Benefits of Life Insurance
Knowing loved ones will be financially cared for in the event of death can give a family breadwinner great peace of mind. Life insurance is a valuable tool in any estate plan because of the benefits it provides.
First, life insurance can help family members bare the financial consequences of an unexpected death. The National Funeral Directors Association approximates the average expense of a funeral to be upwards of $6500.00. This is a cost that may be prohibitive unless there is a reliable and immediate source of funds which can be used to pay for high funeral expenses.
Second, a life insurance policy ensures the loved ones’ future financial security. For example, if the family’s primary income earner passes away, a well funded life insurance policy will provide money to meet current and future household expenses such as mortgage and education costs. If you want to ensure that all of your life insurance proceeds are used for the purposes which you intend, you may want to consider having your attorney prepare an Irrevocable Life Insurance Trust for you.
Life Insurance and Estate Tax
What you may not know is that the proceeds paid on a life insurance policy are included in an estate (everything you own when you die) for estate tax purposes. This means the size of the estate is actually inflated by the face value of the policy. For example, if you have real estate, bank accounts, and stocks that add up to $2,000,000 you may think that only $2,000,000 of the estate will be subject to the federal estate tax rate. However, if you have $500,000 worth of life insurance it is considered part of your estate, and estate taxes will be due on $2,500,000! The underlying reason life insurance benefits are included in an estate is because the policy holder is deemed to “own” the proceeds so that the IRS can fully tax those proceeds as part the deceased persons estate at death.
Reduce Estate Tax With a Life Insurance Trust
One way to avoid tax on life insurance proceeds is to establish an Irrevocable Life Insurance Trust, or ILIT. Under an ILIT, the life insurance policy is not “owned” by the decedent or his or her spouse. Therefore, the proceeds are not considered part of the decedent’s estate. This is done by transferring ownership of a life insurance policy to the trustee of an ILIT. After ownership interest of the life insurance policy is transferred to the trustee, you’ll no longer “own” the policy and the proceeds can’t be taxed as being part of your estate when you die.
Advantages and Disadvantages
However, there are a few drawbacks to consider in setting up an ILIT. For example:
- You can’t change the beneficiary of the policy: If you as an insured want the flexibility to deal with changed family circumstances, an ILIT may not be the right choice for you because after the ILIT is created, the insured gives up the right to change the beneficiary of the policy.
- You can’t borrow from the policy: If your policy normally allows you to borrow against the policy or make cash withdrawals from it, under an ILIT you will no longer be able to do this.
- Transferring an existing policy to the trust could be complicated: If you already have a life insurance policy, ownership can be transferred. But, if the insured dies within 3 years of the date from which the policy was transferred, the life insurance policy will be included in the estate for tax purposes anyway! However, depending on a number of factors, your attorney may be able to avoid this problem with a “fail-safe” clause that ensures that the proceeds of a transferred policy are held separately under an ILIT.
Our estate planning attorneys at San Diego Law Firm know the complexities involved in making sure loved ones and assets will be cared for and protected in the worst-case scenario for a family. We can answer your questions about life insurance trusts and other estate planning tools that you can use to ensure that 100% of life insurance proceeds go to the beneficiaries instead of to paying estate taxes. Also, we can look over your existing estate plan to make sure that all potential “fail-safe” mechanisms are in place. Call us at 619-794-0243 for advice and a consultation on ILIT issues.
