Buying life insurance is supposed to be a way to provide financial security for the people you leave behind. If that expensive policy actually triggers an estate tax to be levied against your estate, is there any point in buying life insurance at all?
The answer is yes, but only if you know how to do some strategic estate planning.
How Life Insurance Affects Estate Taxes
We’ve found that a lot of people share the misconception that life insurance policies are tax-free. It’s true that the death benefit your carrier pays to your beneficiaries is not subject to any income tax, so your children and other heirs don’t have to immediately set aside a chunk of that money to give the IRS. However, life insurance money isn’t safe from estate taxes.
Whether your life insurance triggers an estate tax depends on a few things, including the state where you life. That’s because estate tax thresholds vary from state to state. The threshold is just $1 million per person in Massachusetts. Compared to the federal estate tax threshold of $11.4 per person, the Commonwealth’s threshold is very low. (The current threshold, which was set by the Tax Cuts and Jobs Act, will expire in 2026 and revert back to the 2017 amount, barring further legislation.)
That low threshold means that here in Massachusetts, your estate will be exempt from tax if it’s valued at less than $1 million at the time of your death. If it’s worth more than $1 million, the estate will have to pay out an estate tax before any of your heirs can access their assets. Because your estate includes your savings and the value of any property or other assets you own at death, even Massachusetts residents who own modest homes often have estates worth more than $1 million. The estate tax is only applied to any value above the threshold. If your estate is worth $1.5 million, for example, your heirs will pay taxes on $500,000.
Here’s where life insurance complicates things. Death benefits that paid on an insurance policy that you own are considered part of your taxable estate. For many people, that death benefit is enough to tip them over the exemption threshold.
For example, if your estate is valued at $900,000 and your policy has a $250,000 death benefit, your estate will owe taxes on $150,000. If your estate is already worth more than $1 million, the entire value of the death benefit will be taxed.
What You Can Do
In talking about estate taxes and life insurance, it’s important to talk about what it means to be the owner of a policy. With life insurance, the owner is the person who buys the policy. The owner can name beneficiaries, like a spouse or children, who receive benefits when he or she dies. While he or she has the policy, an owner can make changes to the coverage, borrow against the policy or cancel it altogether. No matter who is designated as beneficiary, the policy’s value is still considered one of the owner’s assets – even when the owner dies.
If you’re concerned about minimizing or avoiding an estate tax, don’t rush to cancel your life insurance policy. One option is to change the owner of your life insurance policy. This strategy removes the death benefit from the value of your estate. Transferring ownership is a fairly simple process, but because it will have tax implications for the new owner, it’s something that requires input from an estate planning expert. Act quickly: the transfer must be done at least three years before the original owner’s death, or the value will still be counted toward his or her estate.
Establishing a life insurance trust is another option. The trust will own your policy, replacing you as the owner and therefore keeping the policy’s value separate from your estate. The trust must meet some specific criteria, so discuss this possibility with your tax advisor and estate planner.
We know that estate planning can feel like a game of Jenga sometimes. Every piece you move has an effect on the whole. You buy life insurance to protect the financial future of your loved ones – but it triggers an estate tax that eats up a ton of money. Fitting all the pieces in place requires the help of experienced attorneys.
At Ladimer Law Office PC, we’re experts in helping our clients navigate the legal and financial complications of estate planning. We’ll make the estate tax planning process easy to understand and help you find creative solutions that maximize your money and minimize your worries. Contact us today to schedule a consultation.
Copyright © 2023 Ladimer Law Office PC
209 West Central Street
Natick, MA 01760
Ladimer Law specializes in estate planning. We protect our clients, their heirs, and their assets by listening closely, knowing the law, and executing estate plans that fit and evolve.