Life Insurance – An Essential Part of Your Estate Plan

Whether your estate is large or small, life insurance is an essential part of your estate plan. It should not be overlooked!

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Life Insurance generally plays two roles, within the context of Estate Planning:

• it provides liquidity for your estate
• it increases the value of your estate

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Increasing your estate through life insurance is usually done if you:

• are younger*, with financial dependents (*of course, many of us can/do have financial dependents— at any age!)
• have small to moderate-sized estates

Obviously, the purpose of Estate Planning is to provide for your surviving family members.  

Typically, in smaller estates; federal estate taxes and other death taxes are not of significant concern.

Certain credits and deductions —available under the federal estate transfer system— help reduce such concerns, as well:  

• The estate tax unified credit (which everyone is eligible for) is a credit against estate taxes
• The unlimited marital deduction refers to your right to give your spouse an unlimited amount of assets —during their lifetime or upon your death— without paying gift or estate tax

Life Insurance benefits are usually paid out, quickly (once a death claim form and original death certificate, are provided). This can certainly help ease financial burden on your beneficiaries during a difficult time.

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The Importance of an Estate Plan

Estate planning normally addresses the disposition of your property: both during your lifetime and after your death.

An appropriately designed estate plan can:

• minimize your asset-transfer taxes owed during your lifetime
• help you reduce taxes at the time of your death
• address the need for liquidity to meet estate settlement costs

The main role of life insurance, if you have a larger estate; is to conserve the estate itself.  Your estate can use the benefits to cover taxes and settlement costs, rather than having to liquidate your assets.

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Avoiding Estate Tax on Life Insurance

Estate taxes (assessed on the transfer of assets at your death), generally apply only to those assets you own when you die.  If you own a life insurance policy, the death benefit is part of your federal gross estate and is included in determining your taxable estate.  However, life insurance death benefit proceeds are included in your estate only if you owned:

• the policy at the time of your death or
• any of the rights in the policy (known as incidents of ownership)
  i.e. the right to receive dividends OR the right to change the beneficiary, at the time of your death

In addition to the life insurance you actually own at death, federal estate tax rules bring back into your estate any policy you transferred in the 3 years preceding your death. As well as any death benefits payable to your estate, which has to go through probate.  A way to avoid having life insurance included in your estate, is to have a third party buy and own the policy on your life.

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Creating an Irrevocable Life Insurance Trust (ILIT)

To avoid inclusion of life insurance death benefit proceeds in your estate, a person other than you must own the life insurance.  An approach you can often use to keep a life insurance policy death benefits out of your estate is to arrange for life insurance to be purchased on your life by your adult children.  Alternatively, you could create an irrevocable life insurance trust, (ILIT) and have the trust own the policy.

When creating an ILIT, the trust grantor (the person who creates the trust-most likely you) names a trustee who then purchases life insurance on the life of the grantor.  The policy is owned by the trust, and policy death benefits are payable to the trust.  Typically, whether your life insurance policy is owned by an ILIT or by your adult children, you can arrange to make annual noncharitable gifts to either the trust or to your adult children to pay the premiums on the life insurance policy.

Example:

The use of annual noncharitable gifts to pay life insurance premiums on policies owned by third parties also offers certain tax advantages. For example, consider the ILIT just mentioned.  Suppose that John and his wife Mary own a substantial estate and want to be sure life insurance purchased on John’s life for purposes of providing estate liquidity will not be included in his estate.  Accordingly, John creates an ILIT, and his trustee purchases a $3 million life insurance policy on his life payable to the trust.  The annual premium is $150,000.

John and Mary also have five living children who are trust beneficiaries.  John can make a nontaxable gift each year to each of the beneficiaries equal to the annual gift tax exclusion amount.  Currently that amount is $15,000.  If Mary joins in the gift—a strategy known as a split gift—the amount that can be gifted each year is raised to $30,000 for each recipient.  In other words, John and Mary can give away $30,000 each year, tax free, to each of their children (or to anybody else).  Because each of their children is a beneficiary of the ILIT, John and Mary can transfer $150,000 to the trust each year—the amount needed to pay the annual life insurance policy premium—and the entire gift avoids gift taxation ($30,000 × 5 = $150,000).

Gift of a Present Interest

For the transfer of the money to the trust to qualify for the annual gift tax exclusion, the noncharitable gift must be a gift to the recipient of a present interest rather than a future interest.  Present interest is a legal term that refers to a recipient’s right to current enjoyment of a noncharitable gift.  To ensure that the beneficiaries have a present interest in the gift of premiums made to the trust, the five beneficiaries of the trust must be given at least a limited right to withdraw the annual gift from the trust.  Typically, the beneficiary’s right to access the noncharitable gift residing in the trust is limited to 30 days.  These trust provisions giving beneficiaries limited withdrawal rights are known as Crummey provisions.

