Life insurance policies are emerging as important estate planning tools, which is especially important with so much tax uncertainty for the future. While the status quo is likely for now, we can’t say the same for the second half of 2021 or 2022, what with talk about lowering federal estate tax exemptions, the elimination of basis step-up for inherited property, and other possible changes (read more).
What Makes Life Insurance So Vital to Estate Planning?
Life insurance benefits are generally payable to beneficiaries income-tax free upon the insured’s death. Instead of putting money into traditional investments or even tax-deferred investments such as IRAs, paying premiums on life insurance is a way to pass money onto loved one’s tax free after your death.
Payout from life insurance can be a source of quick cash upon your death — cash that can be used by your loved ones to defray funeral costs, settle your debts and other obligations, and even pay the taxes you still owe. Life insurance proceeds can even help avoid having to sell an asset of the estate in order to pay estate taxes or other debts.
In the case of cash value life insurance policies, which build-up their cash value over time, as the insured you can access these funds during your lifetime in the form of tax-free withdrawals and/or loans. Take note that we’re talking tax free, which means no taxes, vs. tax-deferred, which means a tax bill eventually comes due. Thus, investing in cash value life insurance, either in lieu of or in addition to making tax-deferred investments in qualifying plans, can be an effective strategy for minimizing the income taxes you owe during your lifetime (on retirement plan payouts, for example), as well as an effective way to pass along life insurance proceeds to your beneficiaries income-tax free.
Irrevocable Life Insurance Trusts
Another important life insurance-related strategy is called an Irrevocable Life Insurance Trust (ILIT). An ILIT is especially important if you anticipate the size of your estate to exceed $11.7 million (the current estate tax exemption) at the time of your death.
An ILIT allows you to purchase a life insurance policy for yourself, transfer it to the ILIT so that it is owned by the Trust, and name your heirs as beneficiaries of the Trust. This way, when you die, the insurance policy is not considered part of your estate (it’s owned by the Trust), so it’s not subject to federal taxes. Instead, the payout from the insurance policy gets distributed to your heirs income-tax free.
Of course, there are numerous caveats to be aware of when setting up an ILIT. For example …
- If you already have a life insurance policy and transfer it to an ILIT, it is subject to what’s called a “three-year lookback period.” As such, any proceeds from the policy paid out within three years of the transfer are considered part of your estate.
- The policy must be owned by the ILIT, not the insured, and the insured individual cannot exert any rights of ownership, such as changing beneficiaries or modifying the terms of the trust.
Because of the numerous other considerations and nuances involved in setting up an ILIT properly and/or otherwise using life insurance as part of your estate planning strategy, interested individuals should speak with an estate planning expert to ensure best practices are followed and all necessary steps are taken.
We Can Help
If you want to explore how life insurance could play a role in your estate planning, the attorneys at Shoup Legal can help. We are experts at Estate Planning and helping clients secure their assets and protect their heirs. Contact us at (951) 445-4114 or email us at [email protected] to discuss your unique situation today.