After a lifetime of saving and building up assets, who will benefit more upon your passing – Uncle Sam or those you love and care about?
Unfortunately, for many families, it’s the federal government that benefits the most – and if no one realizes it until it is too late, a substantial amount of taxes must be handed over. This, in turn, could significantly reduce what is left over for your loved ones.
In fact, depending on how much is owed in tax, it may require the liquidation of property and other assets – and in some cases, the combination of federal and state estate tax could wipe away more than half the total value of the estate. So, everything that you’ve worked so hard to build up could quickly disappear.
While nobody can (or should) completely avoid the payment of taxes that are due, there are viable ways to reduce – or possibly even eliminate – tax that is due on your property and assets upon death, so that your loved ones won’t have to struggle financially going forward.
If you’ve done a good job of creating a large – or even a moderate-sized – nest egg, you may feel that your future financial security is intact, as well as that of your survivors, when you pass away. But what you may not know is that in many ways, you have an investment “partner” named Uncle Sam – and he is going to want his “share” of what you have built up.
For instance, you will typically face taxation in a variety of situations throughout your lifetime, such as through income tax, as well as capital gains taxes when you generate a profit on an investment.
But being taxed by the government doesn’t just occur during your life. It can also happen after you’ve passed away.
This could be in the form of estate tax that is due and inheritance tax – possibly at both the federal and state level.
In any case, a major issue with many estates is a lack of liquidity – liquidity that is needed primarily for paying taxes after someone dies. For example, estate taxes are oftentimes due from those who pass away leaving an estate that is valued at or above a certain level.
As of 2021, the amount of the federal estate tax exemption was $11.7 million. This means that federal tax would be due on the amount of the estate value that is over the exemption. But that could be just the tip of the iceberg.
That is because on top of federal estate tax, there are several states that also levy state estate taxes. These states – with tax thresholds that can range from $1 million to $5.74 million – include (in 2021) the following:
In addition, there are also six states (in 2021) that levy an inheritance tax. This is separate from estate taxes, with the key difference between estate an inheritance taxes being who is responsible for paying them.
For instance, estate taxes are taxes that are levied on the transfer of property and assets to your heirs. In this case, it is the estate of the deceased individual that is liable for paying the tax. On the other hand, an inheritance tax is taxation on the privilege of receiving property from a deceased individual or estate. It is the recipient of the property or asset who pays the inheritance tax.
The states with inheritance taxes (in 2021) are:
While many people do not fall into this financial category, though – and in turn, won’t have to face federal or state estate taxation – it doesn’t mean that there won’t be any type of tax liability at all faced by your survivors.
In fact, in many instances, the death-related taxes that are faced by those without large estates can oftentimes create more of a financial hardship for those who are left behind and have to pay them.
When you read or hear the word “estate,” it might conjure up images of large homes, a driveway filled with fancy cars and a substantial investment portfolio. But the reality is that you don’t need to be ultra-rich to have an estate.
Rather, your estate is simply defined as the economic value of everything that comprises your net worth. This value is of particular relevance in two primary situations. These include the declaration of bankruptcy and upon your death.
With that in mind, you may be surprised to learn that there is a similar – and rigorous – legal assessment and proceeding that takes place if a person files for bankruptcy as well as when an individual dies. This is why it is so important to have a good solid estate plan in place. Otherwise, a sizeable portion of your estate value could be lost to unnecessary taxation.
Estate planning is the “act of managing the division and inheritance of your personal estate.” There are many financial and legal experts who feel that estate planning represents the most important financial planning of a person’s life. Those who’ve had a loved one die without an estate plan in place would likely agree.
Your estate can consist of many different types of assets and property that you own, such as:
Your “taxable” estate, then, consists of the portion of your net assets that are subject to taxation upon your death. In this case, the amount of the taxable estate would be determined by adding up the total value of everything that you own, and then subtracting what you owe – or your liabilities – such as the balance that is left on mortgages and vehicle loans.
Examples of liabilities that can reduce the size of your taxable estate include:
When coming up with the total amount of tax liability at death, there are also some additional items that may be deducted from this figure, like:
The remainder of your estate value could be subject to taxation, though, which can ultimately take money out of your loved ones’ pockets – and in some cases, it could even cause a substantial financial hardship for them going forward.
