Every time I meet with a client I hear the same misconception, “we have life insurance, but that is tax free for our children, right?” Wrong! Life insurance death benefits are not necessarily tax free. Life insurance death benefits are included in your taxable estate when it comes to calculating the estate tax liability. Therefore, let me tell you the horror story about George and Barbara.
George and Barbara worked hard, saved their money, invested conservatively, and raised their family. George and Barbara both worked outside of the home and retired in their mid-60s. George and Barbara owned their home which was worth $450,000, a second home in Gatlinburg worth approximately $500,000. George and Barbara also inherited some real estate that they had held onto for years from George’s parents. George’s parents owned a condo in Manhattan that has a fair market value of $4.5 million. In addition, George had investment accounts, annuities, bank accounts, an IRA, and some farm land in West Tennessee. In total, George and Barbara had an estate totaling $6.45 million.
However, George and Barbara were not worried. They had met with an estate planning attorney years ago and completed a comprehensive estate plan including a revocable living trust, last will and testament, durable and healthcare power of attorney, and living will documents. In addition, George and Barbara ensured that all of their assets were retitled into their revocable living trust, just as their attorney had instructed them to do. In addition, George and Barbara were aware that the federal estate tax exemption was $5.45 million. However, when the first of them passes away, the surviving spouse could transfer that spouse’s $5.45 million exemption and effectively create a $10.9 million exemption from the estate tax.
So, George and Barbara were not worried… or so they thought! What George and Barbara did not know is that their life insurance polices were included in their taxable estate. You see both George and Barbara had life insurance policies in their name. They owned permanent insurance and term life insurance policies. George had a total of three policies totaling $3 million, and Barbara had three policies totaling $3 million.
As it turned out, George died first. When George passed away, Barbara did exactly what she was instructed to do. She filed the necessary IRS tax form making the portability election thereby transferring George’s unused estate tax exemption to Barbara and creating a $10.9 million estate tax exemption. In addition, because everything was set up in advance, the estate settlement process was very smooth for Barbara.
However, three years later Barbara passed away. Not knowing what to do, the three children hired a lawyer to settle their mother’s estate. This is where they received some devastating news! When Barbara died the estate was a total of $9.45 million. However, the lawyer informed the children, Barbara’s three life insurance policies totaling $3 million are includable in her taxable estate. This created a total taxable estate of $12.45 million. Unfortunately, the lawyer explained, what this meant is that $1,550,000 of the estate is subject to estate taxes. In addition, he explained that at the 40% tax rate, there is going to be a tax bill due to the IRS within 9 months of the date of their mother’s death in the amount of $620,000!
Unfortunately, George and Barbara didn’t know that there was something they could have done to remove their insurance polices from their estate, thereby saving their children $620,000 in unnecessary taxes. One strategy would be to establish an Irrevocable Life Insurance Trust, and so long as it was set up correctly, it would have removed $6 million from their taxable estate, and never would have subjected their children to having to pay estate taxes!
If you have questions or concerns about this type of comprehensive estate planning or believe that an Irrevocable Life Insurance Trust could be the perfect type of planning for your family, then please contact our office for a complimentary visit and planning session so that we can discuss your estate planning needs in further detail.
We look forward to hearing from you!