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.

What the Return of the Federal Estate Tax Will Mean To You

Unless Congress enacts new estate tax legislation before December 31, the federal estate tax – which under the Bush 2001 tax laws was repealed for 2010 – will return with a vengeance in 2011.   Beginning January 1, estates for deceased individuals will be taxed at a rate of 55% for assets in excess of $1 million that pass to anyone other than a spouse.  Assets that pass to a spouse – either outright or in a qualified “marital deduction trust” – will qualify for the same “unlimited marital deduction” that existed under prior law.

The impact of a $1 million estate tax exemption will be dramatic for many estates.  For example, assume a widow residing in New York dies on December 31, 2010 with a $5 million taxable estate.  Her estate would be subject to payment of New York state estate tax of $391,600, leaving $4,608,400 to go to the widow’s heirs.  If she were to die on January 1, 2011, however, the total federal and New York state estate tax obligation would jump to $2,045,000, leaving $2,955,000 for the heirs.   

If the $1 million estate tax exemption in fact returns in 2011, here are a few key planning ideas for consideration:

• For married couples, your wills and/or living trusts should include estate tax planning clauses that allocate the maximum exemption amount to a “credit shelter trust” after the first spouse’s death.  This relatively simple strategy will ensure that each spouse will be able to use their respective $1 million exemption – thereby sheltering a full $2 million from federal and New York state estate tax.  One caveat is that each spouse (or their respective living trust) must individually own assets that will be made available for funding into the credit shelter trust after the first spouse’s death. If assets are owned jointly between spouses, the tax planning clauses will be rendered useless, since the jointly owned assets will pass automatically to the surviving spouse.
• For larger estates, life insurance held in an “irrevocable life insurance trust” will, in most cases, pass to the heirs exempt from both estate taxes and income taxes.   Life insurance held in this type of trust is especially helpful if a majority of your assets are illiquid, such as real estate or business interests.
• Couples (both married and unmarried) can use “spousal gifting trusts” that allow for the transfer of assets to each other that will be exempt from estate taxation in either partner’s estate. 
• Consider making annual gifts up to the exemption amount (currently $13,000 per year) to children, grandchildren or other desired beneficiaries.  Note that neither qualified medical expenses nor educational expenses (e.g., college or private school tuition) are subject to the $13,000 annual cap.

 Rarely in our nation’s history have we faced such a dramatic change in our estate tax law.  Given the ever-changing landscape, you’re well advised to seek competent professional advice to update your estate plan to ensure that both your tax and non-tax planning objectives are satisfied.