Life insurance can be one of the most overlooked tools for estate planning purposes. Oftentimes, younger families will purchase life insurance when they buy their first home or when they have minor children as a way to provide for income replacement if one spouse dies. Occasionally, when those families accumulate assets they view themselves as “self-insured” and drop the insurance, especially as premiums rise with age. However, there may be really important estate planning reasons to maintain life insurance coverage.
When people think about life insurance, the problem is that they will never see that money because the benefit of life insurance is paid out when someone passes. When we can’t physically see what we are spending our hard earned money on, it is easy to ignore or forget about, but let me give you an example of why life insurance can be so valuable.
First, we need to set the stage with some of the current tax laws. At the federal level in 2022, there is a $12.06 million dollar estate tax exclusion, meaning you can die with anything less than 12.06 million and there is no federal estate tax. In Maryland, the estate tax exclusion is $5 million. One common misconception about life insurance is that it is not taxed. It is not subject to income tax for the beneficiaries however, it is included in the decedent’s estate for estate tax purposes.
Bill and Mary Jones own an ice cream shop. This is a very successful ice cream shop worth about $3.5 million. They own a house worth $1,000,000, a beach condo worth $750,000, classic cars worth approximately $150,000 and cash assets about $50,000. Their total estate value is $5,450,000. The Maryland estate tax rate is 16% of the excess over $5,000,000. In this example, the estate tax would be $72,000. There is not enough cash to satisfy the tax payment. The family will have to sell something to pay the tax. This is not a desirable situation with potentially illiquid or sentimental family assets.
If Bill and Mary had even a smaller life insurance policy worth $75,000-$100,000 the infusion of cash into the estate could provide liquidity to pay taxes and expenses.
Another strategy for even larger estates and life insurance policies could be the use of an Irrevocable Life Insurance Trust (ILIT). An ILIT allows the creator to transfer a life insurance policy to the trust. In doing so they can provide that liquidity and the trust removes the life insurance out of the decedent’s estate for estate tax purposes.
As with anything in estate planning, there are many different options and tools to create a comprehensive estate plan. If you have any questions, contact us today!