I am often asked questions by clients and prospective clients regarding life insurance. Specifically, families will ask me how much life insurance is appropriate and whether the life insurance proceeds will be taxed when the proceeds are pay out to their children and loved ones. First, the question regarding how much life insurance is appropriate for your family is a question that you should ask a financial planning or life insurance professional. However, the question regarding whether the IRS will tax the life insurance proceeds is an important question, and also a question that very few people think to ask their estate planning attorney.
The assumption about life insurance is that it is there to help your family and loved ones handle final expenses in the event of your death. Although, depending upon a number of factors such as whether you own the life insurance policy and how much life insurance is set to pay out at death, will determine whether or not the proceeds will be taxed by the IRS.
According to the IRS, if you own your life insurance policy on the date of your death, it is considered part of your taxable estate and can be assessed estate tax liability by the IRS. For example, let’s say that on the date of your death you own a home worth $500,000.00, $4 million in investments and other assets, and a life insurance policy with a value of $10 million. In this situation, the IRS would determine that the gross taxable estate for estate tax purposes is $14,500,000. However, with the current estate tax exemption, and let’s say that the surviving spouse utilized portability from the first deceased spouse, then $10,860,000 would be exempt from the federal estate tax. However, the remaining $3,640,000 would be subject to the federal estate tax, which has a top tax rate of 40%. Therefore, under this example, because of the $10 million life insurance owned at the date of death, the estate would have an estate tax liability of approximately $1,456,000. This tax would be due no later than nine months after the date of death.
Therefore, due to the significant estate tax liability present in this example, an irrevocable life insurance trust may be an appropriate avenue to reduce or completely eliminate the estate tax liability.
First, an irrevocable life insurance trust is irrevocable. This means that once the trust has been established by the settlor, it can never be revoked. Second, the settlor cannot be the trustee of the trust. This means that once you set up the trust, you will lose all control and you must select someone else to act as trustee of the trust during your lifetime. Third, the trust must own the policy. This means that the trustee of the trust must purchase the policy and pay all of the insurance premiums going forward.Now, how does this affect the estate tax liability in the example above? Well, let’s say that on the date of death you still owned a home worth $500,000 and $4 million in investments and other assets. However, let’s say that you set up an irrevocable life insurance trust earlier in life and the trust purchased the $10 million policy. Well, under this example, the taxable estate would be $4,500,000 and the $10 million life insurance policy would not be considered a taxable asset for estate tax purposes. This also means that the estate would only be worth $4.5 million, and under the $5.43 million estate tax exemption. Therefore, in this example, this type of advanced planning would be an estate tax savings of approximately $1.45 million.