Although life insurance proceeds may be tax free for income purposes, they could result in significant estate taxes if they push your gross estate value over the state or federal exemption amount.
Fortunately, Federal estate taxes don’t kick in until you’re estate is over $5.45 million (or $10.9 million for married couples) in 2016. However, some states have their own estate or inheritance taxes. For example, Massachusetts has a $1 million estate tax exemption. Although you could increase that amount to $2 million with the help of an estate planner, this exemption is not subject to inflation and it’s likely that many people will exceed this threshold after adding up their investments, home, and proceeds from their life insurance policies.
While most would be hesitant to give up ownership of their investments or home to avoid estate taxes, it is a popular strategy to place a life insurance policy in an irrevocable trust. Assuming the trust is drafted and funded properly, the irrevocable trust will become the owner of the life insurance policy. Since you are no longer the owner, its proceeds would no longer be part of your estate – effectively reducing your Massachusetts estate taxes significantly (if not entirely).
Before jumping into this strategy it’s important to be aware of a couple things. First, if you are funding this trust with an already existing policy, but pass within three years of doing so then the proceeds will still be included in your estate. Also, if there are signs that you still have control over the life insurance policy (i.e. “incidents of ownership”) then the proceeds will still be included in your estate.
For this reason, it’s important that you speak with an experienced attorney when setting up and funding the trust. If you are interested in pursuing this strategy or would like to learn more about your estate planning options then feel free to contact Simmons & Schiavo at (781) 397 – 1700.