One of the first shockers when I started to practice estate planning was to learn that the death benefit for life insurance is subject to estate tax. Yikes! You’re asking yourself, “Can this really mean that, when I buy life insurance to benefit my family, they will have to pay estate tax on the death benefit?” That is exactly what I mean.
Now, I want to be clear that estate tax is not the same thing as income tax or inheritance tax. Estate tax is an “everything tax” on the value of everything that you own when you die that is not subject to the applicable exclusion amount. That “applicable exclusion amount” is like a coupon that the IRS gives you. Anything above that amount is subject to estate tax. The applicable exclusion amount changes over time. In 2010, the applicable exclusion amount became 5 million dollars per person and adjusts annually for inflation. In 2017, a person can pass $5,490,000 to others during life and on death. The amounts above that are subject to estate tax, which in 2017 is 40%.
Let me restate that the life insurance proceeds that go to your beneficiaries are not treated as income or inheritance to them. They are only subject to being included in the total value of your assets when you die. So if you die and have a compilation of assets, including the death payout of your life insurance; that exceeds the applicable exclusion amount, the excess will be subject to estate tax.
Let’s assume all of your assets are community property because you live in Arizona. Let’s also assume you live in a home with a value of 1.5 million dollars, have an IRA worth 3 million dollars, and you have a life insurance policy for 2 million dollars. The total value of your estate (albeit we have ignored lots of assets that might be part of an estate) is worth 6.5 million dollars. The portion of the estate above $5,490,000 is going to be taxed at 40%. The IRS will take 40% of $1,010,000.
There are ways to avoid this result! Creating an Irrevocable Life Insurance Trust (ILIT) is a common solution. The ILIT owns the life insurance policy rather than the person. So when the person dies, the life insurance is NOT in his/her estate. That death benefit can pay the tax so the beneficiaries receive all that you intended to give them.
There are other reasons to use an ILIT. However, discovering that my life insurance might be split between my family and the government sent chills up my spine. It is worth understanding.