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Estate tax planning is no place to be a daredevil, but some people are often reckless when it comes to making sure their heirs get the family fortune. Consider the rock star Prince for instance. His sudden death sent shock waves through the music industry that sometimes, famous people die too young. His family is feeling the tremors as well because it’s estimated that more than 50% of his $300 million estate is going to the IRS instead of his family.
But don’t feel too bad for Prince’s family. There will still be enough money to “Party like it’s 1999” and drive plenty of “Little Red Corvettes.” But I doubt you want to make this estate planning mistake too.
What is Estate Planning?
Estate planning is a strategy to transfer all or most of your wealth to your children or your heirs when you die. A person’s estate consists of everything they own. Real estate, investments, retirement accounts, fine art, jewelry and so on. Estate planning or planning your estate, provides a variety of ways – some which include life insurance – to transfer wealth to the next generation while minimizing federal estate taxes and expenses that are due when the owners pass away.
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Federal estate taxes are expensive. They start out at 45% and must be paid in cash to the Government, usually within nine months after you die. Because the Government only accepts cash, some assets such as real estate, investments, family businesses need to be liquidated to pay these taxes. But, life insurance can create the liquidity needed to reduce and even eliminate estate taxes.
Who Has To Pay Estate Taxes? Should You Worry?
If your estate is worth over $10 million, you most probably will need to do some estate tax planning. Here is the calculation for estimating your estate: Assets – Liabilities = Your Net Worth.
However, every American has an estate tax exemption which if used properly, could lower the net worth of an estate. Currently for 2016 the exemption is $5.4 million per person. For married couples the total exemption is $10.8 million. So technically, if your estate is worth $10 million, you might not have an estate planning problem at all. But you must take advantage of the exemption in order to get it.
How A Credit Shelter Trust Reduces Estate Taxes
The estate tax exemption, sometimes referred to as a credit shelter trust may be funded during the lifetime of each spouse. It can even be used at the time of death of the first spouse to die if the trust is in place (estate planning).
The way the trust works is that assets such as a home, real estate investment properties or retirement accounts can be transferred to the surviving spouse’s trust reducing the family estate tax obligations up to the Federal tax exemption of 5.4 million dollars (2016).
The surviving spouse who receives the asset(s) can be given access or control over the assets in the credit shelter trust. The trust can provide income for living expenses or he/she can withdraw money for expenses such as health, maintenance support, or education.
When the second spouse dies, his or her federal exemption ($5.4 million – 2016) is passed to their credit shelter trust, reducing the entire estate by $10.8 million. No estate taxes due. End of article.
Well, maybe if everything works out perfectly but as we all know, not everything goes as planned. That is why people use life insurance for estate planning.
Life Insurance and Estate Tax Planning
Life insurance is a flexible estate tax planning tool that provides liquidity for people to help solve their estate planning obligations.
“There is one type of insurance that should never be used in estate planning –
Term Life Insurance”
Estate planning specialists often recommend life insurance – owned by an irrevocable trust – to create liquidity, establish a family legacy and reduce estate tax obligations.
If arranged properly, life insurance can reduce or totally eliminate estate taxes that are due. The insurance policy will pay the bill. For most wealthy couples, this type of planning is a “no brainer” because they don’t want everything they’ve accumulated over a lifetime to be put up as a fire sale.
What Type Of Life Insurance Policies Are Used In Estate Tax Planning?
There are several types of life insurance that can be used for estate tax planning. Some advisors or attorneys prefer some specific policies over others. This could be due to their comfort level of past experiences with certain insurance companies and or policies.
With that being said, there is one type of policy that should never be used in estate tax planning: Term life insurance. Term life is temporary coverage and if you outlive the term, your estate plan will blow away like dust in the wind. If the policy expires the trust becomes unfunded to pay the taxes.
I have seen some advisors recommend term insurance because it is very inexpensive. Their game plan is convert the term to permanent coverage as the insureds get older or closer to the end of the term. This plan generally ends up costing more in the long run because as you get older, it becomes more expensive to convert the policy.
Most folks who are getting older, nearing retirement or already retired, do not want to take on new payments because they are living on some type of fixed income. Asking a retired couple to come up with an additional $40,000, $50,000 or more to pay the new premiums -no matter how wealthy they are, is never a good conversation. That is why permanent insurance is almost always recommended for estate planning.
Second to Die Life Insurance
Second to Die life insurance also known as joint life insurance, survivorship life, joint survivor insurance or duel life insurance is very different from a traditional life policy in that it insures the lives of two people (typically a married couple) under one single policy.
Estate planning experts often recommend a duel life policy instead of an individual policy because it pays a death benefit on the last surviving spouse. Along with being a vital estate planning tool, second to die life insurance comes in many different varieties of permanent insurance.
Types of Permanent Life Insurance Coverage
A permanent life insurance policy is designed to last a lifetime. As long as you live and pay the premiums, the policy will never expire. Plus, most permanent policies earn cash value or a savings account that grows over time. So if the policy is inforce for many years, there is a good possibility, that premiums could be discontinued and paid for from the cash value account. This is essential in providing coverage for the trust to be able to pay the taxes.
There are several different types of permanent policies that are appropriate for trust or estate planning: Whole life insurance, Universal life insurance (UL) and Guaranteed Universal Life Insurance (GUL). If you have ever looked into getting 2nd to die life insurance quotes, you may have noticed that life insurance companies design their permanent policies to match the needs of estate planning.
Joint Whole Life Insurance (JWL) – This is the most basic form of permanent life insurance and probably the most expensive option. Whole life covers the insured with a guaranteed amount of death benefit for life of the insured. The premiums are guaranteed not to increase regardless of the insured’s age. There is a cash value or investment component that grows over time which could help pay future premiums if the value is significant.
Survivorship Universal Life Insurance (SUL) – Universal life is a form of permanent life insurance coverage whereas it has a death benefit and a cash value component but the premium structure is more flexible. The policyholder can within certain guidelines, modify the premium payments. The policyholder can also how much of their premium goes to cash value and how much goes towards the death benefit.
This feature makes the policy more affordable but is also dangerous in an estate planning situation because if the premium is not funded properly or paid regularly, the policy could lapse.
Survivorship Guaranteed Universal Life (SGUL) – is designed specifically for estate planning purposes. The policy is a combination of permanent insurance and term insurance which makes the premiums more affordable. Unlike whole life and Universal Life insurance, GUL does not build cash value but the premiums are guaranteed level and will never go up.
Typical GUL policies are purchased by people who have an estate planning need now in the present or sometime in the future so the policy can be guaranteed to age 100, 110 or even to age 121.
Final Thoughts
Life insurance is not as frightening or confusing as some people think. It’s actually a very flexible product that is used for a variety of reasons: Estate planning, funding college, spousal insurance, business continuation, mortgage protection and on and on. We are independent insurance agents that work with more than 30 insurance companies so we don’t have to push you to one particular carrier. Contact us with any questions or a free, no obligation quote.
