Why Life Insurance Should Be a Serious Consideration in the Estate Plan

Life insurance can play a crucial role in estate planning. Most often it is the most efficient and least costly method to use for heirs to cover the estate tax. In today’s blog, we will cover this topic in more depth. In addition to the estate tax payment, however, it can also provide several other benefits. Let’s mention those first:

1.?? ?Liquidity: Life insurance can provide immediate liquidity to an estate, which is particularly important if most of the estate's value is tied up in illiquid assets like real estate or a business. This can be used to pay estate taxes, debts, or any other immediate expenses, preventing the need for a hasty sale of assets.

2.?? ?Wealth Replacement: If you've planned to give a significant portion of your wealth to charity, a life insurance policy can replace that wealth for your heirs. This allows you to make charitable contributions during your lifetime without reducing the inheritance you pass on.

3.?? ?Estate Taxes: Life insurance can be used to pay any estate taxes that might be due upon your death. This can be particularly beneficial for high-net-worth individuals, as estate taxes can be quite significant.

4.?? ?Equalizing Inheritances: If your estate includes assets that can't be easily divided (like a family business), a life insurance policy can be used to "equalize" inheritances among your children. For example, one child might inherit the business, while the others receive the life insurance proceeds.

5.?? ?Income Replacement: For younger families, life insurance can provide an important source of income replacement. If the primary earner dies unexpectedly, the life insurance proceeds can ensure that the family continues to have a source of income.

6.?? ?Establishing a Legacy: Life insurance can be used to create a financial legacy for your heirs, providing them with a significant inheritance even if you haven't had time to build substantial wealth.

7.?? ?Estate Creation: A life insurance policy can help create an estate where none existed before, especially for those who haven't had time to accumulate a significant amount of assets.

8.?? ?Business Planning: For business owners, life insurance can be a part of succession planning or used to fund buy-sell agreements.

Estate Tax:

Passing on our legacy to future generations can be significantly impacted if proper planning for the payment of estate taxes is not done. Estate taxes can present a significant financial burden that can go up to 40% for the large estates and are typically due within 9 months. There are several methods that heirs can use to pay them:

1.?? ?Out of Pocket: If the heirs have substantial assets of their own, they may choose to pay the estate taxes out of pocket. This can be a straightforward method, but it requires the heirs to have a significant amount of readily available liquidity.

2.?? ?Selling Assets: Heirs may choose to sell some of the assets they inherit to cover the estate tax. This can be a problem if the assets have decreased in value or if the market conditions are unfavorable. In some cases, heirs might have to sell assets they would rather keep, or in the case of expediency, might have to sell the assets at the discount.

3.?? ?Installment Plan: The IRS allows heirs to pay the estate tax in installments over a 14-year period under certain conditions. However, interest accrues on the unpaid balance.

4.?? ?Borrowing: Heirs can borrow to pay the estate tax. This could be a viable option, but it might be difficult if the heirs don’t have sufficient creditworthiness, and it also incurs additional interest costs which is a major issue in today’s interest rate environment.

5.?? ?Estate Tax Deferral: The IRS allows tax deferral on closely held businesses. In this case, the tax attributable to the business interest can be deferred for 5 years and then paid in 10 annual installments. This still results in eventual payment with interest.

6.?? ?Life Insurance: A life insurance policy can provide a lump-sum payment upon death that can be used to pay estate taxes. It offers an immediate source of liquidity and won't require the sale of assets or incurring debts. In addition, the premiums paid for the policy are significantly less then the death benefit paid out to the heirs.?

Given that all the other options mentioned above involve either a dollar-for-dollar asset to tax sale, or an additional interest applied to the amount owed, life insurance comes out as the best (least costly) and most efficient method for the following reasons: ?

• Liquidity: Life insurance provides immediate cash upon the death of the insured. Unlike assets, which might take time to sell or could decrease in value, a life insurance payout provides a guaranteed, immediate source of funds.
• Efficiency: Life insurance proceeds are generally income-tax-free and, if structured properly through an irrevocable life insurance trust (ILIT), can be estate-tax-free. This allows the full face value of the policy to be used to cover the estate tax bill.
• Cost-Effective: Depending on the health and age of the insured, life insurance is the most cost-effective method of paying estate taxes. The premiums paid may be significantly less than the eventual benefit received.
• Preserves Wealth: It enables heirs to keep the estate intact by not requiring the sale of assets to pay estate taxes.
• Predictability: The death benefit of life insurance is predetermined and not subject to market fluctuations.

Example for the estate worth $50M.

With the estate tax exemption in 2023 at $12.92 million per individual or $25.84 million for a married couple (with some basic planning), if the estate worth is $50 million, the taxable amount would be $50M - $25.84M = $24.16M. Lets take a look at each payment method:

1. Out of Pocket: Heirs could pay the estate tax from their personal assets. At a 40% tax rate, they would owe $9.664M ($24.16M * 40%). They would need to have this amount readily available.

2. Selling Assets: Heirs could sell a portion of the inherited assets to cover the estate tax. They might need to sell more than the $9.664M owed due to transaction costs, market conditions, and potential capital gains taxes.

3. Installment Plan: The IRS allows certain estates to pay the tax in installments over up to 14 years. The heirs would owe $9.664M, plus interest over the installment period.

4. Borrowing: Heirs could borrow to cover the tax bill. They would have to repay the loan principal of $9.664M, plus any interest, according to the loan terms.

5. Estate Tax Deferral: If the estate is primarily a closely-held business, the IRS allows some tax deferral. The heirs could defer payment for 5 years and then pay the $9.664M in 10 annual installments, plus interest.

6. Life Insurance: A life insurance policy with a death benefit of at least $9.664M could be used to cover the estate taxes. The premiums would need to have been paid by the estate or by the individual prior to death. Typically in the estate planning cases, permanent insurance policy would be used because it would need to last for the life time. The premiums could range significantly depending on the type of policy, insured age, health, and the policy structure. In most cases though, an individual in a decent health and in his/her 50s should expect to be able to cover this estate tax cost at 30-50 cents on a dollar because the death benefit paid out would be larger than the premiums paid in. In addition, if the policy is held outside of the estate (irrevocable trust) all the proceeds would be excluded from the taxable estate.

Again, remember, the efficacy of life insurance as a method to cover estate taxes can depend on the insured's age, health, and other factors. In addition, these calculations are simplified and do not account for factors such as potential state-level estate taxes, deductions, credits, or other considerations that could affect the tax owed.?

As with any other financial tool at our disposal, life insurance will work for some and not for others. In either case it should be one of the considerations when putting your estate plan together, especially in the cases where a significant multi-million estate tax could be expected. In many instances it could be the least costly and the most streamlined and efficient method of making sure your legacy is passed on to your heirs in its entirety. Please remember, professional advice is key when dealing with estate planning complexities.

Ascent Wealth Strategies provides strategies for financial/estate and/or tax planning. These strategies do not constitute tax or legal advise. Consult legal or tax professionals for specific information regarding your individual situation.

Clear Creek Financial Management, LLC dba Ascent Wealth Strategies is a Registered Investment Advisor. This case study is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Clear Creek Financial Management, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Clear Creek Financial Management, LLC unless a service agreement is in place.