Life Insurance
If you, your spouse or your companion is the insured or the beneficiary of a large life insurance policy you must read this article and understand how the IRS may take 40% of the proceeds of the policy after the death of the insured. This article also explains how to prevent the IRS from taking any part of a large life insurance policy.
Most people understand that the recipient of life insurance proceeds does not have to pay federal income tax on the proceeds. If you are the beneficiary of a $1,000,000 life insurance policy you do not have to pay any federal or state income tax on the money you receive after the death of the insured.
The Federal Estate Tax
The United States imposes a tax (called the estate tax) on the estate of a deceased person who dies in 2024 - 2025 whose net worth exceeds $13,610,000 adjusted for inflation. The estate tax is 40% of the value of the deceased person’s net estate that exceeds $13,610,000 for 2024 - 2025. For example, if the value of your estate (total asset value – debts) is $15,000,000 and you were to die in 2024 - 2025, your estate must pay the IRS $1,368,000 [($12,500,000 – $13,610,000) x .40] nine months after your death.
Unless Congress changes the estate tax exemption amount it will become $5,490,000 adjusted for inflation for people who die after December 31, 2025.
If you are married your taxable estate will be reduced by the value of the assets you leave to your spouse. In the above example if the entire $15,000,000 went to the spouse of the deceased person the estate of the deceased person would not owe any federal estate tax. The $15,000,000 left to the surviving spouse avoids federal estate tax until the death of the surviving spouse.
Warning: Leaving the entire amount to the surviving spouse would be a mistake because it would cost the family who inherits after the death of the surviving spouse megabucks in federal estate taxes that could be eliminated if the first spouse to die had created a trust that contains federal estate tax minimization provisions. Married couples whose combined net worth exceeds $13,610,000 need a trust with estate tax saving provisions to eliminate or reduce federal estate taxes on the death of the second spouse.
Federal Estate Tax on Life Insurance Proceeds
The U.S. does not impose a direct estate tax on life insurance. However, the amount of life insurance proceeds is ADDED TO THE VALUE OF THE DECEASED PERSON’S ASSETS FOR ESTATE TAX PURPOSES if the insured has any incidents of ownership of the policy such as the ability to name the beneficiary!!! Read the preceding sentence again. It is the single most important fact you must understand if you are the insured or the beneficiary of life insurance and the value of the estate of the insured or the beneficiary will exceed $13,610,000.
Irrevocable Life Insurance Trust (ILIT) Eliminates Estate Tax on Insurance Proceeds
The second most important fact you need to understand is that all of the proceeds of a life insurance policy can be eliminated from the estate of the insured and the beneficiary by creating an Irrevocable Life Insurance Trust (an “ILIT”). Instead of the insured acquiring life insurance, the trust acquires new insurance or purchases an existing policy from the insured. AN ILIT CAN LITERALLY SAVE A FAMILY HUNDREDS OF THOUSANDS OR MILLIONS OF DOLLARS IN FEDERAL ESTATE TAXES THAT WOULD OTHERWISE BE OWED TO THE IRS.
When You Must Adopt an Irrevocable Life Insurance Trust
If your net worth exceeds $13,610,000 and you have any life insurance you should create an Irrevocable Life Insurance Trust (ILIT) to own the insurance so your estate does not have to pay the IRS $400,000 in estate taxes for every $1 million of insurance.
Irrevocable Life Insurance Trusts
The following table explains how an ILIT is structured.
| Trustmaker | The person who is the insured under a life insurance policy. |
| Trustee | A trusted person other than the insured. The Trustee (not the insured) must administer the ILIT. Before death of the insured most people who create an ILIT name a family member, trusted friend or their CPA as the trustee. If the policy is large consider an institutional trustee such as Trust Bank, First Western Bank, Arizona Bank & Trust or Northern Trust. |
| Owner of the Life Insurance Policies | The ILIT |
| Life Insurance Beneficiary | The ILIT |
| Assets in the Trust Before Insured’s Death | None other than ownership of all life insurance policies on the life of the insured trustmaker. |
| Assets in the Trust After Insured’s Death | All life insurance proceeds payable on the death of the insured. |
| Asset Protection | Because this trust is irrevocable, assets in this trust are protected from the beneficiaries' creditors, ex-spouses if it has proper asset protection language. |
| Premium Payments | The trustmaker/insured must make gifts to the trust in amounts sufficient to pay all future life insurance premiums. The ILIT, not the insured, should pay the premiums to the insurance company. |
| Gifts to the ILIT to Pay Insurance Premiums | When the insured makes gifts of money to pay the premiums the current beneficiaries of the ILIT have a short period of time to withdraw the money. This is necessary so the gift will qualify for the federal gift tax annual exclusion. This withdrawal right is called a “Crummey” right after a famous tax case won by Mr. Crummey in which the IRS tried to impose gift tax on the money Mr. Crummey paid to his ILIT for insurance premiums. |
| Current Beneficiary | Determined by the insured and stated in the trust agreement. Most married people will name their spouse as the current beneficiary, but the insured could name any family member(s), loved one(s) or any person or entity as a beneficiary. |
| Distributions | Trustee may distribute assets to the current beneficiary or beneficiaries per the insured’s instructions in the trust agreement. |
| Future Beneficiaries | Determined by the insured and stated in the trust agreement. Usually assets go equally to the insured’s children, but if a child is deceased the share of the deceased child would go to that child's living children and if none then equally to the surviving siblings. |
How to Book a Free Meeting to Get Answers to Estate Plan Questions
If like most people you have questions about Wills, Trusts and estate planning and want to learn more about how an estate plan can protect your most important asset – your family – then you should:
1. Make a free appointment with Arizona estate planning attorney Richard Keyt using our online scheduling calendar or by calling our estate planning legal assistant Michelle Watkins at 480-664-7413. Our meeting will be a phone, in office or Zoom video meeting approximately one hour in length.
2. Complete our online Gold Estate Plan Questionnaire. The Questionnaire gives us information we need for our meeting. You may have questions about the questions in the Questionnaire. We will answer your questions during our meeting. If you don't have time to complete the Questionnaire that's ok. We can go over the Questionnaire during our meeting.
If you have any questions about Arizona estate planning, the process, fees or anything else, call Richard C. Keyt at 480-664-7472 or his father Richard Keyt at 480-664-7478. There is no charge for inquiries about estate planning or estate planning documents.
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