Life insurance can play an important role in your estate plan. It
is often necessary to support your family after your death or to
provide liquidity. Not only do you need to determine the type and
amount of coverage you need, but also who should own insurance on
your life to best meet your estate planning goals.
Avoid Liquidity Problems
Estates are often cash poor, and your estate may be composed
primarily of illiquid assets such as closely held business
interests, real estate or collectibles. If your heirs need cash to
pay estate taxes or to support themselves, these assets can be hard
to sell. For that matter, you may not want these assets sold.
Insurance can be the best solution for liquidity problems.
Even if your estate is of substantial value, you may want to
purchase insurance simply to avoid the unnecessary sale of assets to
pay expenses or taxes. Sometimes second-to-die insurance makes the
most sense. Of course, your situation is unique, so please get
professional advice before purchasing life insurance.
Choose the Best Owner
If you own life insurance policies at your death and you die
while the estate tax is in effect, the proceeds will be included in
your taxable estate. Ownership is usually determined by several
factors, including who has the right to name the beneficiaries of
the proceeds. The way around this problem? Don't own the policies
when you die. But don't automatically rule out your ownership
either.
Determining who should own insurance on your life is a complex
task because there are many possible owners: you or your spouse,
your children, your business, an irrevocable life insurance trust
(ILIT), a family limited partnership (FLP) or limited liability
company (LLC). Generally, to reap maximum tax benefits, you must
sacrifice some control and flexibility as well as some ease and cost
of administration.
To choose the best owner, you must consider why you want the
insurance: to replace income, to provide liquidity, or to transfer
wealth to your heirs. You must also determine the importance to you
of tax implications, control, flexibility, and ease and cost of
administration. Let's take a closer look at each type of owner:
You or your spouse. Ownership by you or your spouse generally
works best when your combined assets, including insurance, do not
place either of your estates into a taxable situation. There are
several non-tax benefits to your ownership, primarily relating to
flexibility and control. The biggest drawback to ownership by you or
your spouse is that on the death of the surviving spouse (assuming
the proceeds were initially paid to the spouse), the insurance
proceeds could be subject to federal estate taxes, depending on when
the surviving spouse dies.
Your children. Ownership by your children works best when your
primary goal is to pass wealth to them. On the plus side, proceeds
are not subject to estate tax on your or your spouse's death, and
your children receive all of the proceeds tax free. There also are
disadvantages. The policy proceeds are paid to your children
outright. This may not be in accordance with your general estate
plan objectives and may be especially problematic if a child is not
financially responsible or has creditor problems.
Your business. Company ownership or sponsorship of insurance on
your life can work well when you have cash flow concerns related to
paying premiums. Company sponsorship can allow premiums to be paid
in part or in whole by the company under a split-dollar arrangement.
But if you are the controlling shareholder of the company and the
proceeds are payable to a beneficiary other than the company, the
proceeds could be included in your estate for estate tax purposes.
An ILIT. A properly structured ILIT could save you estate taxes
on any insurance proceeds. Thus, a $2 million life insurance policy
owned by an ILIT could reduce your estate taxes by hundreds of
thousands of dollars in 2006. How does this work? The trust owns the
policies and pays the premiums. When you die, the proceeds pass into
the trust and are not included in your estate. The trust can be
structured to provide benefits to your surviving spouse and/or other
beneficiaries. ILITs have some inherent disadvantages as well,
foremost among them that you lose control over the insurance policy
after the ILIT has been set up.
Planning Tip
CONSIDER SECOND-TO-DIE LIFE INSURANCE
Second-to-die life insurance can be a useful tool for providing
liquidity to pay estate taxes. This type of policy pays off when the
surviving spouse dies. Because a properly structured estate plan can
defer all estate taxes on the first spouse's death, some families
find they don't need any life insurance then. But significant estate
taxes may be due on the second spouse's death, and a second-to-die
policy can be the perfect vehicle for offsetting the taxes. It also
has other advantages over insurance on a single life. First,
premiums and estate administrative costs are lower. Second,
uninsurable parties can be covered. But a second-to-die policy might
not fit in your current irrevocable life insurance trust (ILIT),
which is probably designed for a single life policy. Make sure the
proceeds are not taxed in either your estate or your spouse's by
setting up a new ILIT as policy owner and beneficiary.
