Life insurance is a valuable tool for wealthy families facing high estate taxes. As the federal estate tax exemption amount is set to decrease, families need to prepare for potential tax liabilities. The temporary increase in the exemption provided by the Tax Cuts and Jobs Act of 2017 is unlikely to become permanent, prompting planners to explore techniques such as life insurance planning to mitigate the impact of estate taxes.
Many people are unaware that insurance proceeds may be subject to estate taxes unless properly planned. By ensuring that the policy is not included in the taxable estate, estate taxes on insurance proceeds can be avoided. This also creates opportunities for liquidity and replacing value used for other estate tax obligations.
According to Section 2042 of the Internal Revenue Code, life insurance proceeds can be taxed if paid to the insured’s estate or if the insured retains any “incidents of ownership” in the policy. Outright ownership and certain lesser rights, like changing beneficiaries or borrowing against the policy, can trigger estate taxation.
To avoid estate taxes on life insurance proceeds, two primary techniques are employed. First, having someone else apply for and purchase a new policy on the insured’s life can be effective if no existing policy is in place. If the insured never owns a policy, the proceeds generally remain untaxed, even if they pass away soon after acquiring the policy.
In cases where an existing policy is already in the insured’s name, the second technique is necessary transferring all “incidents of ownership” to another person or entity. It’s important to note that Congress has implemented a claw-back provision regarding transfers of existing life insurance policies. To avoid this provision and the estate tax on insurance proceeds, the insured must survive for three years from the date of the policy transfer.
Given the anticipated decrease in the taxable estate threshold, individuals with taxable estates should consider avoiding the purchase or continued ownership of life insurance on their own lives. Without legislative action, the taxable threshold is expected to be lower in the coming years, potentially leading insurance policy payouts to push taxpayers over the lower limits. However, alternative ownership arrangements through irrevocable trusts, limited partnerships, limited liability companies, or direct ownership by children can enable significant estate tax savings.
To understand the potential tax savings, let’s consider an example. Assume a couple owns a life insurance policy with $2,000,000 in proceeds, with their two daughters as beneficiaries. They also possess other assets totaling $6,000,000 and intend to leave all assets to their daughters in their will. If they pass away in 2026 when the exemption drops to approximately $6,000,000, let’s explore the estate tax consequences of their policy ownership.
Insureds Own Policy:
- Total Assets: $8,000,000
- Taxable Estate: $8,000,000
- Estate Tax Owed: $800,000
- The girls’ inheritance: $7,200,000
Insureds Do Not Own Policy:
- Total Assets: $8,000,000
- Taxable Estate: $6,000,000
- Estate Tax Owed: $0
- The girls’ inheritance: $8,000,000
Through appropriate estate planning for his insurance policy, the taxpayers could avoid $800,000 in estate taxes, benefiting both of their girls significantly.
Life insurance offers additional planning opportunities, such as creating liquidity and providing wealth replacement. When an estate has an estate tax liability, the tax must typically be paid in cash within nine months after the decedent’s death. Experienced Insurance professionals can show wealthy families how to unleash the power of Life insurance to unlock substantial estate tax savings and seize the opportunities to overcome estate tax challenges in 2026 and beyond.