How to use life insurance to pay estate taxes

With the 2022 federal estate tax exemption amount of $12.06 million ($24.12 million for a married couple), it may seem unlikely that your heirs will have to pay estate taxes under current tax law. However, that law is expected to expire at the end of 2025, with the exemption returning to an inflation-adjusted amount of approximately $6.2 million ($12.4 million for a married couple). Unless Congress votes to extend the higher estate tax exemption amount, many more Americans will be at risk of having their estates taxed. At a 40% tax rate, that could mean a significant amount goes to the Internal Revenue Service (IRS) instead of loved ones. Additionally, your state may also have an estate tax. State exemption amounts are often less than the federal amount, so your state of residence may still collect significant taxes after your death.

One estate planning tool in particular can be used to pay all or a portion of estate taxes when a large portion of the estate consists of physical assets such as real estate, art, jewelry, collectibles, etc. If your goal is to keep these tangible assets in the family, the life insurance held by an irrevocable life insurance trust (ILIT) can be used to pay estate taxes, so the assets do not need to be sold.

An ILIT is a type of trust that is funded over your lifetime with 1 or more life insurance policies. It is irrevocable, meaning that once you create an ILIT, the trust generally cannot be changed or revoked. In exchange for moving your life insurance policy to an ILIT, there are several advantages: you can avoid including the life insurance policy’s death benefit in your estate for federal estate tax purposes; fund the trust with life insurance to provide the money needed to cover estate taxes and other expenses after you die; and finally, you have the ability to direct, through the trust document, how and when the death benefit is used and for whom.

However, it is important to remember that this is an irrevocable trust. Once you either transfer an existing policy to the trust or purchase new life insurance through the trust, you must give up any right to make changes to the policy or the trust. If you retain any rights on the policy, such as the ability to remove the cash value, both the IRS and state tax authorities will consider you to still have “property incidents” and require the policy to be included in your estate. Therefore, you must choose someone else such as a spouse, sibling, adult child or attorney to be the trustee of the ILIT. The trustee will then oversee the maintenance of the policies held in the ILIT and the life insurance will no longer be part of your estate.

To pay premiums on life insurance policies, you transfer money to the ILIT and the trust pays the premiums. However, you should be aware of gift taxes. Putting money into a trust that someone else will benefit from can be considered a gift. If the premium payment for each beneficiary exceeds the gift tax exemption of $16,000 per year, gift taxes may be due.

One way to avoid this is to have the trustee send the beneficiaries a “Crummey letter” every time you transfer money to the trust. This letter will let them know that they can claim their share of the deposited money within a certain period of time. If they are immediately entitled to the money, the gift tax does not apply. However, your beneficiaries would be foolish to take the money because without that money the insurance premiums would remain unpaid and the policy would lapse. The eventual payout of a life insurance death benefit would far exceed the amount intended to pay the premiums.

If you own an existing policy and roll it over to an ILIT, the IRS will still consider it part of your estate if you die within the next 3 years. (This does not apply to policies purchased by the trust.) With the existing estate tax law scheduled to expire at the end of 2025, we are moving closer to aligning the expiration of the tax law with the 3-year waiting period for life insurance transfers at the end of the ILIT. Depending on your age and life expectancy, this timeline may be of some importance to you.

Determining whether you are at risk of paying estate taxes and whether an ILIT makes sense for you will likely require coordination between your CPA, your financial advisor and your estate planning attorney. Due to the irrevocable nature of the ILIT, all aspects of your financial life should be carefully considered.

200 North LaSalle Street – Suite 2300 – Chicago, IL 60601

312-419-3733 – Toll Free 800-883-8555 – Fax 312-332-4908 – www.mediqus.com

Investment advisory services offered through MEDIQUS Asset Advisors, Inc. Securities offered through Ausdal Financial Partners, Inc. Member FINRA/SIPC ∙ 5187 Utica Ridge Rd ∙ Davenport, IA 52807 ∙ 563-326-2064 ∙ MEDIQUS Asset Advisors and Ausdal Financial Partners, Inc are independently owned and operated.

Effective June 21, 2005, newly issued Internal Revenue Service regulations require certain types of written advice to include a disclaimer. To the extent the foregoing communication contains written advice relating to a federal tax matter, the written advice is not intended or written for use and may not be used by the recipient or any other taxpayer for the purpose of avoiding federal tax penalties, and is not written in furtherance of the Promotion or the marketing of the transaction or the matters discussed herein.

The information contained in this report is for informational purposes only. All calculations are made using techniques we believe to be reliable, but are not guaranteed. Please contact your tax advisor to review this information and consult with them about any questions you may have regarding this announcement.

MEDIQUS Asset Advisors, Inc. does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied upon as, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before entering into any transaction.

Leave a Comment