You’ve worked your entire life to build a legacy for your heirs, but what happens to it all when you pass away? The answer can become a little bit complicated…
If you’re single and your estate is worth more than $5.49 million, your heirs will run into some hefty estate taxes when you pass away. If your married, your federal estate tax exemption doubles to $10.98 million, but your heirs may still face state inheritance taxes and creditors when you pass away.
Thankfully, there are a few affordable options that can help you preserve your legacy and your estate for future generations. In this guide we’ve explained how you can utilize estate planning with life insurance to reduce or eliminate estate taxes and help your heirs avoid creditors.
Quick Article Guide:
1. What is Estate Planning with Life Insurance?
2. Separating your Life Insurance from Your Estate
3. Creating an Irrevocable Trust for Estate Planning
4. Selecting the Right Policy for Your Life Insurance Trust
5. Getting Started on your Estate Plan
For 99% of Americans the death benefit from a life insurance policy is paid out as tax-free lump sum. If you’re not married and estate is worth more than the federal estate tax exemption of $5.49 million at the time of your death your insurance policy’s death benefit may be subject to estate taxes.
When you pass away the IRS will add up the total value of the assets that you left behind. This includes; real estate, investments, life insurance, jewelry, artwork, businesses, family farms, mineral rights, bank accounts, collectibles, automobiles, etc. If the total value of your assets exceeds the current estate tax exemption your heirs will owe estate taxes on the assets you intended to leave behind for them.
The IRS estate tax rates and exemption amounts change every year as well as with every legislation. In 2017, the estate tax exemption was set at $5.49 million per individual ($10.98 million per married couple), and the estate tax rate was set at 40%. This means that if a non-married person with an estate worth more than $5.49 million passed away in 2017, their heirs would owe the IRS 40% of the value of the estate that exceeds $5.49 million.
As an Example:
Let’s assume your total assets are worth $10 million.
$10 million (total value of your estate) – $5.49 million (current estate tax exemption) = $4.51 million
$4.51 million (value of your estate that exceeds the exemption) X 40% (estate tax rate) = $1.8 million
Total tax liability = $1,804,000
These estate taxes must be paid to the IRS within 9 months of your passing or your heirs will face hefty fines and penalties, even property seizure. The threat of these taxes often forces people to quickly sell off assets for a fraction of their value, or hold estate sales at a time of grieving. However, selling off expensive assets may cause further tax liabilities including additional income taxes and/or capital gains taxes.
If You’re Married…
For married couples, the IRS estate tax exemption doubles to $10.98 million, and you leave an unlimited amount of assets behind to your spouse untaxed. When your spouse passes away he/she can leave up to $10.98 million behind to your loved ones untaxed, but any assets that exceed this value will be subject to the federal estate tax rate of 40%. Like income tax, these federal taxes are in addition to any additional inheritance taxes your state may charge.
Even if your estate is worth less than $10.98 million and you’re married, you may want to consider estate planning with life insurance. The value of property doubles every 10 years on average, and while your estate may not exceed the estate tax exemption now, it may in 20 years. In addition, estate tax exemptions can change at any time.
To avoid estate taxes, financial advisers, attorneys, and bankers usually recommend purchasing a life insurance policy and establishing an irrevocable life insurance trust. This separates your life insurance policy from your estate preventing the death benefit from your life insurance policy from being taxed. In-turn, your trust will use the death benefit from your life insurance to settle your estate tax liability with the IRS.
Proper estate planning with life insurance can help you avoid or eliminate your estate tax liability to preserve your legacy for future generations. To take advantage of this tax loophole though, there are some basic steps that you must follow to separate your life insurance policy from your estate. The most important is relinquishing personal control of your life insurance policy.
When purchasing a life insurance policy for estate planning, you cannot name yourself, your estate, or an individual as the owner of your life insurance policy. If you, your estate, or a relative owns your policy, the IRS will consider the policy to be under your control and it will be considered a taxable asset. To prevent your life insurance policy from becoming an asset, or part or your estate, it must be owned by an Irrevocable Life Insurance Trust.