Further, because John and Mary are making nontaxable gifts to pay premiums each year of $150,000, they are effectively reducing their federal gross estate by that amount in addition to the earnings (in interest/dividends) the $150,000 might have produced.  Without consideration of the gift’s earnings, ten years of such gifts reduces John and Mary’s federal gross estate by $1.5 million and also reduces the estate tax.

When John dies, the $3 million death benefit proceeds of the life insurance policy under which John was insured are payable to the ILIT. Because John never had any incidents of ownership in the $3 million life insurance policy, none of those proceeds are included in his federal gross estate.

Transferring Currently Owned Life Insurance to an ILIT

An existing life insurance policy can be transferred to a third party, such as to an adult child or an ILIT, and avoid inclusion in your estate if:

• No donor retains incidents of ownership in the policy.
• The beneficiary of the policy is not your estate.
• The policy is not brought back into your estate because your death occurring within three years of the transfer.

Although the value of life insurance when used as a gift is approximately equal to the policy’s cash surrender value, the gift tax that may be due on the lifetime transfer of the policy to the trust or to adult children is likely to be smaller than the estate taxes payable on the death benefit proceeds if they are included in the estate.  The gift value is the cost to replace such a policy, which is approximately equal to its cash value.

After you have transferred ownership of a life insurance policy, you must live at least three years and can no longer retain any incidents of ownership in the policy in order for it to escape inclusion in your estate.  That is an important reason for you to thoroughly consider the impact of giving away the policy.  Once given away, you no longer are able to take a loan from the policy, surrender it, or use it as collateral for a loan from a bank. In short, it no longer belongs to you.

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The Marital Deduction and Unified Credit

To properly understand the role of life insurance in estate planning, some background on the federal estate transfer system may be helpful.  Under federal law, you can transfer at death an unlimited amount of assets to your eligible spouse without incurring federal estate taxes.  This is known as the unlimited marital deduction and defers federal estate taxes on the amount transferred until the death of the second spouse.  In general, an eligible spouse must be a United States citizen and married to you at the time of death.

In addition to the unlimited marital deduction, regardless of your marital status,  your are entitled to transfer a certain amount of assets at death estate tax free via the estate tax unified credit.  Because the estate tax unified credit tends to increase over time, the amount that can be transferred tax free also tends to increase.

As a general rule, the federal estate tax does not apply to estates valued at less than the estate tax unified credit.  Estates of that size can be transferred estate tax free.  Estates larger than that amount can have significant taxes and settlement costs.  For that matter, estates of any size can have state estate or inheritance taxes to consider as well.  Although the proceeds of a life insurance policy are not generally subject to income tax, they can be subject to estate taxes.

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Using Insurance to Pay Estate Taxes

In addition to using life insurance to create an estate, many people with larger estates use life insurance to provide funds to pay their estate taxes and other settlement costs.  For these wealthier people, life insurance may be a perfect tool for estate conservation.

Example

Jim and Shirley are married and own a business worth $15 million that they manage with their two children.  They want to be sure to leave the business to their children when they die.  The problem to be solved is how to pay an anticipated estate tax bill of $3.5 million on their entire estate.  Without a source of funds to pay the estate taxes, the Jim’s children may have no choice but to sell all or part of the business.

The solution for the Jim and Shirley may be to purchase a joint and survivor life insurance policy—also known as a second-to-die policy—on their lives for $3.5 million.  Under a second-to-die policy, both Jim and Shirley are insured, and the death benefit is not paid until the second insured one dies.

The most effective method of ensuring that the life insurance funds are available when needed and that they avoid being included in the federal gross estate is for Jim and Shirley to create the ILIT.  The trustee of the ILIT applies for the needed coverage, and the policy death benefits are payable to the trust.  Jim and Shirley could pay the premiums through yearly transfers of funds to the trust that may qualify for the gift tax annual exclusion.

Upon the 2nd death (either Jim or Shirley), the $3.5 million death benefit is paid to the trust.  The trustee then purchases assets from the estate with the money or lends money to the estate.  The necessary funds are transferred to the estate executor to pay the estate taxes and settlement costs.  When the estate is settled, the trust distributes the assets it purchased from the estate to the trust beneficiaries, Jim and Shirley’s two children.  The net effect is to use life insurance that is not included in the estate for the purpose of settling the estate’s tax liability and other settlement costs.

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Many clients don’t know that their life insurance is an asset they can leverage and it’s the responsibility of agents and advisors to explain it to them. This option becomes even more relevant for clients considering letting their policies lapse without getting anything in return. More than $200 billion in face value of life insurance lapses every year, according to a 2018 Conning Study. It’s a huge potential market and one that many individuals still don’t know anything about.

Wm. Scott Page, Life Insurance Policy Appraisal Expert

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The Bottom Line

Whether your estate is large or small,  life insurance is an essential part of your estate plan.  It can either create —or preserve— wealth.  It provides liquidity to help ensure a smooth transition of your estate assets to your heirs.  Life insurance should not be overlooked.

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