Life insurance is often associated with protecting family members when an unexpected death could create a financial crisis. However, life insurance is also a valuable tool that can be used in conjunction with estate planning. Personal assets are often used to pay a significant portion of federal estate tax. Assets such as IRAs, real estate, and family owned businesses are not easily liquidated and may incur penalties. Death benefits from life insurance are typically received income tax-free and estate tax-free and are immediately available to use for expenses, such as federal estate taxes.
Irrevocable Life Insurance Trusts (ILITs) are a popular way to provide for children, grandchildren, or other heirs. The following are advantages of an ILIT:
For gifts to an ILIT to qualify for the annual exclusion, the transfer must qualify as a present interest gift. Since the death benefit of a policy owned by an ILIT will get paid to the beneficiaries at some point in the future, this will not qualify as a present interest gift. However, the ILIT can provide temporary withdrawal rights for each beneficiary, which would allow the gifts to an ILIT to qualify for annual exclusion. The trustee will provide a beneficiary with written notice that lets the beneficiary know of their right to withdraw the amount gifted within a reasonable period of time (usually 30 days). These notices are referred to as “Crummey Letters”. Once the period of time expires, the gift will be used to pay the premium on the life insurance policy.
Example: An ILIT owns a second-to-die life insurance policy on the life of Jeff and Linda with a death benefit of $5 million, which is not included in Jeff and Linda’s taxable estate. The annual premium payment for the policy is $68,000, with four beneficiaries named on the ILIT. Each year Jeff and Linda will gift $68,000 to the ILIT, which will eventually be used pay the annual premium on the second-to-die life insurance policy. When the surviving spouse passes away, the $5 million death benefit is distributed into the ILIT both income and estate tax free. The ILIT will use the proceeds from the death benefit to pay any estate taxes and to transfer wealth to the four named beneficiaries.
Estate planning can be challenging for blended families when parents have children from previous relationships.
Example: John is married to Kathy and has three children from a prior marriage. John’s children do not have the best relationship with Kathy. Instead of leaving his entire estate to Kathy with his children as the contingent beneficiaries, John funds a life insurance policy that will provide a direct benefit to his children at his death, while John’s estate will distribute to Kathy. If John uses an ILIT in this situation, the death benefit on the life insurance policy will be excluded from John’s taxable estate.
When an estate contains a large asset or several large assets that can’t be evenly distributed, such as a family business, it can be challenging to ensure that there is an equal inheritance for all heirs. Purchasing a life insurance policy with an ILIT can help equalize inheritances and can help avoid a forced liquidation of the family business.
Example: A business owner and father of two children creates an ILIT and has it purchase a life insurance policy to equalize the inheritance between his two children after his passing. The daughter has an active role in the management of the business and will want to continue the business after her father’s death. The son is not involved in the business and lives in another state. After the father’s death, his daughter will receive the family business while his son will receive the life insurance proceeds from the ILIT. Without the ILIT in place, his children may have been forced to sell all or part of the family business to receive an equal inheritance.
There are many beneficial strategies to use life insurance in estate planning. Schedule a meeting with your MAI Wealth Advisor to discuss the best strategies that will benefit you.
Source: Ivan & Daugustinis Estate and Tax Attorneys – information updated as of 8.22.23
The opinions and analyses expressed herein are subject to change at any time. Any suggestions contained herein are general, and do not take into account an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Distribution hereof does not constitute legal, tax, accounting, investment, or other professional advice. Recipients should consult their professional advisors prior to acting on the information set forth herein. In accordance with certain Treasury Regulations, we inform you that any federal tax conclusions set forth in this communication, were not intended or written to be used, and cannot be used by any taxpayer, for the purposes of avoiding penalties that may be imposed by the Internal Revenue Service.