Life insurance plays a very important role in estate planning. The payout from a life insurance policy can be used to leave an inheritance, settle a buy-sell agreement for your business, pay your final expenses, or to reduce and/or settle your estate taxes with the IRS when you pass away. Depending on the size of your estate, estate planning with life insurance can be vital to ensuring your heirs are able to retain the assets you have worked for.
Quick Article Guide
1. Avoiding or Reducing Estate Taxes with Life Insurance
2. Estate Planning Life Insurance Trusts 3. Selecting the Right Type of Coverage for your ILIT
4. Ownership Considerations with Estate Planning
However, it is important to note that most people who purchase life insurance do not want to protect an estate or leave an inheritance.
Term life insurance seems to be the most popular type of coverage, but term life insurance is not designed to last your entire lifetime. Term Life insurance is more commonly purchased for mortgage protection or to protect your income until you reach your planned retirement age.
If you need to protect your estate from estate taxes, do not work with the call centers you see on TV.
These centers are set up to handle a high volume of calls and the agents in these centers are trained to sell term life insurance only. You will want to work with an estate planning life insurance agent that can help you with an affordable permanent life insurance policy. When estate planning, most of our client’s will need to leave money behind, and term life insurance is not set up to do this. The majority of term life insurance policies expire before the age of 80.
According to Forbes, 99.5% of American’s have estates that are valued at less than $5,000,000. The majority of life insurance agents will never work with a client that has an estate tax liability. When you are setting up life insurance to protect your estate, you do not want to work with someone who is not experienced with estate planning. If your policy is not set up correctly, you may actually increase your estate tax liability with life insurance. There are 3 problematic situations that we commonly encounter when working with clients who are purchasing life insurance to reduce or avoid estate taxes.
- Your life insurance policy pays to your estate. If your policy pays to your estate, it is considered as an asset and it will be calculated into your total estate’s value. If you have a large estate and a large life insurance policy, this can create an estate tax liability. If the total value of your estate exceeds the current year’s estate tax exemption, your heirs will owe estate taxes of up to 40% of this amount.
- The life insurance policy is owned by the insured. If you own your own life insurance policy, it is considered to be under your control and direction, and it will still be viewed as an asset. An irrevocable life insurance trust should be listed as the owner, beneficiary, and payer of your life insurance policy.
- There is an incident of ownership involving your life insurance policy and your trust. Your irrevocable life insurance trust must be listed as the owner and payer of your life insurance policy to avoid incidents of ownership. If you have already purchased your life insurance without first creating an ILIT, you must transfer the ownership of your policy into your irrevocable life insurance trust with 3 years of your passing.
We receive dozens of calls very month from clients asking; “What is the difference between a revocable life insurance trust and an irrevocable life insurance trust?”
Revocable Life Insurance Trust:
A revocable life insurance trust allows the owner of the life insurance policy to maintain control and ownership of their life insurance policy, a “revocable trust” can be revoked or changed at any time if your needs change. However, because of the flexibility in these types of trusts, they do not carry the same tax advantages.
If your life insurance policy is owned by a revocable trust, it will be included in the total value of your estate and it the payout could be subject to estate taxes. These types of trusts are more ideal for younger families with smaller estates. They are not designed to avoid any potential estate tax obligations.
Irrevocable Life Insurance Trust:
An irrevocable life insurance trust separates the life insurance policy payout from the estate of the insured and his or her spouse to reduce or avoid estate taxes. By separating the policy from your estate, you lose complete control or your life insurance, but your eliminate your tax liability. You can still control the proceeds of your estate and life insurance policy, but these wishes will be carried out by the trustee of your will when you have passed away. Commonly, clients will choose an attorney or an executive of their bank as the trustee of their ILIT. You can also name a family member as your trustee, if you elect to name a family member, be sure to pick someone who is responsible, honest, and good with managing finances.
We you pass away, the proceeds of a life insurance policy are paid to your trust, tax free. This money is the used to pay off any estate taxes owed to the IRS on your final estate. By settling these taxes with the proceeds of your life insurance policy, your estate can be passed on in accordance with the directions laid out in your trust. Your trustee will direct these transactions to ensure that your final wishes are carried out. For an irrevocable life insurance trust to function correctly, you must purchase a permanent life insurance policy.
There are lots uses of life insurance. If you’re buying life insurance for estate planning, settling final expenses, leaving an inheritance, or wealth accumulation; you need to buy a life insurance that you will not outlive.
If you outlive your policy, the policy will not provide a benefit to your beneficiaries.
This is why you need to work with an estate planning life insurance agent and not an agent that specializes in term life insurance only. Term life insurance is excellent for income replacement, mortgage protection, SBA loans, student loans, buy-sell business agreements, and divorce decrees. Term life insurance is not permanent life insurance coverage; it provides a set amount of coverage for a guaranteed period of time. For some of our clients the best solution is permanent coverage, other clients prefer term coverage, or a combination of the two.
Whatever your need for coverage is, we can help. We work with almost four dozen companies that offer term life insurance and various forms of permanent life insurance like whole life insurance and guaranteed universal life insurance – term to 90, 95, 100, 110 and 121.
