Using Life Insurance to Pay Estate Taxes

In our prior post, we saw that Life Insurance has many uses in Estate Planning, beyond just “Breadwinner Replacement.”

We saw that Creating an Estate with Life Insurance is a simple and cost-effective solution for most families.

Now let’s look at one of the more common uses of Life Insurance for affluent families – using Life Insurance liquidity to pay Estate Taxes.

In 2012 and 2013, families can shield up to $5 million per spouse against Federal Estate Tax.  Above the credit amount, taxable estates pay Federal Estate Taxes at a 35% rate.

While many families think they don’t need to worry about Estate Taxes, bear in mind these rules apply only for 2011 and 2012.

If Congress fails to act, in 2013 the credit shelter numbers will drop to $1 million per spouse, with the excess taxed at a 50% rate!

So if your Estate is subject to Estate Tax, the question arises: how can your Estate pay your Estate Tax bill in a timely manner?

The truth is, the IRS expects all estate taxes to be paid off within nine (9) months from one’s date of death!

The average Californian’s estate is dominated by two assets:

  1. Their Personal Residence; and
  2. Their Individual Retirement Account/Pension/401(k)

Neither of these assets is easily liquidated on short notice without triggering substantial tax or other penalties.

As the current real estate crisis demonstrates – being forced to sell real estate in a down-market can destroy one’s hard earned equity.

Fire sales of Real Estate or Taxable Assets are rarely a good idea.

Even if your heirs were able to liquidate one or more of these assets to pay taxes, using Life Insurance proceeds instead may make far greater sense.

Not only are you able to satisfy a tax bill for pennies on the dollar, but the proceeds are immediately liquid and available, without needing to sell off precious assets.

One Tax Planning Note:  to achieve the maximum benefit from this strategy, one needs to use a Life Insurance Trust.  Otherwise, you can wind up paying a giant chunk of the Life Insurance death benefits to the IRS!