How to use life insurance to pay estate taxes

Jeff Witz, CFP

With the 2022 federal estate tax exemption amount at $12.06 million ($24.12 million for a married couple), it may seem unlikely that your heirs will need to pay estate taxes under the current tax law. However, this law is expected to sunset at the end of 2025, with the exemption reverting to an inflation-adjusted amount of approximately $6.2 million ($12.4 million for a married couple). Unless Congress votes to extend the higher estate tax exemption amount, many more Americans will be at risk of having their estate subject to taxes. At a tax rate of 40%, this can mean a substantial amount going to the Internal Revenue Service (IRS) instead of loved ones. Additionally, your state also may have an estate tax. State exemption amounts are often smaller than the federal amount, so your state of residence could collect considerable taxes upon your death as well.

One estate planning tool in particular can be used to pay all or a portion of estate taxes when a large part of the estate consists of physical assets such as real estate, art, jewelry, collectibles, and so on. If your goal is to keep these tangible assets in the family, life insurance owned by an irrevocable life insurance trust (ILIT) can be used to pay estate taxes, so the assets don’t need to be sold.

An ILIT is a type of trust that is funded during your lifetime with 1 or more life insurance policies. It is irrevocable, meaning that once you create an ILIT the trust generally cannot be changed or revoked. In exchange for moving your life insurance policy into an ILIT, there are several benefits: you can avoid having the life insurance policy’s death benefit included in your estate for federal estate tax purposes; fund the trust with life insurance to help provide the cash needed to cover estate taxes and other expenses after you die; and finally, have the ability to direct, through the trust document, how and when the death benefit is used and for whom.

However, it is important to remember that this is an irrevocable trust. Once you either transfer an existing policy into the trust or purchase new life insurance using the trust, you must relinquish any right to make changes to the policy or trust. If you retain any rights to the policy, such as the ability to remove the cash value, both the IRS and state tax authorities would view you as still having “incidents of ownership” and would require the policy to be included in your estate. Therefore, you must select someone else such as a spouse, sibling, adult child, or attorney to be the trustee of the ILIT. The trustee would then oversee maintenance of the policies held in the ILIT, and the life insurance would no longer be a part of your estate.

To pay premiums on the life insurance policies, you transfer money to the ILIT and the trust pays the premiums. However, you must consider gift taxes. Putting money into a trust that someone else will benefit from can be considered a gift. If the premium payment for each beneficiary exceeds the gift tax exemption of $16,000 per year, gift taxes could be owed.

One way to avoid this is to have the trustee send the beneficiaries a “Crummey letter” each time you transfer money to the trust. This letter would notify them that they can request their share of the deposited money within a specific time period. If they have an immediate right to the money, the gift tax doesn’t apply. However, your beneficiaries would be foolish to take the money out because without this money the insurance premiums would go unpaid and the policy would lapse. The eventual life insurance death benefit payout would far exceed the amount that was intended to pay the premiums.

If you own an existing policy and transfer it into the ILIT, the IRS will still count it as part of your estate if you die within the next 3 years. (This doesn’t apply to policies purchased by the trust.) With the existing estate tax law scheduled to sunset at the end of 2025, we are approaching an alignment between when the tax law expires and the 3-year waiting period for life insurance transfers into the ILIT ends. Depending on age and expected life expectancy, this timeline may be of some importance to you.

Determining whether you are at risk of paying estate taxes and whether an ILIT makes sense for you will likely require coordination between your certified public accountant, your financial adviser, and your estate planning attorney. Due to the irrevocable nature of ILITs, all aspects of your financial life should be carefully considered.

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