Everything you own or control is part of your estate. From tangible assets (like your car, wedding ring and antique Radio Flyer) to intangible assets (like your bank accounts, annuities and investments), your estate encompasses all your life’s treasures. Crafting a thoughtful plan right now helps you protect your estate while you’re alive, and it can also provide many benefits for you and your family during and after your retirement.
Upon your death, you can plan to do three things with your estate:
- Donate it to a philanthropic organization
- Give it to the government through estate taxes
- Designate certain people to get certain assets
If you choose the third option, it’s likely that you’re doing so because you want to leave a legacy for your loved ones. You want them to experience the benefits of your estate to their fullest extent. Unfortunately, the costs of settling an estate can add up quickly, and the taxes assessed on some estates can end up being more of a burden than a bonus for your heirs.
Paying Taxes on Your Estate
In 2022, the federal estate tax exemption is set at $12.06 million, which means if your total estate is valued at less than $12.06 million, it won’t be subject to federal estate tax. For most people, this is not an issue. However, states can levy their own estate tax or even something called an inheritance tax, which, instead of taxing your estate, actually taxes your heirs/beneficiaries directly. Currently, 17 states impose either an estate tax or inheritance tax, and Maryland actually has both.
State estate tax exemptions are much lower than the federal exemption (Connecticut has the highest exemption at $7.1 million—nearly $5 million less than the federal exemption), so depending on where you live, there’s a greater chance that you’re on the hook for estate taxes. And if you live in a state with an inheritance tax, there is no exemption. Your heirs simply owe taxes based on a certain percentage of the value of the property bequeathed to them.
Additionally, there are certain restrictions that come with paying estate taxes. These taxes must be paid before the estate is distributed, and they must be paid within nine months of death. If payments aren’t made in a timely fashion, the amount due is subject to interest.
Many families don’t have that kind of cash readily available, so they turn to banks to take out loans (which could end up costing them more, since the money they were loaned will have to be repaid with interest), or they sell various assets (which, depending on the situation, could force them to sell assets for substantially less than market value). What many people don’t know is that if you plan ahead, life insurance can help you offset some of these costs.
How Life Insurance Can Help
While it’s well known that life insurance provides a financial replacement for income lost upon one’s death, these policies can also be structured such that your heirs benefit from your policy’s proceeds tax-free. Most life insurance proceeds are received income tax-free, but to receive these benefits estate tax-free, you need to implement a particular plan. Here’s what you can do:
Irrevocable Life Insurance Trust
Establishing an Irrevocable Life Insurance Trust (ILIT) allows you to reduce your overall taxable estate and provide immediate liquidity for estate settlement costs so you can maximize the wealth that’s passed on to your heirs. Using this strategy, the ILIT—not the individual—owns the life insurance policy. Upon one’s death, the trustee receives the benefits and passes them on to the estate’s executor to help pay for various estate taxes and other settlement costs, effectively bypassing federal estate taxation.
Donating to Charity
You can also use a life insurance policy to leave funds to a particular charity for a tax advantage. It’s important to make sure that the charity is a 501(c)(3) nonprofit organization and that it can accept donations in the form of life insurance. To receive a tax deduction, you can donate your policy by naming the charity as both owner and beneficiary. As you make donations to the charity each year so that it can pay your policy’s premium, you can add the cash value of the policy and money you pay for premiums to your tax deductions.
Next Steps
Establishing a careful estate plan can positively affect your heirs now and in the future, and it’s an essential part of any financial plan. Your favorite philanthropic causes could also benefit. If you decide to include life insurance as part of your estate plan, you’ll want to make sure that it’s the right kind of life insurance, such as whole or universal life insurance.
Contact your financial advisor today to coordinate an appointment with one of our insurance specialists to discern which kind of life insurance as an estate planning tool is right for you and your financial situation. If your goal is to leave your loved ones and/or your favorite causes with the maximum amount of support possible, our team is ready to help.
