There are a number of good reasons to buy life insurance, but one of the most compelling ones is to provide for your children in the event that something happens to you before they are old enough to care for themselves. In many cases, even parents who are not particularly wealthy carry $1 million or more in life insurance in order to plan for this relatively unlikely but tragic possibility.
What many people may not realize is that life insurance proceeds, although not subject to income tax, can be subject to estate tax. Specifically, if you own or control a policy on your own life, or if there is a policy on your life with your estate named as the beneficiary, the proceeds will be included in your taxable estate for both federal and Minnesota estate tax purposes.
Now, depending on what Congress decides to do after the outcome of this year’s election, the federal estate tax could soon be going away entirely. And if it is kept in place, it will probably only be imposed on very large estates. In Minnesota, however, all estates worth more than $1 million are subject to estate tax. That means that, if you live in Minnesota and you have at least $1 million of life insurance, you should be thinking about your estate tax planning options. These include:
- Pay the tax. If your potential estate tax liability is relatively small as a percentage of the life insurance proceeds your beneficiaries will receive, you may be willing to have a portion of the proceeds used to pay the tax. If you take this approach, you will need to be sure that your will is drafted to apportion a fair share of the estate tax liability to the beneficiaries of the policy.
- Put your life insurance in a trust. Creating an irrevocable life insurance trust (ILIT) to hold insurance on your life is generally regarded as the most foolproof way to avoid estate tax on life insurance proceeds. Because an ILIT is a very complex type of trust, it is preferable to use a professional trustee, who will typically charge a fee to administer the trust.
- Use other tax planning strategies. For some people, the costs of setting up and administering an ILIT will outweigh the potential benefits. However, it may still be possible to gain some benefits by transferring ownership of a life insurance policy to someone else and/or writing contingent trust provisions into your will. These approaches must, however, be planned out very carefully.
Which of these approaches is right for you will depend on your personal circumstances and priorities. In any case, if you are considering purchasing life insurance, now is the best time to carefully weigh your options. And if you already have an insurance policy that is large enough to have potential estate tax consequences, then the sooner you talk to an attorney, the better.