Life Insurance & Estate Planning

lifeandestate

WHAT IS USING LIFE INSURANCE & ESTATE PLANNING FOR RETIREMENT PLANS?

The assets in your qualified and nonqualified retirement plans will be included in your taxable estate when you die. For those who have accumulated substantial assets in their retirement plans, the inclusion of these assets in their taxable estate may cause an estate tax problem. So, you may have to pay an estate tax for which you had not planned.

Many estate planners recommend that people use life insurance as a means to provide liquidity to their heirs for the payment of any future estate taxes resulting from the inclusion of retirement plan assets in your taxable estate. In most cases, estate planners recommend that you set up an irrevocable life insurance trust and name your heirs as the beneficiaries of the trust. You can then either transfer an existing life insurance policy into the trust or make gifts of cash into the trust so that the trustee can buy a new life insurance policy on your life. If you do not retain any incidents of ownership in the policy within three years of your death, the insurance proceeds should not be included in your taxable estate. Your heirs will then have the necessary cash to pay for any increase in your estate taxes because of the inclusion of the retirement assets. (One exception to this rule is if you transfer an existing insurance policy to another individual or into a trust, and then you die within three years of the transfer. The insurance proceeds will then be included in your taxable estate, but the proceeds will still be available to pay any associated taxes.)

 

WHEN SHOULD YOU USE LIFE INSURANCE AS AN ESTATE PLANNING TOOL FOR YOUR RETIREMENT PLANS?

 

Inclusion of retirement plan assets will increase estate taxes.

You can use life insurance as an estate planning tool for your retirement plan when the inclusion of the retirement plan assets in your taxable estate will increase your estate tax liability. It is important to note that the assets in both qualified and nonqualified retirement plans will, in almost all cases, be included in your taxable estate when you die. If you have substantial assets in your retirement plan, then the inclusion of the assets may dramatically increase the estate tax liability for your heirs. One way to offset the estate tax liability is to provide additional liquidity to your heirs to pay the estate taxes through the use of life insurance.When rent is received, the child will then be required to pay income tax on this amount.

 

EXAMPLE

You die when you still have $1 million left in your retirement plans. You also have $3 million in other net assets, so your taxable estate is $4 million. The inclusion of your retirement plan assets has now substantially increased the size of your taxable estate. The estate tax liability for your heirs will also increase. One way to offset the increase in the estate tax liability is to have your heirs purchase a life insurance policy on your life (for the amount of the tax increase) and name themselves as the beneficiaries. As long as you do not have any incidents of ownership in the policy, the insurance proceeds will not be included in your taxable estate. Another possible option if your spouse is still alive is to purchase a second-to-die life insurance policy. Then, when the surviving spouse dies, your heirs can use the insurance proceeds to help pay the applicable estate taxes due at that time.

 

Use of life insurance even if all assets left to spouse.

You may want to consider using life insurance to provide liquidity to your heirs (to pay the estate taxes on your retirement plan assets) even if you plan to leave all your assets to your spouse. Although transfers to a spouse qualify for the unlimited marital deduction (meaning an unlimited amount of assets can be left to your spouse without paying any federal estate tax), when your spouse dies, then the assets will be subject to the estate tax. Your heirs (usually your children) will then be responsible for paying the applicable estate taxes. To provide liquidity to their heirs at this point, many people will purchase a second-to-die life insurance policy (so that when the surviving spouse dies, the insurance policy will pay off at that point). It is important that the ownership of this policy be set up properly, so that the insurance proceeds are not included in the surviving spouse’s estate. Another benefit to using a second-to-die life insurance policy is that the premiums on these policies are usually less than the premiums for an insurance policy on a single life.

 

EXAMPLE

You have $1 million in your retirement plan when you die. You also have other net assets worth $3 million. In your estate plan, you leave all of your assets to your surviving spouse. Because of the unlimited marital deduction, there is no federal estate tax due at your death. Your spouse then executes a will, leaving all of his or her assets to your three children. At your spouse’s death, your children will then be responsible for paying the applicable estate taxes. With a second-to-die insurance policy, with the proper ownership, your children will have the liquid assets to pay the increased estate taxes due to the inclusion of the retirement assets in your spouse’s estate.

 

WHAT ARE THE STRENGTHS OF USING LIFE INSURANCE AS AN ESTATE PLANNING TOOL FOR YOUR RETIREMENT PLANS?

 

Provides liquidity to heirs for payment of estate taxes.

The main benefit to using life insurance as an estate planning tool for your retirement plans is that it will provide liquidity to your heirs to help pay the taxes on your estate. As noted above, the assets in your qualified and non-qualified retirement plans when you die will be included in your taxable estate. This inclusion may substantially increase your estate tax liability. A life insurance policy can be an excellent source of liquidity for your heirs to pay the additional estate taxes.

