People purchase life insurance for many different reasons. Some people purchase life insurance to replace income, while others purchase life insurance to provide liquidity to pay estate taxes. The government includes life insurance in the estate of people who own any incident of ownership in a life insurance policy. An “incident of ownership” is outright ownership, the right to change the beneficiary, to assign the policy or obtain a loan on the policy.
1. Removing Life Insurance From an Estate.
If a person owns assets in excess of $2,193,000 after January 1, 2018, then keeping the incidents of life insurance ownership outside of his or her estate avoids a portion of the life insurance being subject to estate tax.
For example, David owns assets worth $2,000,000. David buys a $500,000 life insurance policy. He names his daughter, Chris, as the beneficiary of the policy. If David dies in 2018 when his estate is worth $2,500,000 (the $2,000,000 in assets plus the $500,000 in life insurance), the estate tax due on his death will be approximately $30,700. Chris, the beneficiary of his estate, will receive approximately $2,469,300.
In comparison, Chris owns the policy on David’s life and all of the incidents of ownership and is the beneficiary of the policy on David’s life. There will be no estate tax due on David’s death. Chris, the beneficiary of his estate, will receive approximately $2,500,000.
2. Irrevocable Life Insurance Trust.
Sometimes, a person does not want the life insurance policy beneficiary to own the policy. The reasons that an insured does not want the beneficiary to own the policy vary with the insured but some common reasons include the beneficiary’s age or inability to handle money. When this occurs, an insured can use a life insurance trust to keep the insurance proceeds out of his or her estate.
For example, David owns assets worth $2,000,000. David wants to buy a $500,000 life insurance policy for the benefit of his 10-year-old daughter, Chris. David does not want Chris to own the policy. David creates a life insurance trust. David’s friend Frank acts as trustee of the trust. David dies in 2018 when his estate is worth $2,000,000. There is no estate tax due on David’s death. David’s estate does not include the life insurance in the trust. Frank receives the life insurance proceeds and applies them for Chris’s benefit as David directs in the life insurance trust.
When a person uses an irrevocable life insurance trust (“ILIT”), he or she should do the following:
a. Give the trustee an amount in excess of the life insurance premium amount so that the trustee invests a portion in something other than a life insurance policy.
b. If the trust agreement allows a beneficiary the right to withdraw the contribution to the trust, the donor should make the trust contribution so that a beneficiary’s right to withdraw the contribution ends before the trustee must make the life insurance premium payment.
c. The trustee should give notice to the beneficiary or the beneficiary’s guardian as required by the trust agreement.
3. Death of Insured.
On the insured’s death, the trustee collects the proceeds, then holds, administers and distributes the proceeds according to the trust terms. The trust terms can allow a surviving spouse to receive the trust income and principal during the surviving spouse’s lifetime as long as the trust is funded with the insured’s separate property.
The trust language can allow the trustee to loan the trust proceeds to the personal representative of the insured’s estate to pay the insured’s estate taxes.
The trust provisions for children should correspond to any other provisions for children in the insured’s other estate planning documents.
4. Currently Owned Life Insurance Policy.
If a person gives a currently owned policy to individual beneficiaries or to a trust, the person’s estate must include the life insurance policy for three years after the gift for estate tax purposes.
For example, David owns a $500,000 life insurance policy. On January 1, 2018, David gives the life insurance policy to his daughter, Chris. On December 15, 2018, David dies. The value of David’s estate for estate tax purposes includes the $500,000 policy that he gave to Chris in January 2018.
Generally, it is better for the trustee of a life insurance trust or an individual beneficiary to purchase a new term life insurance policy instead of receiving one currently owned by the insured. However, all insured persons should verify that they can receive comparable insurance and that they are insurable before they allow an old policy to lapse.
The terms and beneficiaries of an irrevocable life insurance trust cannot be changed by the insured after the trust is created. Of course, an insured can quit making cash gifts to the trust to pay the life insurance premiums. If the trustee does not have sufficient assets to pay the life insurance premiums, the life insurance will eventually lapse.
In comparison, if the insured owns the policy, he or she can change the beneficiaries or the conditions under which the beneficiary receives the benefits as frequently as desired.
5. Life Insurance Needs.
A person may want to calculate the appropriate amount of life insurance to benefit a spouse by considering the following factors:
a. Final expenses
b. Amount of debt
d. Education expenses
e. Emergency fund
f. Income replacement amount and for how long
g. Estate taxes.
A person with young children should consider the cost of daycare and housekeeping if one parent died and the other parent became the sole provider.
A person reduces the financial need by his or her savings, investments, and retirement plans. The difference between the financial need at the time of death and the person’s liquid assets indicates the appropriate amount of insurance for a person.
The federal and Washington state governments receive from 10% to over 50% of the life insurance proceeds owned by people with assets in excess of the federal and state amounts exempt from gift or estate taxes. Removing all incidents of ownership from the insured either by gifting the life insurance outright to the beneficiaries of the policy or into a life insurance trust increases the share of the beneficiaries while reducing the federal and state estate taxes on the life insurance.