How Life Insurance Can Affect Estate Taxes

Some combinations are delightful, like chocolate and peanut butter. But when life insurance mixes with estate taxes, the results can be good or bad. If you have significant assets, understanding this intersection is essential.

The IRS exempts the first $5.45 million from estate taxes for people who die in 2016. Only the amount of an estate above the exemption level is subject to federal estate taxes. If your estate’s value is $5.45 million or less, your heirs would not owe any tax on their windfall. If your estate is worth, say, $6.45 million, then $1 million would be subject to federal estate tax.

It’s unlikely the estate tax will affect you. Among people who died in 2013, the latest data available, fewer than one of every 500 estates was subject to federal estate tax, according to the Joint Committee on Taxation.

How life insurance comes into play

There are two main reasons to pay attention to life insurance if you have a sizable estate.

1. Life insurance proceeds could become part of your estate

For many people, leaving life insurance to family members doesn’t trigger taxes. But if the life insurance money goes into your estate and pushes the estate’s value above the exemption level, your heirs could owe estate taxes.

Let’s say your estate is worth about $5 million before your death, you have a $2 million life insurance policy, and the payout goes into your estate after your death. That $2 million just made your taxable estate worth more than $5.45 million, meaning tax is due.

How can life insurance money end up in your estate?

• If you name the estate as the beneficiary.
• If you are the policy owner and your beneficiary is someone other than your spouse. For example, if you’re the policy owner and your children, other family members or friends are the beneficiaries, the payout counts toward the taxable estate.

To avoid this, make sure that you’re not the policy owner and that the estate itself isn’t named as the beneficiary. An estate planning lawyer can help guide you. You can:

• Transfer ownership of the policy to another person, like your spouse.
• Transfer ownership of the policy to a trust.

But don’t dilly-dally too long: If you die within three years of transferring the policy, it can still count as part of your estate. In addition, the transfer could be subject to gift taxes if the policy has a cash value of more than $14,000 (that’s the annual gift tax exemption for 2016).

2. You have a taxable estate, and you want to help heirs pay the taxes

You may hear of using life insurance for “estate planning purposes,” and this is where a policy’s payout can be instrumental in passing on wealth: Some wealthy individuals buy life insurance so the policy provides the money for heirs to pay the tax man. This is especially advantageous if your estate’s value is tied up in property, such as real estate or a business. Remember, your heirs have only nine months to pay the federal tax bill. If they had to sell off assets in a lousy market, they could lose out on considerable value.

Certain types of life insurance, such as whole life and universal life, are suitable for this purpose because they last your entire life. Term life insurance does not work because the term could expire before your death, leaving your heirs without the cushion of a payout.

However, term life insurance is ideal if you want life insurance to cover specific financial obligations after your death, such as living expenses for your family or paying off your mortgage.

» COMPARE: NerdWallet’s life insurance comparison tool

So, what’s your estate really worth?

Here’s what’s counted in your estate:

• Cash and securities
• Real estate
• Insurance, trusts and annuities
• Business interests
• Other assets

And here’s what’s subtracted from the above total:

• Estate administration expenses (such as the executor’s commission, attorney’s fees and court costs related to the estate)
• Property left to a spouse
• Mortgages and other debts
• Property left to charities

Once you know the value of your estate, you can figure out whether it will be subject to estate taxes. Remember that the IRS exempts the first $5.45 million from estate taxes for people who die in 2016.

Passing your estate to heirs

When talking about estate taxes, by heirs we often mean children or grandchildren but not your spouse. You can pass an unlimited amount to your spouse tax-free as long as he or she is a U.S. citizen, a tax rule often called the unlimited marital deduction.

If tax is due, your heirs will have nine months after your death to pay any federal estate tax. The estate tax rate is 40% and applies only to the amount above the exemption. So on a $6.45 million estate, the tax due would be $400,000 (40% of $1 million).

Exemption amounts are “portable” from spouse to spouse. If your spouse passes away, any “unused” exemption amount can go to you, for a maximum exemption total of $10.9 million.

Don’t forget about state estate taxes

A $5.45 million estate sounds pretty large, and you might dismiss estate taxes as a nuisance that has nothing to do with you. But don’t forget that states often impose their own taxes, which could make you reassess your life insurance needs.

For example, New Jersey’s estate tax exemption is just $675,000. A nice house in Montclair would easily exceed that. Make sure you know your state’s exemption level. The Tax Foundation has more information on state-by-state exemptions and tax rates.

Remember, help is available

Don’t go it alone in estate planning. Enlist the help of a financial planning professional who can make sure you’re laying down the best foundation for a financially sound future for your heirs.

Amy Danise is an editor at NerdWallet, a personal finance website. Email: adanise@nerdwallet.com. Twitter: @AmyDanise.