 

Provides liquidity to heirs for payment of estate taxes.

If you set up an irrevocable life insurance trust to hold the life insurance policy, then transfers of cash into the trust (to buy the insurance policy or to pay premiums) may qualify for the annual exclusion from federal gift tax. As long as the beneficiaries of the irrevocable life insurance trust are given Crummey powers, then gifts into the trust will qualify for the $13,000 annual exclusion from the gift tax in 2010.

 

EXAMPLE

You have $1 million in your retirement plans and $3 million in other net assets. You are concerned about the estate tax consequences of inclusion of your retirement plan assets in your estate if you should die in the near future. You would like to find a way to provide some liquidity to your heirs. One solution is to set up an irrevocable life insurance trust, name your children as the beneficiaries, and then begin making transfers of cash into the trust so the trustee can purchase a life insurance policy on your life and pay premiums on that policy. As long as the beneficiaries are given Crummey withdrawal rights, transfers into the trust will qualify for the annual exclusion from the gift tax. (The annual exclusion applies against all gifts to a donee by one donor during the year.)

 

Assets in irrevocable trust not included in your taxable estate.

Another benefit of using life insurance as an estate planning tool is that, if set up properly, the insurance proceeds are not included in your taxable estate. If the insurance policy on your life is held in an irrevocable trust or if your heirs are the owners of the policy, then the policy proceeds will not be included in your taxable estate. Your heirs will then be able to use the full proceeds to pay any applicable estate tax.

 

 

 

 

Life insurance proceeds not subject to income taxes.

Another benefit to using life insurance as an estate planning tool is that life insurance proceeds are not subject to income tax. Your heirs will be able to use the full proceeds to help pay for any additional estate taxes due because of the inclusion of your retirement assets.

 

WHAT ARE THE TRADEOFFS TO USING LIFE INSURANCE AS AN ESTATE PLANNING TOOL FOR YOUR RETIREMENT PLANS?

 

Insurance policy may be costly.

Depending on your age and health, purchasing a large insurance policy on your life may be very expensive. Furthermore, when buying a policy to provide liquidity to your heirs, you usually want to purchase a cash value life insurance policy. These policies are much more expensive than a term policy.

 

Irrevocable life insurance trust may be expensive to set up.

Another tradeoff to using life insurance as an estate planning tool is the cost of setting up an irrevocable life insurance trust (assuming you want to provide liquidity for your heirs through a trust). A life insurance trust can be quite expensive to set up and to maintain. You will need to hire an experienced, competent estate planning attorney to draft the trust documents. If you hire a professional trustee (a bank trust department, for example), you may have to pay an annual trustee’s fee. You may also have to hire an accountant to file trust tax returns.

 

Trust should be irrevocable.

To avoid having the life insurance proceeds included in your taxable estate, the life insurance trust should be an irrevocable trust. Once the trust is established, you lose the ability to amend or revoke the trust. You generally cannot change the beneficiaries, you cannot change the trustee, and you cannot change the terms of the trust.

 

WHAT ARE THE TAX IMPLICATIONS?

 

Proceeds from life insurance policy may be included in your taxable estate.

If you maintain any incidents of ownership of the insurance policy at your death, the proceeds from the policy will be included in your taxable estate. If you do not retain any incidents of ownership in the insurance policy, then the proceeds from that policy will not be included in your taxable estate at your death (unless the policy was transferred within three years of your death). This is true whether your heirs are the direct owners of the policy or whether they are the beneficiaries of an irrevocable life insurance trust that is the owner of the policy. Your heirs will then have the full amount of the life insurance policy to provide them with liquidity to pay any increased estate taxes resulting from the inclusion of your retirement plan assets in your taxable estate.

 

Life insurance proceeds not subject to income tax.

Life insurance proceeds are usually not subject to income taxes. Your heirs will then not have to pay any income taxes on the life insurance proceeds.

 

Gifts to buy life insurance may qualify for annual exclusion.

If you make direct gifts of cash to your heirs to purchase a life insurance policy or if you make transfers into an irrevocable life insurance trust for the same purpose, then these transfers may qualify for the annual exclusion from the gift tax. You can make annual gifts up to $13,000 (in 2010) per donee to an unlimited number of individuals without paying any federal gift tax on those transfers. If your spouse elects to split the gift with you, this amount is increased to $26,000 (in 2010) per donee. Your heirs or your trustee can then use these gifts to purchase a life insurance policy on your life and to pay premiums on the policy.