Life insurance is not taxable, right? Wrong.

If you have large life insurance policies, you may be surprised at the estate taxes waiting for you.

Don’t take this the wrong way. Life insurance is an excellent estate planning tool. Life insurance can provide money post death when your loved ones need it most. Also, insurance proceeds generally are not taxable income to the recipient. But even if there is no income tax, the value of life insurance policies that you own or control may be included in your estate for purposes of determining if you must pay an estate tax.

Here is how it works. Your executor reports what assets you owned or controlled at your death. This may include the value of your life insurance policies. If this amount exceeds the estate tax exemption, that is, the value of assets that can be in an estate without paying an estate tax, then taxes of roughly 50% of the overage is due as taxes. Although this is a per person exemption, married couples who do not take tax planning steps generally only get one exemption. This may result in a large tax at the death of the second spouse.

The direct result of purchasing life insurance policies without considering tax planning is that a portion of your life insurance may benefit the government. This is more than patriotic. This is just plain silly.

Here are some ways to avoid this result.

  1. Don’t purchase life insurance. While this option solves a tax problem, it may not be a good answer if your family needs insurance.
  2. Establish estate planning trusts to take advantage of both spouse’s exemption amount. In this case, you can shield significantly more of the estate value from tax. The exact amount will vary based on the amount of the estate tax exemption at the death of each spouse.
  3. Establish irrevocable life insurance trusts (ILITs) to hold large life insurance policies outside of the taxable estate. New policies purchased by the ILIT will be outside of the estate from the date of purchase, regardless of the exemption amount. Policies transferred to the ILIT will be outside of the estate three years after the date of transfer. Although ILITS must be tended to annually, and additional restrictions apply, the potential tax savings for an estate using an ILIT is huge.

If you have or are considering purchasing large life insurance policies, ask your attorney about establishing an estate tax-planning trust or ILIT today.