Life Insurance – an Estate Tax Time Bomb

Life Insurance

One common oversight I see when reviewing new clients’ financial status is failure to consider the estate tax impact of large life insurance policies. Most people know that life insurance proceeds are received free from income tax. What most don’t know, however, is that the proceeds are part of the insured’s estate for estate tax purposes if:

  •     The proceeds are payable to the insured estate, or
  •     The insured has any “incidents of ownership” of the policy, such as the right to change the beneficiary or access the cash value.

Life insurance proceeds of any amount can be paid to a U.S. citizen spouse free from tax. But – those same proceeds, or the value of items purchased with the proceeds, will be included in the taxable estate of the surviving spouse.

This may not be a problem for most of us at the current $3.5 million estate tax exemption. However, barring a change in the law, in less than 14 months the exemption will revert to $1 million, and the rate will increase from 45% to 55%. North Carolina adds another 16%.

With a $1 million exemption even a $250,000 policy could be subject to estate tax when combined with the value of real estate, retirement accounts, and all the other assets of a decedent. Why take the chance of losing over half the proceeds to Uncle Sam? The solution is to create an irrevocable life insurance trust (ILIT)to own the policy. The proceeds will then escape taxation at the death of the insured, his or her spouse, and can be structured to avoid taxes at the death of the children or other beneficiaries are well.  In addition, the proceeds are protected from creditors and mismanagement by the beneficiaries.

If an existing policy is transferred to an ILIT, the proceeds will still be included in the insured’s estate for estate tax purposes if he or she dies within three years of the transfer, so it’s best not to delay planning for existing policies.

ILITs must be structured properly to take into account various estate, gift and income tax issues, as well as state law.  Make sure you have an estate planning specialist prepare your ILIT and work with your life insurance agent.  ILITs are not inexpensive to create, but your beneficiaries could easily save several hundred thousand dollars or more.

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