To learn more about the pros and cons of whole vs term life insurance, and which type of coverage is best for you, please read our articles; Pros and Cons of Whole Life Insurance, 5 Situations that Term Life Insurance would Cover Best, or Term vs. Whole Life Insurance Comparison.
There are many types of whole life insurance or, permanent life insurance, and some should be avoided at all costs. If your purchasing life insurance for estate planning, final expenses, or to leave an inheritance; avoid any type of life insurance that builds a cash value. Cash accumulating life insurance is extremely expensive, especially on a fixed income.
The cash that you accumulate is lost if you pass away before withdrawing it, and if you withdraw your cash, you will reduce your death benefit. Avoid this debacle. Not all types of whole life insurance are the same either. Some whole life insurance policies increase in price every five years.… a nightmare for anyone on a fixed income with other increasing expenses.
Purchase a life insurance policy that guarantees your rates and coverage until age 90 or later. Types of Life Insurance for Estate Planning If your married and your spouse does not need income to survive after you are gone, or if your estate is solely owned and you are not married – the best type of life insurance that you can purchase for estate planning is usually guaranteed universal life insurance – not to be confused with universal life insurance!
These policies are usually referred to as “term to 90”, “term to 95”, or “term to 100”, because they work just like term life insurance. Instead of offering a 10, 20, or 30-year term, you can lock in your rates and coverage until the age of 90, 95, 100, 105, 110, or 121. These policies guarantee your rates and coverage without required investing or paying extra to accumulate a “cash value”, you pay for the life insurance only.
First to die life insurance coverage:
In some situations, guaranteed universal life insurance policies may also work well for estate planning, especially if a spouse is uninsurable or cannot qualify for coverage for other reasons. These policies are also known as a first-to-die-life-insurance policy. The insured spouse can leave the benefits of their life insurance policy to their spouse utilizing the unlimited marital deduction. The surviving spouse can then use the payout of the life insurance to pay bills, save the cash to pay estate taxes, or gift the cash to your heirs to reduce the estate tax liability.
If your spouse relies on your income and vice versa, purchasing a guaranteed life insurance policy on each other is a great way to insure your retirement incomes, like social security. Guaranteed universal life insurance policies often work well as an alternative to electing a joint or survivorship pension plan, a strategy also known as pension maximization. Guaranteed universal life of first to die life insurance policies are also commonly purchased by business executives for buy-sell agreements.
For example, if there are three owners of a business, the business might purchase a life insurance policy on each owner equivalent to their stake in the business. When one of the owners passes away, the life insurance policy pays their family the sum of the life insurance policy, allowing the business to continue functioning without selling assets.
Second-to-Die or Survivorship Life Insurance:
Second-to-die life insurance, survivorship life insurance, or joint life insurance is a type of life insurance that insures a husband and a wife.
These life insurance policies are underwritten based of the life expectancy of both the husband and the wife because the life insurance policy does not pay out until both people pass away. These policies are a less expensive way to insure a couple if either person has some health risks. These policies can also be purchased on a husband and a child. A survivorship life insurance policy is ideal for estate planning, especially to pass a large estate or family farm down to your heirs.
There are some cons to second-to-die or survivorship life insurance however. These policies do not provide a cash payout while either insured is still alive. If your spouse will need an income to pay the bills, or if there is a risk of your spouse not being able to pay the premiums on this policy after you are gone, you may not want to buy this type of life insurance. We often work with client’s whose children have agreed to take over the payments on the policy if needed. We can assist with coordinating payments, or changing payment modes, but make sure you have this discussion with them first.
The question that usually comes after deciding who will pay for your life insurance policy is, “Who will be listed as the owner of my life insurance?” There are pros and cons to just about every scenario, here are the most common scenarios:
- Owning your own life insurance policy:
This is the most common scenario and it usually makes the most sense. As long as you own your own life insurance policy, you control it. You can change beneficiaries, coverage, etc. With this ownership comes estate tax liabilities however. If you own your life insurance policy, it is considered to be an asset. According to Section 2402 of the IRS Estate Tax Code, the payout from a life insurance can be taxed as part of your estate.
If the total value of your estate and life insurance is less than the current year’s estate tax exemption, $5.45 million as of 2016, you probably have nothing to worry about. However, as a disclaimer, we must point out that these exemption rates can change or disappear at any time, in addition, they hardly keep up with inflation.
If your estate is growing quickly, you will want to keep this in mind. You can transfer ownership into an irrevocable life insurance trust and reduce or avoid estate taxes, but if you pass away with three years of transferring ownership, the IRS will not honor your trust. This is also known as an incident of ownership.
- Listing Your Spouse as the Owner of Your Policy
Listing your spouse as the owner of your policy will allow you to retain some of the control of your life insurance policy. Your spouse will also be able to inherit the proceeds of your estate and your life insurance estate tax free due to the unlimited marital deduction. The cons to naming your spouse as the owner of your life insurance policy is that when he or she passes away they will still face the same estate tax liability.
Although your spouse may be able to reduce some of the estate tax liability by slowly transferring assets when you are still alive or by donating to charity. In the unlikely event that your spouse passes away before you do, you will become the owner of your policy again.
