Enriching the IRS with your life insurance dollars (death benefits) at the expense of your family makes my blood boil. Turning the insurance tax table on the IRS makes me one happy camper.
I’m talking about big dollars. Most business owners pour their life insurance dollars down two unnecessary tax-loser holes. They pour money down the first hole while they are alive—by overpaying premiums, carrying the wrong kind of insurance, having the policy owned by the wrong person or entity, and a host of other mistakes. Fortunately, while you are alive, we can usually correct these tax-expensive mistakes.
The second hole can rob you of up to 55 percent of the death benefit in the form of estate taxes, paid either at your death (if you are the insured) or at the death of your surviving beneficiary spouse. Once you go to the big business in the sky, it’s too late to change a bungled life insurance tax plan.
I recently got a call from a reader, a 55-year old (call him Joe) and second-generation business owner whose father (the founder of the business) had just died suddenly. His mother had been ill for years, and the long-term prognosis was uncertain. The good news was that there was just more than $2 million in life insurance on Dad, with about $1 million going to the family C corporation and the other $1 million being deposited in a new bank account for Mom. But Joe was shocked when the family lawyer told him that he and his two sisters would only net about $760,000 after all taxes when Mom passed on (assuming Mom died after 2010).
After receiving a small mound of paper, I confirmed that the lawyer was right. Worse yet, the cash surrender value (CSV) of the policies totaled $725,800. This would be not even a $35,000 net profit to the family after Dad paid premiums for 34 years.
Joe did some digging. It turns out that Mom and Dad were healthy (they took annual physicals) just 4 years before Dad died. What follows is typical of what can be done (what Mom and Dad should have done) with proper life insurance planning.
Dad could have used a combination of his CSV and the money in his profit-sharing plan ($850,000 was in the plan when Dad died) to buy $7.5 million of second-to-die life insurance on Mom and Dad’s lives. Every dollar of the $7.5 million would have gone to Joe and his sisters free of tax.
Joe changed his wealth transfer plan to do what Dad didn’t do: He turned about $1.5 million in taxable life insurance into more than $6 million (half on his life and half second-to-die) in tax-free coverage without increasing his out-of-pocket premium cost. You can, too. Warning: Your professional advisors must have the knowledge and experience required to do this right.
Here’s a three-step procedure to maximize your family’s after-tax life insurance dollars. 1) Write down the total face value of your policies (we’ll say $1 million, but substitute your own real number). That is the amount that must go to your family, all taxes paid. 2) Have an independent third party analyze your policies to determine that you are with the right companies, have the right kind of policies and are paying the premiums in the most tax-advantaged way. 3) To make the proceeds tax-free, ownership must be in: a) an irrevocable life insurance trust; b) a subtrust; or c) a family limited partnership or an intentionally defective trust. 4) When done right, that $1 million (or your real number) usually doubles to $2 million (or more) without an increase in premium cost.
Remember, if you make a mistake, life insurance is the easiest asset to give the IRS a big payday when you check out. But when you do it right, it is the most tax-advantaged, wealth-creation investment you can make.
To help you get started, I have arranged for readers of this column to have their life insurance coverage professionally analyzed without any cost or obligation. Send your policy information to Insurance Test, Blackman Kallick Bartelstein, LLP, 10 South Riverside Plaza, Suite 900, Chicago, Illinois, 60606. If you have questions, call me.