How to Reduce Estate Taxes with Life Insurance

How to Reduce Estate Taxes With Life Insurance

Every day our agency receives calls from potential clients asking, “How do I reduce my estate taxes with life insurance?”

In the vast majority cases, we can help eliminate or greatly reduce your estate tax liability with life insurance.

Quick Article Guide

1. Life Insurance to Pay Estate Taxes
2. Estate Taxes on Life Insurance Death Benefits 3. Creating an Irrevocable Life Insurance Trust
4. What’s the Best Age to Create an Irrevocable Life Insurance Trust?
5. Avoid Term Life Insurance when Estate Planning
It is vital that your life insurance policy is setup correctly though….

By assigning the wrong beneficiary to your policy or creating the wrong type of trust, you could actually increase your estate tax liability.

To avoid this disaster, continue reading and we’ll show you how to correctly reduce estate taxes with life insurance.

Life Insurance to Pay Estate Taxes

If your estate is worth more than the IRS’s Federal Estate Tax Exemption for that year, your heirs will owe taxes on your estate when you pass away. If you want your heirs to be able to keep all of the assets you’ve worked so hard for, they will need an influx of cash to pay the estate taxes due on your property when you pass away.

As of 2016, the federal exemption amount for an estate is $5.45 million. Depending on the state that you reside in, your heirs will owe estate taxes on the value of your estate that exceeds this exemption.

The federal estate tax rate is currently set at 40%, but some states also impose a state inheritance tax, increasing the tax liability of your estate. In addition, in some states, your heirs will be subject to state inheritance tax even if your estate is not worth more than the federal exemption amount for that year.

After providing my clients with this explanation the next question is always;

“How do I avoid having my heirs owing estate taxes on the death proceeds of my life insurance policy?”

Estate Taxes on Life Insurance Death Benefits

The most common mistake that we see with life insurance purchased for estate planning is when people name the beneficiary of their life insurance policy as “payable to my estate” or when the policy owner names an immediate family member as the beneficiary of their policy.

Leaving financial products such as life insurance policies or annuities to your estate or an immediate family member increases your estate’s overall value which can leave your heirs with an unexpected tax liability when you pass away. In addition, if you name your estate as your beneficiary, you take away the contractual advantage of naming a real person or a trust, which then subjects your life insurance proceeds to the timely and costly probate process.

The money to settle your estate taxes with the IRS must be paid by your heirs within nine months of your passing. Your beneficiaries cannot afford delays due to the courts or court procedures.

According to Section 2042 of the Internal Revenue Service Tax code states that the proceeds of your life insurance policy will be added to the gross value of your estate if the proceeds are paid to your estate whether it’s directly or indirectly, or if you possessed any incidents of ownership of the policy at the time of your death.

In the eyes of the Internal Revenue Service incidents of ownership include;

  • Having the ability to cancel or surrender the policy.
  • Being able to change the beneficiary or beneficiaries.
  • Having the ability to borrow cash that the policy has accrued.
  • Having the ability to choose the payment method of the proceeds to the beneficiaries. (Installment payments or lump sum)

If you cannot name your estate or a family member as a beneficiary of your policy, who are you supposed to leave the money too?

To avoid these dilemmas, you will need to create an irrevocable life insurance trust to control your life insurance policy.

When creating an irrevocable life insurance trust, we usually recommend utilizing a trust/estate attorney or an executive from your bank. If you’re having troubles deciding where to go or how to start the process, give us a call and one of our agents will be happy to help walk you through the process. We specialize in educating our clients on how to reduce estate taxes with life insurance and we have helped hundreds of clients just like you.

Creating an Irrevocable Life Insurance Trust

The best way to prevent your heirs from paying estate taxes on the proceeds of your life insurance is to create an Irrevocable Life Insurance Trust or “ILIT.”

However, you cannot be the trustee of the trust, and you cannot retain any rights to revoke the trust.  The policy is held by the trust, which means that you will no longer be the listed owner, therefore proceeds will not be considered as part of your estate.

Although creating an Irrevocable Life Insurance Trust is a complicated process in which you normally need to involve an attorney, banker, and life insurance agent; they’re the best way for you to retain control over your policy, ensuring that the premiums are paid and the death benefit is exempt from estate taxes.

When you create an ILIT, the trust owns the policy and the trustee must follow the instructions that you specify the assets are to be disbursed. Another benefit of creating an “ILIT” is that the proceeds stay in the trust; protecting the proceeds from courts, creditors, spouses, and any other irresponsible spending. If you name an individual as the beneficiary of your policy and that person is incapacitated when you die, the courts will likely take control of the money.

Most insurance companies will not pay the proceeds of your policy to an incompetent person, and they will usually demand court supervision.  If you set an up in Irrevocable Life Insurance Trust, you’ll avoid the court process known as “probate” and the trustee will allocate the correct share of your estate towards the personal care of your incapacitated relative after you pass away. ILIT’s are also commonly used to establish trusts for special needs children. To learn more about these types of trusts, please read our article; “Establishing a Trust for A Special Needs Child.”

What’s the Best Age to Create an Irrevocable Life Insurance Trust?

Most people wait until they reach their 50’s or 60’s to set up an Irrevocable Life Insurance Trust. By the time you reach your 50’s; family relationships are usually settled, your children have moved out, and retirement is on your horizon.

It’s important not to wait too long to buy life insurance in the case you become uninsurable. Remember, the younger you are when you buy your insurance, the more you will save in the long run. For these reasons, we usually recommend buying permanent coverage to protect your estate as soon as you realize you need it. Don’t worry if you’re getting into the game a little later in life, we can offer estate protection policies until the age of 80 and in some cases up to 85.

While we are experts at life insurance, we are not estate planning attorneys. Most attorneys will recommend executing a trust document with an independent trustee, opening a bank account in the name of the trust, and obtaining a tax identification number for the trust to get started. Once the trust is in effect you can give us a call and we can help you start the application process.

While term life insurance policies work well for many people, we always recommend a permanent life insurance policy for estate planning.

The best policies on the market for estate protection is a guaranteed universal life policy. These policies provide affordable coverage until the age of 90, 95, 100, 110, or 121. These polices work just like a term policy, but they guarantee coverage until later in life.

Avoid Term Life Insurance when Estate Planning

When you are ready to purchase the coverage you need, avoid the big-box term life insurance companies that your see advertised on TV. Most banks and attorneys will turn away someone who wants to create an irrevocable trust with term life insurance.

How to Reduce Estate Taxes With Life Insurance_

Term life insurance policies usually expire by age of 80 and your attorney does not want to deal with the liability of you outliving your life insurance policy. Most life insurance policies purchased for estate protection will lock-in and guarantee your coverage until you reach age 90 or later. In fact, with increasing lifetime expectancy, most experienced trust attorneys will recommend purchasing a policy with a guaranteed rate until age 100 or later.

Like any other product, when purchasing a permanent life insurance policy, shop the market to make sure you have the best deal. Being diligent and choosing the right company will save you thousands of dollars over your lifetime. No matter what your life insurance needs are our agents at JRC will be happy to help.  JRC is appointed with over 40 highly-rated life insurance companies so we can shop the market to ensure that you get the best deal. We’re also an owner operated company so customer service is our number one priority. Give us a call today for a FREE consultation. Toll Free (855) 247-9555.

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Cliff Pendell

VP of Marketing at JRC Insurance Group
Cliff is a Managing Partner and Co-Founder at JRC. He has helped thousands of families of businesses with their life insurance needs since 2012 and specializes with applicants who are less than perfect health. In his spare time he enjoys spending time with family, traveling, and the great outdoors.
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