Life insurance as protection from federal estate tax

Dear Jonathan: I am a single man. My net worth is between $9 million and $10 million. I understand that under the current law the federal exclusion from federal estate taxes is $5 million, which means that if I die this year, my estate will incur a federal estate tax. My financial advisor is encouraging me to purchase a life insurance policy with a death benefit sufficient enough to offset any federal estate tax liability that will be imposed against my estate. Do you think this is a good idea?

Jonathan says: The exclusion from federal estate taxes is actually $5.25 million for 2013. Having said that, your financial advisor’s recommendation for you to purchase life insurance in an amount necessary to offset any federal estate tax liability, is a common planning tool that is used when a client wants to minimize the effect of the imposition of federal estate taxes against his or her estate.

In your case, if you were to die this year, your estate would incur federal estate taxes in an amount in excess of $2 million, so purchasing a life insurance policy with death benefits of at least $2 million might be something you may very well want to consider. In order for this plan to work, however, you cannot own that policy outright, otherwise that policy’s death benefits will be included as part of your taxable estate, which means those death benefits would be taxed. For example, if you purchased a life insurance policy with a death benefit of $2 million and died this year, then the value of your estate would be increased by $2 million and taxed accordingly.

If you want to avoid having the death benefits of any life insurance policy you purchase taxed as part of your estate, you need to set up a separate irrevocable trust for the purpose of purchasing and owning that policy. So long as you have no control over that trust and have no rights or ownership in that life insurance policy, and you comply with certain other procedures that are too involved to address here, the proceeds received from that life insurance policy should not be included as part of your taxable estate.

So instead of being taxed in your estate, those death benefits could be used to offset any taxes you have to pay. For example, if at the time of your death your estate incurs a federal estate tax of $2 million, and you have an irrevocable trust which owns a life insurance policy on your life which has a death benefit of $2 million, then your estate would in essence be made whole. In other words, the $2 million life insurance death benefit would serve to offset the $2 million in federal estate taxes your estate would incur.

Before going through the expense of setting up an irrevocable trust and having it purchase a life insurance policy on your life, you will first want to determine whether this plan is right for you. For instance, do you have children or other people you are trying to provide for after your death, which would give you a reason to preserve as much of your estate as possible? If not, this course of action may not be warranted in your case.

I recommend that you meet with both your financial advisor and an estate planning attorney in your area who can further review with you what would be involved in putting this type of plan in place, as well as help you examine not only your objectives but the pros and cons of taking this course of action, which should help you make an educated decision about what to do going forward. Good luck.

Jonathan J. David is a shareholder in the law firm of Foster, Swift, Collins & Smith, P.C. in Grand Rapids, Mich.

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