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How to Avoid Estate Tax on Your Life Insurance Payout - Werner

How to Avoid Estate Tax on Your Life Insurance Payout

Troy Werner and his family

Written by Troy Werner

Troy Werner has been an indispensable asset to The Werner Law Firm since joining in 2009, providing exceptional legal service to its clients.

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POSTED ON: December 12, 2022

Let’s assume you have written and finalized your will and double-checked your accounts. You've specified your designations and talked to your family about certain medical decisions and financial responsibilities. Let’s say you have your affairs in order but want to make the funerary costs and final arrangements a little less hefty in your loved ones’ […]

Let’s assume you have written and finalized your will and double-checked your accounts. You've specified your designations and talked to your family about certain medical decisions and financial responsibilities. Let’s say you have your affairs in order but want to make the funerary costs and final arrangements a little less hefty in your loved ones’ pockets, so you arrange for a life insurance payout.

This life insurance payout is enough to cover the immediate costs of your passing and help smoothen the transition. But did you know that a life insurance payout can unintentionally backfire on you and cost your family money? This is because, depending on the size of your current estate and the size of your life insurance policy, the estate tax, or so-called “death tax,” may kick in.

Once an estate reaches a certain total value, a percentage of the estate’s value must be paid in taxes to the federal government. An unexpected tax liability can throw a mighty wrench into an expertly crafted estate plan. However, you can account for this tax liability and work around it by adapting your estate plan. Here is what you need to know.

What Are Estate Taxes?

When a person dies, the material wealth they leave behind is referred to as their financial estate. In simplified terms, the total value of what you leave behind matters for tax purposes.

Any estate valued below the lifetime estate tax exemption limit will not owe the federal government any additional death taxes. But anything over the estate tax exemption limit may owe anywhere from a few hundred dollars to up to 40 percent of the excess value, depending on the size of the estate.

The estate tax exemption limit changes yearly with inflation but may also be individually unique due to how it acts as your lifetime gift tax exemption limit. For example, suppose the annual gift tax exemption limit is $15,000, and you gift friends and family members more than $15,000 in goods and assets in that given year. In that case, the excess value is stripped from your lifetime gift tax exemption limit, which then becomes your estate tax exemption limit at your date of death.

Individual estates in 2022 must be valued at an excess of $12.06 million before the federal government levies any estate taxes. For married couples, that limit is effectively doubled. Therefore, the vast majority of Americans don’t have anything to worry about for the time being.

Estate Tax Exemption Limit

But exemption limits can change – and they have changed frequently in the past. Just a decade ago, all estates above $5.12 million in total value had to pay estate taxes.

In 2009, the estate tax exemption limit was as low as $3.5 million, and in 1997, the estate tax exemption limit was $600,000 - even when accounting for inflation, that is a significant difference to today’s exemptions and rates.

While most Americans can plan their estate knowing they likely won’t owe estate taxes to the IRS, our current exemption limits are the result of the relatively recent 2017 Tax Cuts and Jobs Act, which brought the exemption limit up from $5.49 million to $11.18 million in 2018. The Tax Cuts and Jobs Act will be overridden in 2026 unless it is written into the tax code first, causing exemption limits to revert to 2017 levels.

Alternatively, there is also a chance that the next major tax change may involve drastically lowering the estate tax limit to pre-2010 levels. Anything is possible. If you don’t plan on dying anytime soon, it’s worth keeping an eye on how estate tax exemptions are developing.

How Does a Life Insurance Payout Work?

Put simply, a life insurance plan allows you to pay a monthly fee for a sum of money poured into your estate upon your death. This is a life insurance payout.

Most people get into life insurance plans to leave behind a larger sum of cash for their loved ones upon death, to pay the bills, cover funerary expenses, or invest in a college fund. Life insurance policies give people the chance to leave behind an additional windfall for their loved ones.

Different plans have different payouts. Most life insurance payouts range between mid-five figures to low six figures. That might seem like a relative drop in the bucket, given today's estate tax rules.

Unless your total estate’s value – counting the value of your various investment properties, business stakes, bonds, cash accounts, and more – is already approaching the high eight figures, a few hundred thousand dollars likely won’t make the biggest difference. But that can change in years to come. Suppose your estate plan is meticulously designed around the total value of your current assets. In that case, any major increase in value – including a life insurance payout – may put you at risk of additional tax liability in the future.

But what can you do when an estate becomes too large and gains tax liability?

Avoiding Estate Taxes with Special Trusts

Your estate’s value determines whether you owe state or federal estate taxes. Only a few states levy state estate taxes and their tax rates are generally much lower than the IRS’s top tax rate of 40 percent on estates. But thankfully, you can affect that value in two common ways:

  • Take advantage of your annual gift tax limit and give away as much as possible to friends and family members.
  • Use a special trust to collect your life insurance payout and independently distribute it to your loved ones without feeding into your estate to begin with.

Trusts are legal agreements between a trustor, their trustee, and their beneficiaries. Trusts are defined by their respective trust documents and exist as legal entities managed by a successor trustee after the trustor’s death.

A trust written to be irrevocable can also hold assets independently. You can fund an investment property or a tidy sum of cash into an irrevocable trust and effectively remove it from your estate without a major tax liability. This is how an irrevocable life insurance trust (ILIT) allows you to transfer the contents of a life insurance payout to your loved ones without affecting the value of your estate and thus avoiding additional estate taxes.

The downside is that you lose some control over that asset or wealth. But since life insurance payouts are a sum of money you will never see to begin with, this is a minor issue.

It pays to note how day-to-day tax changes might affect your estate plans in the coming years. Work with an estate planning professional to keep on top of recent changes, and keep your plans up-to-date.

How to Avoid Estate Tax on Your Life Insurance Payout - Werner

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