In tax planning there are essentially two primary goals: reduce/eliminate the income tax and reduce/eliminate the estate tax. To understand how life insurance fits into the picture we first
have to understand some nuances of these two tax systems.
1. The Estate Tax
The estate tax is levied on the value of an individual’s total assets on death. There are some exceptions to the tax if money is left to either a surviving spouse or charity. If you want to leave everything to charity it is very simple to avoid the estate tax; however, leaving everything to a spouse is not always an answer to avoiding the estate tax for two reasons:
1) Assets left to a spouse will simply be included in their estate on their death if they do not spend them, gift them, or leave them to charity.
2) Assets left to a spouse have the ability to continue to appreciate in value, and if they appreciate too much they could force the surviving spouse’s estate to pay estate tax.
To be subject to the estate tax your total assets must exceed a certain threshold. Currently, that threshold is $12.06 million in 2022, and double that for a married couple. This amount is huge, and clearly eliminates the need to do estate tax planning for the vast majority of Americans, or so you might think. This very high estate tax exemption was signed into law in 2017 by President Trump, essentially doubling what it had been for 8 years. In fact, for most of our history, the estate tax exemption has been much, much lower than what it is today. In 2026, the current estate tax exemption will go back down to its pre-Tax Cuts and Jobs Act level. Adjusted for inflation it is estimated that the estate tax exemption in 2026 will be around $6.5 million. It is very likely that this amount will fall even further in the future as Congress searches for more tax revenue to reduce our skyrocketing federal debt, currently at $30.6 trillion.
Any amount over the applicable exemption in the year of death will be subject to the estate tax. That rate starts at 18% on the first $10,000, and increases to 40% on any amount in excess of $1 million.
In my professional opinion, if you are a retiree with more than $4 million in assets and you plan on leaving a substantial amount to your children, you should be planning for estate taxes. This is especially true if you are in a state that has its own estate tax, like Illinois.
There are many planning techniques to avoid paying estate tax, but unfortunately almost all of them are horrible for planning for the other tax—income taxes.
2. Income Taxes
If you are reading this article you are already very familiar with income taxes. I could write multiple books on income tax, but that’s not why we are here. The present question is how do income taxes affect your estate plan. Well, most techniques used to avoid the estate tax have to do with shifting assets away from yourself and into some form of an irrevocable trust.
These estate planning techniques get those assets out of your estate, effectively avoiding the estate tax. That’s possible because a properly written irrevocable trust will make it so that those assets are not considered your own anymore. If they are not yours then you can’t be taxed on them, right?
That’s right. In fact, you won’t be responsible for paying any income tax on any of the growth of those assets either. That includes capital gains, interest, dividends, royalties, etc.
But all of those items are still income, so who pays the income taxes? The trust will. The trust is considered a completely separate taxable entity, and the IRS will force the trust to file its own tax return and pay tax on all the income the trust assets generate.
“But what’s the big deal? If the income was mine or the trust’s it doesn’t really matter. One of us would have had to pay the tax on it either way.”
Yes, that is completely true. Someone will have to pay the tax either way. The big deal is that the trust will be forced to pay higher tax rates much more rapidly than you would have. The top marginal tax rate is exactly the same for both individuals and trusts, 37%. The difference is that a married couple doesn’t have to start paying that 37% tax rate until they have had $628,300 of income, a trust will begin to pay 37% on any income above $13,451.
The general rule is that anything that is good for the estate tax is terrible for the income tax.
The exception to this rule is life insurance. Life insurance death benefits are free of income tax regardless of whether or not they are owned by an individual or a trust. This is one of the most powerful tax benefits in the entire internal revenue code.
Life Insurance and Estate Planning
Life insurance is the only vehicle that is able to avoid:
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1. The federal estate tax (40% top marginal rate)
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2. Any state estate tax, if applicable (16% top marginal rate in Illinois)
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3. The federal gift tax (40% top marginal rate)
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4. Income tax, including the harsh trust income tax rates (37% top marginal rate)
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5. Any state income tax, if applicable (4.95% in Illinois)
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6. Federal and state capital gains tax (23.8% top marginal rate)
To achieve these tax benefits, one cannot simply purchase a life insurance policy and name the beneficiaries of the policy directly. An extra step is needed—establishing trust. This type of trust is called an irrevocable life insurance trust, or ILIT, for short. Establishing the ILIT, and funding it properly, will assure that the estate tax and gift tax is avoided.
The gift tax is an additional tax imposed on transfers during an individual’s lifetime. The gift tax and the estate are a unified system. Every individual is allowed an annual gift tax exclusion. This is an amount that may be given to an individual each year without being subject to the gift tax. For 2022, that amount is $16,000 per person, per year ($32,000 for a married couple if gift splitting is elected). If you give more than this amount, the excess will offset the lifetime estate tax exclusion at death (discussed earlier), currently $12.06 million.
When establishing an ILIT, it should generally be a goal to fall under the annual gift tax exclusion. An example may help illustrate this.
We have Mary and Todd, both aged 65. They have three children: Robert, Edwin, and Sarah. They would like to leave $1.8 million to their children at death while avoiding estate and income tax. They establish an ILIT, with a permanent, second-to-die life insurance policy that has a guaranteed $1.8 million death benefit. The policy will require 5 payments of $96,000. They have elected gift splitting, so they are able to give $32,000 per year, per beneficiary gift tax-free ($16,000 * 2). Because there are 3 beneficiaries specified in the trust, they are under the annual gift tax exclusion amount and are not required to file a gift tax return ($96,000/3=$32,000). When they pass, Robert, Edwin, and Sarah will each receive $600,000 completely tax-free.
To benefit from this strategy, the insured under the policy needs to be insurable—they need to be in relatively good health. A current policy may be contributed to an ILIT, but there are additional considerations to be taken into account regarding the gift tax. If establishing an ILIT is of interest to you, it’s important to start the planning ahead of time, while you are still insurable and the premiums on life insurance are reasonable. An ILIT is not appropriate for everyone, but in the right situation, it can be one of the most powerful tax and estate planning tools in your arsenal.