Every once in a while we receive a call from someone who named their spouse as the owner of their life insurance policy and they are now divorced. In this situation, you cannot regain ownership of your life insurance policy, without court intervention. As long as your spouse maintains the payments on the policy, the coverage will stay active.
- Listing your Children as the Owner of Your Policy
If you list your children as the owner of your life insurance policy, you will still theoretically maintain control of your life insurance policy. The life insurance policy will stay in your family, but your children will ultimately have the final say in how the proceeds are spent or divided.
This will allow your life insurance policy to avoid the estate taxes associated with your estate. The proceeds of your life insurance policy would instead become a part of your children’s estate. If your children inherit your estate or have large estate of their own, they may encounter some of the same estate tax problems that you or your spouse would have encountered.
If you children are minors, naming them as the owner of your life insurance policy is not advisable. Your estate and life insurance proceeds will enter probate and this is a long and drawn out legal process that involves the courts naming a legal guardian to whom they will allocate money as needed.
- Listing A Revocable Trust As the Owner of Your Policy
Listing a revocable life insurance trust as the owner of your policy will allow you to maintain ownership of your life insurance policy and it will prevent creditors and unwanted people from seeing the final details of your estate. With a revocable life insurance trust, you maintain control of your life insurance, and you change the terms of your revocable trust at any time.
Because a revocable life insurance can trust be revoked or changed by you, a revocable trust doesn’t separate your life insurance policy from your estate. The IRS will consider your life insurance policy as an asset and it may be subject to estate taxes. You can transfer the ownership of your policy from a revocable life insurance trust to an irrevocable life insurance trust.
We recommend doing this as soon as possible. If you pass away within three years of transferring ownership, your life insurance policy will still be considered to be part of your estate, also known as an incident of ownership.
- Listing An Irrevocable Life Insurance Trust as the Owner of Your Policy
If you list the owner of your life insurance policy at the as an irrevocable life insurance trust when you purchase your life insurance policy, it will be separated from your final estate for estate tax purposes. This means that your life insurance policy payout will not be included in your estate calculation when determining your final tax liability. If you transfer the ownership of your life insurance policy from an individual, yourself, or a revocable trust, there is a three year period where the IRS will not honor the irrevocable life insurance trust for exclusion from your final estate tax calculation.
This is also known as an incident of ownership. To avoid this we recommend setting up an irrevocable life insurance trust or ILIT before you buy your life insurance policy. The downside to listing an ILIT as the owner of your life insurance policy is that you will relinquish control of your life insurance policy. The policy will pay to your trust and your trustee will carry out the terms of the trust that you have dictated. Our clients will usually name a bank executive, an attorney, or a close and trusted family as the trustee of their ILIT. (Read: The Pros and Cons of an Irrevocable Life Insurance Trust to learn more about reducing your estate tax liability with life insurance.)
Naming the Beneficiaries on Your Life Insurance Policy Our clients often ask us, “Why wouldn’t I list a close and trusted family member as the beneficiary of my life insurance policy and avoid dealing with a Trust?”
Naming a family member or any individual as the primary beneficiary of your life insurance policy seems like the easiest option, but it can also present the most challenges for your heirs when you pass away.
Once you have listed an individual as the beneficiary of your life insurance policy, you have relinquished all control of the life insurance payout. This removes your life insurance payout from your estate, so it is not subject to estate taxes, but it also allows the person that you name as your beneficiary to have free rein of the life insurance payout. Once the life insurance policy pays them, there is no legal or binding agreement that forces them to spend the money on your settling your estate taxes or carrying out your final wishes. Naming a minor as the primary beneficiary of your life insurance policy can further complicate settling estate taxes and life insurance payouts. If your beneficiary is under the age of 18, your life insurance policy payout will enter into probate when you pass away.
At this time the courts will appoint a relative or legal guardian to oversee the child’s life insurance proceeds. This is a very delayed, expensive, and time consuming process. We would recommend avoiding probate if possible, you do not want to leave your child or children and their appointed legal guardian with the task of settling your estate tax liabilities. If your estate is listed as the beneficiary of your life insurance policy, the proceeds of your life insurance will be included in your final estate calculation.
Depending on the value of your estate, your life insurance policy could create an increased estate tax liability for your heirs. To avoid these increased estate taxes, the beneficiary of any life insurance policy that is purchased to reduce estate taxes should list an irrevocable life insurance trust or ILIT as the primary beneficiary. You should always consult a will, trust, or estate planning attorney when drafting your irrevocable life insurance trust. In addition, you will want to consult an estate planning life insurance agent that is well-versed in permanent life insurance options and estate planning.
Do not buy term life insurance for estate planning, you need to buy a life insurance policy that will guarantee your coverage for the rest of your life, not 10, 15, 20, or 30 years. Our agents are well-versed in estate planning and we have helped hundreds of clients with their estate planning needs. We work directly with over 40 top-rated life insurance companies so we can find you best options in minutes, saving you time and money. Give us a call today or request a free quote online. Toll Free (855) 247-9555
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