Guide to Life Insurance & Estate Tax

How To Use Life Insurance to Pay Estate Taxes

People often purchase life insurance to cover their funeral expenses, pay off debt, and pay off their mortgage when a death occurs. Many people purchase life insurance to pass on a legacy to their family. A significant benefit of having life insurance is that it may be used to cover estate taxes.

Life insurance is an often recommended method of paying estate taxes without having to liquidate other assets that you plan to pass to your heirs.

Below you will learn exactly how to pay estate taxes using life insurance.

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About Estate Taxes & Life Insurance
How to Pay Estate Taxes with Life Insurance
Life Insurance Death Benefits & Estate Taxes
Creating An Irrevocable Life Insurance Trust
The Smart Way to Set Up Life Insurance & Estate Tax

Life insurance and estate taxes

About Estate Taxes & Life Insurance

The estate tax is a tax imposed on your heir’s inherited portion of your estate if the value of the estate exceeds a certain amount.

As of 2019, the Federal Estate Tax Exemption amount for an estate is $11.4 million. Your heirs will owe estate taxes on the value of your estate that exceeds this exemption when you die (depending on the state that you reside in).

If you want your heirs to be able to keep all the property that you’ve worked for, your heirs will need a stream of cash to pay the estate taxes on your property when you die.

It’s important to understand how taxes are going to impact your life insurance and funds!

Don’t Let Estate Taxes Surprise You!

Estate taxes often come as a surprise to heirs who inherit large estates. Most of them are not aware of estate tax laws. Heirs will be required to pay Federal taxes if the value of the assets exceeds the federal exemption.

The Federal Estate Tax Exemption changes on an annual basis.

Heirs are given nine months to pay the estate taxes that are due. After this period, the IRS has the right to put a lien on the property, claim property or levy wages. To avoid penalties and collection action, estate taxes must be paid before the due date.

Obviously, you cannot predict when you will pass away. That’s why you should assume that your heirs will be taxed 35% of the amount inherited. If your heir is not able to pay the taxes, they may be forced to sell off the assets to pay the taxes.

How to Pay Estate Taxes with Life Insurance

Large estate

The best tax-free way to pay these estate taxes is to purchase a life insurance policy for a face amount equivalent to 40% of your estate.

When you purchase life insurance, you can provide your heirs with the liquidity they need to pay the taxes without selling your property. This way you can keep the property in the family without forcing your heirs to figure out a way to pay estate taxes.

Paying Inheritance Taxes with Life Insurance

Inheritance taxes are also charged to heirs in most states. Any heirs receiving more than $1 million will have to pay inheritance taxes at the rate of 55%.

This means that if you inherit $1 million; you will be paying $550,000 in taxes. But, if you purchase life insurance and list your heirs as the policy beneficiary, you don’t have to worry about any of this. This is the reason why life insurance should be a part of estate planning for all individuals.

Life insurance is the best safety net you can purchase for your family. It’s the best way you can ensure your family will have the resources they need in the future regardless of what happens to you. For a minimal amount each month, you can protect your financial assets and investment portfolio.

Life Insurance Death Benefits & Estate Taxes

Your life insurance policy may create an additional tax liability to your dependents or heirs.

If you control your life insurance policy, the payout from your life insurance will be considered as part of your estate according to the IRS section 2442.

In other words, when you die, your life insurance and all your assets will be considered as part of your estate. If your estate’s value exceeds the tax exemption for the current year, the value of the property that exceeds the exemption is subject to estate tax.

Avoid This Mistake When Purchasing Life Insurance for Estate Taxes

The most common mistake life insurance policyholders make in regard to estate planning is when they name their beneficiary as “payable to my estate” or when the owner names an immediate family member as the beneficiary of their policy.

Leaving life insurance policies to your estate or immediate family member increases your estate’s value which leaves the heirs with more tax liability when you die.

Creating an Irrevocable Life Insurance Trust is the best way to prevent your heirs from paying estate taxes. Consult an estate attorney or bank executive to create an irrevocable life insurance trust.

Creating An Irrevocable Life Insurance Trust

An Irrevocable Life Insurance Trust (ILIT) is an irrevocable trust that is funded by a life insurance policy for the policy owner or whoever set up the trust.

It can be set up by an individual or jointly by the husband and wife (a second-to-die life insurance policy). The death benefit for a spouse or a second-to-die policy will not be paid out until the surviving spouse dies.

