Caution: Although Life Insurance Passes Outside of Probate, It is Still Considered Part of Your Gross Taxable Estate

We recently had one of our educational events, and a married couple asked me about their life insurance policies and whether taxes would be due when they die. I informed them that there are a lot of different type of taxes, but if they are talking about income taxes, then the answer is no, there are no income taxes on life insurance proceeds. However, the family said their question was about estate taxes, because they were under the impression that life insurance proceeds would pass to their loved ones outside of probate, and therefore no estate taxes would be involved. I told this family that, unfortunately, it depends on how the life insurance policies are owned.

I continued to discuss the financial assets and life insurance that this couple owned, and they informed me that they had approximately $15 million in assets between their home, vacation home, investment accounts, bank accounts, and life insurance. In addition, this couple informed me that they owned their life insurance policies. Unfortunately, I informed this family that they may have an estate and gift tax issue when they pass away.

In 2012, Congress amended the tax code, and you are allowed to pass up to $5.4 million in assets at your death without any estate tax being owed. However, Congress also amended the tax code to introduce and make a term called portability permanent. This is where the first spouse to pass away is allowed to transfer their unused estate tax exemption to the surviving spouse, and thereby provide the surviving spouse with a $10.8 million estate tax exemption. However, I explained to this couple, any amount over the $10.8 million exemption would be subject to the estate tax, which has a top tax rate of 40%.

I discussed with this couple that the $5 million in life insurance proceeds going to their three sons at their death would be included as part of the taxable estate and subject to the estate tax. I explained that $4.2 million of their estate would be subject to the estate tax, which is approximately $1.68 million in taxes that would be due within 9 months of the last spouse to pass away. Obviously, this husband and wife we were very concerned.

However, a possible solution that I presented to this couple was to set up an Irrevocable Life Insurance Trust or (ILIT) for short. I explained that because you own the life insurance policies with a $5 million death benefit, then this would be included in your gross taxable estate. However, we could transfer ownership of the $5 million life insurance policies to the name of the ILIT, thereby reducing your taxable estate to $10 million, and eliminating the $1.68 million in estate tax liability. However, I cautioned this couple, that there are some very important rules that we need to follow to ensure that this tax planning strategy is not voided by the IRS.

First, the trust is irrevocable and you will not be able to have any control over the trust or these insurance policies. I explained that the IRS will not allow you to take advantage of these estate tax planning techniques if you maintain control over the life insurance policies or the ILIT in anyway. Instead, a separate trustee would manage the ILIT and maintain these life insurance policies.

Second, you can transfer up to $28,000 in joint assets to anyone as a gift without incurring any federal estate and gift tax consequences during your lifetime. Therefore, you can also transfer up to $28,000 of joint assets to the trustee of the ILIT in order to pay the annual premiums of these life insurance policies.

Finally, and most importantly, you need to live for at least 3 years after we set up the ILIT and transfer your existing life insurance policies to the trust. If you pass away before this 3 year period is over, then the IRS will invalidate the transfer and consider the life insurance policies as if you owned them at the time of your death, and bring that $5 million in proceeds back into your taxable estate.

However, I also explained that if their estate gets larger over the years, an ILIT can also be used as a relatively inexpensive way to pay estate taxes that will be due on the date of the death of the second spouse. For example, if your estate, minus the transferred life insurance grows to $15 million and you have $5 million in the ILIT. It may make sense for the ILIT to purchase another $1.75 million in life insurance for the purpose of paying the estate tax of $1.68 million that will be due on the date of death of the second spouse.

If you have questions about Irrevocable Life Insurance Trusts as a way to reduce estate taxes, or you have other questions about estate taxes and estate planning, then please feel free to reach out to me and I’d be happy to discuss these matters with you and your family. Also, if you would like to learn more about estate planning and probate in an educational environment, please reserve a spot at one of our upcoming live educational events or webinars that we have scheduled this month.

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