Now that’s a great question and one I have heard asked and answered a million or so times over my law career. It’s right up there with the questions “What’s all this gonna cost?”, “Should I do a Will or a Living Trust?” and “What’s better, an LLC or an S corporation?” and it’s definitely in the top ten most FAQs of all time.
You would think a simple question like that would have a simple answer. Um… not really. Not when you understand who makes the rules (the IRS) and who plans among the rules (lawyers and CPAs). Honestly, it’s just not a simple topic. So I apologize in advance for the long, technical answer, but I’ll do my best to make it understandable.
Most of the confusion surrounding life insurance in the estate planning context comes about because we are talking about two different taxes here. Income tax and estate tax are both involved. Let’s start with the basics.
The current estate tax exemption, the amount that is free and clear from estate taxes upon your death, is $11.4 million for each individual, and $22.8 million for a married couple. In 2020, those amounts increase to $11.58 million and $23.160 million respectively. Additionally, current law provides that in 2025, the exemption goes back to $5.5 million and $11 million unless Congress acts.
Life insurance is generally not considered taxable income to the person who receives it (the “beneficiary”). However, Section 2042 of the Internal Revenue Code states that the full amount of the death benefit is included in the gross estate of the “decedent” (the person who died) for estate tax purposes if the person who died had “incidents of ownership” in the policy. That means that if the decedent had the power to change the beneficiary of the policy, surrender or cancel the policy, assign the policy, revoke an assignment of the policy, pledge the policy for a loan, or obtain from the insurance company a loan against the surrender value of the policy, then the total death benefit is included in the decedent’s gross estate for estate tax purposes.
Here’s an example. Let’s say that my client Jim, a successful business owner, owns a $10 million insurance policy on his life. He has named his wife Jill as the primary beneficiary of the policy. The estate tax exemption is currently $11.4 million meaning that the first $11.4 million of his estate is not subject to estate tax. Anything over $11.4 million is taxed at 40%.
Let’s also say that Jim also owns $3M worth of assets; e.g., his business, his home, 401(k), Roth IRA, investment accounts, and a rental property. So, Jim’s total gross estate, including his life insurance is $13 million. When Jim dies, his total gross estate is valued at $13 million because he owned the policy in his own name and had “incidents of ownership” in the policy. The law exempts the first $11.4 million, leaving $1.6 million as Jim’s “taxable estate.” Therefore, Jim’s estate owes the federal government $640,000 in estate taxes (40% of $1.6 million) even though Jill receives the full $10 million income tax free. The numbers get really bad in 2025 when the exemption goes back to $5.5 million. In that case, Jim’s estate would owe about $3,000,000 in estate taxes! Yikes!
Because of the size of Jim’s life insurance policy, Jim’s other “real” assets, including his home, business, investments, etc. may need to be sold, or a portion of the life insurance policy may need to be used, upon his death just to pay the estate taxes. There is another whole discussion and analysis that needs to occur if Jim’s business owns, or is the beneficiary of the insurance policy.
So what do we do? Like I’ve told my kids and employees over the years, you can’t just complain about the problem. You must bring a potential solution to the discussion. Interestingly, in this situation, we have a fairly straightforward solution – remove Jim’s “incidents of ownership” in the policy.
The simplest way to do that is to create an irrevocable life insurance trust and appoint a third party trustee to manage it. Then transfer the policy into the trust. The trust is considered an taxpayer, independent of Jim, and the policy benefits are no longer taxable to Jim or his estate when he dies. In our scenario above, we save somewhere between $640,000 and $3,000,000 in estate taxes and Jill receives the benefits income tax free and protected from creditors, and any issues that might arise from a potential subsequent remarriage. We still have to consider the IRS’ “three year rule” and “transfer for value rule” before we pull the trigger, but those are considerations for another time.
We currently manage as trustee about 45 of these trusts, representing about $80M in life insurance benefits for our clients. Now, I know that a big issue for most financial advisors is the access to the policy for loans, retirement income, etc. If that’s an issue for you, rest assured that we can draft the trust to allow access to the cash value of the policy without providing any incidents of ownership to the insured. This is a well established strategy and we have implemented it for numerous clients over many years. It truly is one of the “home runs of estate planning.”
Well, if you’re still with me, and if you have questions, please call. We are honored to be your lawyers and we would be pleased to discuss this with you or your financial advisor.
Douglas G. Goldberg, Esq.
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