When the person who set up the trust dies, then the proceeds from the life insurance policy are paid into the trust, and then distributed to trust beneficiaries (incrementally, or in a lump sum depending on the specifics of the trust and the decision of the trustee).

Changing an Existing Life Insurance Policy to an ILIT

There is a three-year rule that applies when transferring an existing policy to ILIT. If you die within three years of transferring your policy, the IRS will not recognize the irrevocable trust.

You cannot own your life insurance policy to avoid taxation of your life insurance policy. But, you can create an ILIT or Irrevocable Life Insurance Trust to avoid tax implications.

Name the ILIT the Owner & Beneficiary

You can’t be the trustee of the trust, by naming your ILIT as the policy owner; you must separate your coverage from your estate and avoid estate taxes. Since the ILIT acts as the owner and beneficiary of the policy, the proceeds remain separate from your estate eliminating estate tax obligations on your policy.

There are several parties to an ILIT – the grantor, trustees, and beneficiaries.

The grantor is the policy owner who creates the trust. The grantor transfers the life insurance policy to the ILIT. The grantor gives up control to the trustee. The trustee manages the ILIT, and the beneficiaries receive gifts and the estate.

The Best Way To Set Up An Irrevocable Life Insurance Trust

Consult a lawyer and bank executive if you plan to set up an ILIT.

When creating your ILIT, you will need to appoint a trustee who will manage the proceeds of your estate and the life insurance payout as directed by the trust after you die. The best time to create an ILIT is before you buy your life insurance coverage. If you already have life insurance coverage, create an ILIT is as soon as a possible.

Setting up an ILIT can be a complicated process. If it’s not properly drafted, you may not be able to get the benefits you hope to get.

There are strict drafting and procedural guidelines to adhere to conform to the IRS guidelines. The ILIT is an irrevocable trust, meaning once it is set up and funded, you need to step away and let the trustee handle everything. No further modifications can be made nor can you withdraw assets from it.

Benefits Of An Irrevocable Life Insurance Trust

There are a number of benefits we will cover below to set up an ILIT.

1 – Tax Benefits

The heirs may be able to avoid paying inheritance and estate taxes on the life insurance death benefit. Separating your life insurance benefit from your estate by putting in an irrevocable life insurance trust can potentially help your beneficiaries avoid estate taxes.

2 – Flexibility in Managing the Estate

Having liquidated assets from the policy payout that are exempt from inheritance taxes can give your beneficiaries more flexibility in managing your estate. Heirs often have difficulty paying the estate taxes because of lack of cash; they can often be forced to sell some assets to raise some money. Being able to use the life insurance benefits can allow the heirs to settle the estate without selling the family home.

3 – GST (Generation-skipping Transfer Tax) Exemption

You can be exempt from GST another estate tax. There is a 40% tax on outright gifts and transfers in trust imposed on your relatives who are more than a generation younger than the donor (and also to unrelated persons who are more than 37.5 years younger than the donor). Set up an ILIT to remove proceed from your estate and exempt proceeds from the GST. This is particularly helpful if you want the proceeds from your life insurance to be distributed to your family across multiple generations.

4 – Gift Tax Exemption

Contributions to the trust such as premium payments are considered gifts to your beneficiaries and can qualify for the annual $14k gift exclusion. You don’t have to file gift tax returns at death. To qualify, use a “Crummey letter” to notify beneficiaries of the trust about their right to withdraw a share of their contributions for 30 days. The trustee can then use the contributions to the trust to pay the policy premium.

5 – Protection From Creditors

Having an ILIT can help ensure your heirs can receive life insurance proceeds free from creditors claim because the distributions of proceeds are left to the discretion of the trustee. This provides some level of protection to your heirs if they need it.

Avoid term life insurance when you’re estate planning. Most banks and lawyers turn away people who want to create an irrevocable life insurance trust with term life insurance.

Most trust lawyers will recommend purchasing a permanent life insurance policy. Shop the market to find the best deal. Being diligent in choosing the right insurance company will save you thousands of dollars.

The Smart Way to Set Up Life Insurance and Estate Tax

The best way to make sure you set up your life insurance policy, or Irrevocable Life Insurance Trust the right way, is to work with an independent agent.

Fill out our quote tool on this page and give us a call.

We will shop multiple life insurance companies to find you the best rates possible and help make your family’s future secure with no estate taxes on your life insurance policy.