All inheritances are not taxable to the recipients; it’s the estate that must pay taxes, if any are due. In 2009, the amount excluded from any tax due is $3.5 million, and next year, the estate tax is repealed, no tax regardless of the estate size. Unfortunately, the repeal lasts only for 2010, and the exemption returns to only $1 million in 2011.
A million dollars may seem a large sum — many of us don’t have a million dollars even after adding up the value of your house, retirement plans, and savings. However, I often hear “Insurance proceeds are not taxable to the recipient”. I suppose that it’s true, but this is why the conversation began with the question who owns your life insurance policy.
The current rate for a fixed 20 year term life policy for a 25 year old with a million dollar coverage is only $35/mo or $420/yr. (source: SBLI). If we assume the exemption remains at $1 million dollars, it’s easy to see that you can easily find that all your assets (everything above that million dollar policy) become taxable at rates as high as 55%.
Easy. By not being the owner of the policy. It will cost a bit ($1000-$2000) to set up a trust with a knowledgeable trust attorney, but it will be money well spent. The trust is a separate tax entity, and you will gift it the amount needed to pay the annual premiums for the insurance policy.
Not too long ago I was called regarding a very unfortunate situation. An elderly couple died within a few months of each other. They had kept up two policies of $1.5 million dollars each, not really needed as their children were grown and grandchildren already out of school. Upon the husband’s death, the wife had no issue with estate taxes as the spousal amount is unlimited. Upon her death, she left $3 million in cash along with nearly another million dollars from the value of the home and retirement investments. This $4 million dollar estate was subject to taxes on the excess $3 million and the tax due was just under $1.5 million.
This tragedy could have been avoided for the sake of a couple thousand dollars. The husband’s policy should have been owned by a trust. The wife could have accessed that money for a reasonable, but not unlimited amount, usually about 5% per year. This would have kept the money out of her estate. Her policy should have been owned by a trust as well, and the premiums paid by gifts to the trust. Upon her death, the only amount left in the estate should have been just the $1 million, which would have no tax due at all.
This is a financial planning issue that many simply don’t realize or understand. Unfortunately, this ignorance can cost your beneficiaries a large portion of the money you intend for them to have. As always, seek professional council for this or any other financial matter.
If you enjoy this article, please check out On my Death, Please, Take a Breath.