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An Estate Planning Case Study: Too Much Life Insurance

Posted by Larry Jones on Nov 16, 2021 9:30:00 AM
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The Scenario:

Jack Howard, age 70, and his wife Marcy, 64, are very comfortable financially. Jack made a large amount of money from a series of successful patents obtained through the years. The value of Jack and Marcy's estate is calculated to be $11.9 million. Included in that amount will be a $1 million life insurance payout, from a policy on Jack, to Marcy. The life policy currently has a cash value of $700,000

Unfortunately, that million dollars will be included in Marcy's estate when she dies, and it will push her over the Estate and Gift Tax exemption, which is $5.45 million for the first to die, and then is rolled over to the surviving spouse, for a total exemption of $10,900,000. That will leave an estate tax bill of around $400,000. Now, that amount can easily be obtained from the life insurance payout. But is there a better way?

More than one way to skin a cat:

Here's a creative way to beat the above scenario:

(note: this solution assumes good health for Jack and Marcy at the time of implementation)

1. Exchange the life insurance policy for an immediate income annuity. We need to remove that million from the estate. That could be done through giving it to children, or a trust. However, Jack would need to live for three years or the money would still be includable in his estate if he simply gifted it. He would also compromise his gift tax exemption. Under section 1035 of the tax code, however, Jack could roll the cash value of this policy into the annuity with no tax consequences. 

2. The immediate annuity will now begin paying Jack a monthly income. Part of this money will be taxable, but with the remainder he should have enough to make a gift to...

3. An Irrevocable Trust This trust has been previously put in place by Jack. The Trustee has been instructed to take the money that Jack (and Marcy) will gift each month and use it to buy a $1.5 million dollar second-to-die life insurance policy on Jack and Marcy. Now the insurance proceeds will avoid estate and gift taxes. The benficiaries of the trust will now be able to keep all of the proceeds.

The Result:

Instead of paying $400,000 to Uncle Sam, now the kids will get to keep 100% of the estate, with no tax consequences. PLUS the proceeds from the $2 million insurance policy, also tax-free. The old way was worth $11.5 million to the heirs, but with this method they'll inherit an estate worth $12.4 million. That's a net gain of $900,000! There might even be some money from the immediate annuity coming to them, according to the terms of that contract.

The numbers above may need to be massaged a bit to keep inside of gift tax exclusions, and to account for variations on the prices of life insurance, but you can see the concept and how it works. Keep in mind that this is not intended to be legal or tax advice. These solutions should be examined by your attorney and CPA before implementation. Any trust should be designed by a competent estate attorney.

I love a happy ending, don't you?

Until next time,


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