Life Insurance -- Is it Really Tax Free?

Life insurance can be a critical part of an estate plan. The death benefit from a life insurance policy can provide both vital income replacement upon the death of a main “breadwinner,” and can cover the cost of estate taxes for larger estates. 

Many people are unaware that under existing law, life insurance that is not properly owned and administered may provide far less to the family than anticipated, with a significant portion of the death benefit potentially lost to estate taxes.  Why is this so?  Because life insurance is typically purchased in the following manner: the insured is also the owner of the policy, with the spouse as the primary beneficiary and the children as contingent beneficiaries.  Under this arrangement, upon the insured’s death, the entire amount of the death proceeds are included as part of the insured’s taxable estate.

  

Consider the following example:  Frank, a forty-five year old single father, lives in Goshen.  Frank owns a $2 million term life insurance policy insuring his life, and has other assets totaling $1.5 million. His two children are the beneficiaries of the insurance policy.  Frank dies in 2011.  Because he is the owner of the life insurance policy, upon his death his taxable estate will be $3.5 million.  With the current $5 million federal estate tax exemption, there will be no federal estate tax. However, because New York’s estate tax exemption is only $1 million per person, the New York estate tax bill will be $229,200.  Had the life insurance been excluded from Frank’s estate, the New York estate tax bill would have been $64,400.

If you cringe at the thought of your heirs paying an estate tax bill of $229,200 on a $3.5 million estate, consider the result if Frank were to die in 2013, when the federal estate tax exemption is scheduled to be reduced to $1 million per person.  Given the same $3.5 million total estate, of which $2 million consists of life insurance, upon Frank’s death the total federal and New York state estate tax due would be $1,220,000.  If the life insurance death benefit were not taxable in Frank’s estate, the total New York and federal estate tax obligation would be reduced by over $1 million, to $210,000.

Fortunately, removing life insurance for your taxable estate is fairly straightforward.  If in our example Frank’s life insurance policy had been owned in a properly structured and administered Irrevocable Life Insurance Trust (commonly referred to as an “ILIT”) for at least three years prior to his death, none of the death benefit would have been included as part of his taxable estate.  Instead, the entire $2 million would pass to his children free of federal or New York state estate taxes.

The ILIT would provide other benefits. The death benefit can be held in one or more creditor-protected trusts for the benefit of a spouse, children and other generations.  ILIT’s can also be used effectively to create “Dynasty Trusts” which can hold assets in trust for multiple generations free of both estate and generation-skipping taxes. 

ILIT’s can be set up for individuals or couples.  With married couples, we often fund a joint ILIT with one or more “second-to-die” joint and survivor policies, which pay out the benefits only upon the death of both the husband and wife.  These policies are typically used to provide liquidity to cover any estate taxes the couple may incur upon the death of the second spouse.  Because the insurance covers two lives, it is often substantially cheaper than a single-life policy.

One Caveat: if existing policies are transferred to an ILIT, the insured must live at least three years from the date of transfer to have the death proceeds excluded from his or her taxable estate. If possible, it is best to replace existing policies with new policies that are owned from the outset by the ILIT trustee; under this arrangement, the death proceeds will be fully excluded from the insured's estate from day one.

When There's Lots of Money Involved, the Knives Come Out

Forbes has posted a two-part article describing some recent (and mostly ongoing) battles over the lucrative estates involving various celebrities, including Michael Jackson and Whitney Houston (no, she's not dead -- it involves Whitney's father's estate and Whitney's vicious fight with her step-mother).  Part 1 is found here, and Part 2 is here.

More than anything else, these cases point out how vitally important it is to regularly update your estate plan.  Our practice offers an annual estate plan maintenance program, which ensures our clients that their documents will remain current with changes in their lives, their finances, the law, and our own knowledge and experience.

Misconceptions About the Estate Settlement Process

People typically have only a vague idea of the steps necessary to settle an estate upon a person’s death.  Often they have heard “horror stories” regarding the expense and time needed to complete an estate administration. While there are certainly instances where estate settlements have dragged on for years and have cost the estate hundreds of thousands of dollars in legal fees and other administration expenses, it does not have to be that way.

Estate settlement is largely dictated by the form of ownership of the assets possessed by a deceased person (the “Decedent”).  Assets owned in the Decedent’s individual name are typically subject to the probate process, whether or not the Decedent has executed a will.  But for many people, a significant portion of their assets are not owned in their individual name.  Rather, assets may be owned jointly with another person, or the assets may pass to one or more persons who are the named beneficiaries designated to receive the assets at the Decedent’s death (for example, a bank account that includes an “in trust for” designation).  All such assets will not pass as dictated in the Decedent’s will, but instead will pass to the surviving joint owner or the designated beneficiary outside of probate.

Assets held in a revocable or irrevocable living trust will be distributed as provided in the trust document, and will not be subject to the probate process.  This result can be especially helpful when a person owns real estate in more than one state, or desires to disinherit children or other close relatives. If the trust is fully funded by the client during his or her lifetime, the probate process can be avoided and there will be no legal requirement to notify potentially litigious children or other relatives about the nature of the Decedent’s assets and dispositive wishes.

Whether a will or a trust has been used as the foundational estate planning tool, all estate administrations must follow certain procedural steps.  These steps include income tax return filings, and possibly the need to file federal and state estate tax returns.  Since a probate estate is a taxpaying entity, the executor of a probate estate will obtain a federal taxpayer identification number for the estate.  Trustees of any trusts created by the Decedent will also need to obtain taxpayer identification numbers for those trusts.  Whether the estate and/or trust(s) will owe federal or state income taxes depends upon the types of assets owned by the various entities, and the income produced.

Estates for New York Decedent’s owning assets of $1,000,000 or more – which amount includes the death benefits for any life insurance policies owned by the Decedent insuring his or her own life -- will need to file a New York State Estate Tax return, while estates for Decedents owning assets of $5,000,000 or more will need to file a Federal Estate Tax return as well.  Whether any estate taxes are ultimately due depends upon many complex factors, especially whether the Decedent is survived by a spouse, and how the assets are to be distributed upon the Decedent’s death.  Even in cases where no estate taxes are owed, the returns must be filed if the minimum asset threshold is reached.

One caveat:  people have often been led to believe that if you have a living trust, the estate settlement requirements will not apply to your estate.  While a fully-funded living trust will "avoid probate," all other estate administration requirements described above will apply.  While living trusts can be exceptional planning tools, establishing one with the objective of avoiding post-death administration (and all associated expenses) is unrealistic.  Ignoring the formalities of the estate administration process based on such misinformation can lead to trouble down the road, which may include the IRS or New York State assessing interests and penalties for the failure to timely file the requisite tax returns and pay the required amount of taxes.