Unfortunately, even for those who are not considered wealthy, estates can oftentimes lack the needed funds for covering its administrative expenses upon death. These costs could include items such as:
In addition, many of the financial accounts that were owned by the decedent are oftentimes payable to individuals, which could end up leaving the estate without sufficient funds to pay its expenses.
The good news is that there are some strategies that may be used for reducing, or even eliminating, the taxes and other expenses that are due. One viable solution is to use a life insurance policy that is payable to the estate, and not to an individual beneficiary.
Going this route can provide the liquidity that the personal representative of the estate needs, with any excess funds from the policy’s death benefit going to the named beneficiaries, once all of the other obligations are paid.
In addition, the leveraging power that life insurance can offer could provide more funds than having money “parked” in a simple savings or checking account that is just sitting there not being used.
As an example, in order to have $100,000 available in a bank savings or checking account, it will require that there is actually $100,000 in the account. But with a life insurance policy, a death benefit of $100,000 may be purchased for far less than that in premium. For instance, depending on the age and health condition of the insured, a $100,000 death benefit may only “cost” a few hundred dollars in premium each year.
Plus, life insurance proceeds are received by the beneficiary (or multiple beneficiaries) free of income taxation – so 100% of the funds that come from the policy may be used for various financial needs. And, given the direct beneficiary designation (meaning that payment goes directly from the insurer to the beneficiary), life insurance benefits won’t have to go through the costly, time-consuming and public process of probate.
While having life insurance in place to cover taxes that are due at death can be a smart strategy, going this route could end up backfiring – and even adding to the amount of tax that is owed – if the policy and the plan is not properly set up.
For instance, if you own a life insurance policy outright, then upon your death, the value of the proceeds will be included in your overall taxable estate – and the higher estate value can result in more taxes being due.
One option is using an irrevocable life insurance trust.
Irrevocable life insurance trusts, or ILITs, are oftentimes used in estate planning strategies because they can offer the necessary liquidity for the payment of taxes and expenses, but without adding to a decedent’s taxable estate. So, in many ways, using an ILIT can provide you and your loved ones with a “best of both worlds” solution.
In this case, a trust is created with the purpose of either purchasing a new life insurance policy, or even for holding one that already exists on the insured. Using this strategy, the irrevocable life insurance trust (ILIT) becomes the owner of the policy, which in turn, means that the death benefits that are eventually paid out at the insured’s passing are also held outside of their own estate.
Without these funds being added to the estate’s total value, there is a smaller taxable base, which leads to a lower tax amount due from the insured’s survivors – even if the death benefit is in the six- or seven-figure range.
There are some additional benefits, too, if you opt to use an ILIT strategy. For instance, you can stipulate in the trust document how the life insurance proceeds may be used. That way, you can better ensure that these funds will go toward paying taxes and/or used for other specific purposes.
As an example, assets that are donated to a charity could be offset with the life insurance policy proceeds. In this situation, if you make a direct gift of money or other property to a charitable organization, it will reduce the value of your estate and in turn leave less for your loved ones. But the life insurance death benefits could essentially “replace” those lost assets and provide an equal (or similar) amount for your survivors.
Also, money can be gifted to the irrevocable life insurance trust for the purpose of paying the insurance policy’s premium – which can also remove assets from your taxable estate and reduce its taxable base. Up to $15,000 (in 2021) may be moved over and excluded from gift taxes.
If a new life insurance policy is being purchased – regardless of whether the policy will be held in or outside of a trust – there are some items to consider before choosing and committing to a plan. These should ideally include the following:
If you do not qualify for a fully underwritten life insurance policy for health reasons, there may still be other options available to you.
Once you have your life insurance coverage in place, it is important that you regularly review it so you can make revisions, if necessary. For example, reviewing your plan annually is typically recommended. However, you should ideally do so more often if you have experienced a major life change, such as:
Knowing that your estate liquidity needs are covered can give you and your loved ones’ peace of mind in knowing that taxes and other financial obligations will be taken care of in the event of the unexpected. This, in turn, can reduce or eliminate financial struggle for those you care about as they move forward.
There are thousands of life insurance policies available in the marketplace today, though. So, it is important that you have an understanding of how different coverage works and which type and amount is right for you and your specific needs.
That’s why working in conjunction with an insurance and estate planning expert is recommended. In addition to matching up the best protection for your short- and long-term objectives, this type of specialist can also help you with coordinating an overall plan, making the process much easier for you and those you love.
Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.