Essentially, an Irrevocable Life Insurance Trust, or ILIT, functions as an intermediary between you and your life insurance policy. It allows you to fund your life insurance policy, and ensures that your life insurance policy’s death benefit will be paid to the IRS when you pass away. If your trust is listed as the owner of your policy when you purchase it, your policy will not be considered an asset by the IRS.
If you already own a life insurance policy, you can also transfer the ownership of your policy to an ILIT, but there is a three-year waiting period before the IRS will recognize the transfer. If you pass away before these three years have passed, your life insurance will be considered an asset and will be calculated in your heir’s estate tax liabilities. For this reason, we recommend establishing an ILIT before you apply for life insurance.
Establishing an ILIT is a relatively simple process that usually involves working with an Estate, Trust, or Will Attorney. When establishing a trust for estate planning, your attorney should always recommend an irrevocable trust, not a revocable trust.
While both types of trusts sound similar, a revocable trust can be modified, which allows you to maintain some “control” your policy. Having “control” of your life insurance policy makes it an asset and in the eyes of the IRS, and subject to estate taxes. An irrevocable trust cannot be modified once it has been established, so the IRS will not consider it to be an asset. However, you’ll still have an option to cancel your policy if your needs change down the road.
When setting up your irrevocable trust, you will also need to appoint a trustee and a beneficiary to oversee your irrevocable trust. This person will be responsible for ensuring that your trust carries out your final wishes when you pass away. A trustee can be a bank executive, an attorney, or relative that is financially responsible.
There are a few things to consider when you’re deciding on who to name as the trustee and beneficiary of your life insurance policy:
1. While your trustee must act in accordance to the terms established within your trust, we recommend choosing a financially responsible adult. Avoiding listing anyone with drug or alcohol abuse issues, gambling problems, or excessive spending habits.
2. Your trustee will be responsible for paying your life insurance premiums. We recommend establishing a bank account for your trust and setting up a direct deposit with the insurance company. The IRS allows an annual gift tax exemption of up to $14,000 per year, per individual. You can pay this money directly to your trust’s account to avoid paying “gift” taxes.
3. Once you transfer your insurance policy to the trust, it’s irrevocable. You will lose the right to personally make any changes to your life insurance policy, except to cut-off funding. However, if the trustee is a loved one or an executive at your bank, they may be able to make changes to it per your request.
Make sure you always keep a copy of your insurance policy in a safe place, and provide a copy to your trustee as well. The insurance company will also send you a written confirmation of your policy for your records. This letter will typically provide with your insurer’s contact information, your policy number, and a brief explanation of benefits.
When purchasing life insurance to avoid estate taxes, you must outlive your policy for your family to benefit from the coverage. For this reason, we never recommend purchasing term life insurance for estate protection. Term life insurance usually expires around the age 80, and most people outlive their coverage, which is why term insurance is so affordable.
In fact, the attorneys and bankers we’ve worked with tell us that the most common issue they come across is increased longevity…or people outliving their coverage. Estate planning life insurance cannot expire before you pass away, you will be wasting your money, and your loved one’s will be stuck dealing with the IRS.
At Term Life Advice, we focus on life insurance products that will guarantee your coverage and rates until age 90, 95, 100, 105, 110, or even 121. These policies do not require a risky investment, and they work just like term life insurance.
Unlike Non-Guaranteed Universal life insurance which we always recommend avoiding, Guaranteed Universal Life insurance policies provide the insured with level rates and coverage that is guaranteed not to change as you get older. It does not build a cash value and you do not have to pay extra into the policy each month to build an investment. Like term insurance, if you pay your premiums on time, you’ll have level rates and coverage until the age of your choice.
A lot goes into estate planning life insurance, and it’s important that you speak with a licensed professional at your bank or an estate attorney when you establish your irrevocable trust. If you have questions or don’t know where to begin please give us a call. We can guide you in the right direction and help you get started.
Our agents are highly experienced in estate planning matters and we would be happy to help you with any of your life insurance needs. We have worked with hundreds of clients with their estate planning matters, and we can provide the advice you need to get best policy for your situation.
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