Sheltering life insurance from estate taxes
Being a multimillionaire has its perks, but it's not without its downsides -- estate taxes among them.
Estate taxes require your heirs to pay federal taxes, state taxes or both on the value of your estate if it exceeds a certain amount upon your death. In 2015, the value of your estate must exceed $5.43 million before your heirs have to pay any federal estate taxes.
If it does, watch out: The federal estate tax rate currently stands at 40 percent.
Additionally, several states and the District of Columbia also assess their own estate or inheritance taxes. Some, such as New Jersey, Massachusetts and Oregon, will hit your heirs up for taxes if your estate is valued at $1 million or even less.
Your spouse will be exempt from paying estate taxes since your assets are legally shared. But your children and other heirs will have no such protection.
A common approach to coping with estate taxes is to take out life insurance policies to help your heirs deal with their inevitable tax bills. The problem is that the estate tax can also apply to life insurance proceeds -- unless you take specific steps such as the ones below to help guard those life insurance funds.
Arrange an irrevocable trust
The preferred option for many is to transfer ownership of the life insurance policy to an irrevocable trust. You can't be appointed its trustee, but you can decide who benefits from the trust. The trust or another individual should continue to pay your life insurance premiums to keep the policy current.
There can be issues with putting the policy in a trust, however. If you transfer the policy to the trust less than three years before your death, it will be considered part of your estate for tax purposes, and your heirs still could wind up paying estate taxes on it.
Give the policy away
Another way to potentially sidestep estate taxes is to transfer ownership of the policy to someone else, such as your children. Just remember that by transferring the policy, you're also relinquishing control over it. After the transfer, the new owners can do with it whatever they like, including cashing it in.
And again, if you transfer the policy less than three years before you die, it's still considered part of your estate, and if the estate is subject to taxation, your beneficiary won't be able to avoid the estate tax.
You'll also want the new owner to pay the premiums so there's no confusion at the IRS over who actually owns the policy.
Beware the gift tax
Even surrendering the policy three years before your death won't guarantee that taxes won't enter the picture. If you transfer the policy to an individual, its value may be subject to the federal gift tax.
That means you may have to report the transfer on your taxes and it could add to your estate's tax liability upon your death -- again, assuming that the value of your estate and your gifts exceeds the $5.43 million figure.
The gift tax, which also stands at a rate of 40 percent, is designed to prevent people from sidestepping the estate tax by giving away all of their assets before they die.
If your estate is valued anywhere near the threshold that would subject it to federal estate or gift taxes, it would be wise to consult with a tax professional to determine the most sensible course of action.
This may also mark a good time to review your life insurance coverage. If your net worth has increased since you took out your policy or you haven't compensated for the jump in the estate tax rate from 35 percent to 40 percent, you may wish to compare life insurance quotes on additional coverage.
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