on the life insurance policies. If the trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift tax exclusion, so you won’t have to pay gift tax on the contributions.

On your death, the trust continues for the benefit of your spouse during his or her lifetime. Your spouse is given certain beneficial interests in the trust, such as the right to income, limited access to principal (medical, education, etc.), and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants. If the life insurance policy owned by same individual from the preceding example was instead owned by an ILIT, the estate tax liability would be cut almost in half. This example is simplified for illustration purposes. Taxes can be further reduced using other planning techniques.

Life Insurance is also an excellent way to fund buy-sell agreements among business partners, so your company can execute a buy-out plan without putting a strain on company resources. As with life insurance purchased for the benefit of your heirs, life insurance used to fund a buy-sell agreement can be structured so as to be considered outside your taxable estate.

If you are considering setting up a life insurance trust with a policy you own currently, keep in mind that the proceeds will still be taxed in your estate if you die within three years of the transfer (the “three-year look back” rule) — another reason why you should always seek legal advice before you purchase any form of life insurance.

Find out how much you can save using an Irrevocable Life Insurance Trust.