A Smart Retirement Plan Includes Life and Disability Insurance

“Will your beneficiaries receive death benefits free of the federal estate tax?”

Your long-term personal financial plan should include sufficient life and disability insurance as a key planning element. With the proper balance and advance planning, you can collect life and disability insurance proceeds free of federal taxes.

MarketWatch’s recent article, “How to avoid the federal estate tax when collecting life insurance proceeds,” provides some good information on how to do that.

Life Insurance. Most people have life insurance policies to replace income that would be lost if they were to pass away unexpectedly. The beneficiary of a life insurance policy can usually get life insurance death benefit payments without incurring federal or state income tax. But what about federal estate tax?

When you are considered the owner of a policy on your own life, the death benefit is included in your taxable estate. The exception to this rule is if the money goes to your surviving spouse and your spouse is a U.S. citizen. However, when the death benefits go to a non-spouse beneficiary—like a child—without passing through your estate, that money is still included in your taxable estate. If the value of your estate is more than the federal estate tax exemption of $5.49 million (or a combined $10.98 million for you and your spouse), your heirs will have to wait for the IRS to collect taxes on that amount.

Accordingly, if a wait to avoid having life insurance death benefits included in your taxable estate would mean incurring estate taxes, you should ask an experienced estate planning attorney to create an irrevocable life insurance trust to own the policy. The irrevocable trust would pay the premiums, and the death benefits would be paid directly to the trust’s beneficiaries. That way your estate isn’t involved at all. There is no federal estate tax on the death benefit and no federal income tax.

One issue with this strategy is that if you transfer an existing policy to the life insurance trust and die within three years, the death benefits will be included in your taxable estate. To eliminate this issue, you can have the trust buy a new policy on your life, if it’s possible (sometimes it’s not due to health restrictions). Speak with an estate planning attorney before you do anything, because transferring existing policies with cash values over $14,000 could have an adverse gift tax impact.

Work with an experienced estate planning attorney to get the trust created properly.

Disability Insurance. A long-term disability (LTD) policy can protect against lost earnings during a long disability. However, it’s common for LTD policies to limit the benefits to just 60% or 70% of your pre-tax earnings. If you must pay income taxes, count on losing 30% to 40% (or more) to the IRS and your state department of revenue. It means that your coverage could be insufficient. Paying taxes on LTD benefits can really take a bite out of your benefit.

LTD benefits are usually federal-income-tax-free, if you pay the premiums yourself. However, if your employer pays the premiums as a tax-free perk, the LTD benefits will be taxable to you. Likewise, if you set aside some of your salary to pay the premiums with before-tax dollars under your employer’s cafeteria benefit plan. To address this issue, if LTD benefits would be taxable because your employer is paying the premiums, have the premiums paid with after-tax dollars by withholding funds from your paychecks. That means the premiums are treated as part of your taxable salary, causing a bit of an increase in your income tax bill. But any LTD benefits will be tax-free. You can also buy a supplemental LTD policy with your own money. Benefits from your personal LTD policy will be tax-free, because you paid the premiums with your own money.

You can help protect yourself and your loved ones from unanticipated events, by including life and disability insurance in your financial planning.

Reference: MarketWatch (July 19, 2017) “How to avoid the federal estate tax when collecting life insurance proceeds”