Enriching the IRS with your life insurance dollars — death benefits — at your family's expense makes my blood boil. Turning the insurance tax table on the IRS makes me one happy camper. You too can join the tax-saving fun. Become a happy camper.
I'm talking about dollars. Big dollars. Most business owners pour their life insurance dollars down two unnecessary tax-loser holes. The first hole while they are alive: by overpaying their 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% of the death benefit in the form of estate taxes, paid either at your death (say you are the insured) or the death of your surviving beneficiary spouse. Sorry, but once you go to the big business in the sky, it's too late to change a bungled life insurance tax plan.
Recently, I got a call from a long-time column reader, a 55-year-old (call him Joe) and second-generation business owner whose Dad (the founder of the business) had just died. It was sudden. No illness. No warning. Mom, on the other hand has been ill for years, with the long-term prognosis uncertain. The good news was there was just over $2 million in life insurance on Dad, with about $1 million going to the family C corporation, and the other $1 million deposited in a new bank account opened for Mom. But Joe was shocked when the family lawyer told him that Joe 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 of the policies totaled $725,800. Not even a $35,000 net profit to the family after Dad paid premiums for 34 years.
Even worse, the sisters were accusing Joe, the executor of Dad's estate, of shenanigans. Each had hired her own lawyer. A mess. An expensive mess.
Fortunately, it was easy to get the sisters and their lawyers to back o˚ when we were able to clearly show them that Mom and Dad were the victims of sloppy and really stupid tax planning by Mom and Dad's professionals.
Joe, at my request, did some digging for me. It turns out that Mom and Dad were healthy (they took annual physicals) just four years before Dad died. What follows is typical of what can be done (really what Mom and Dad should have done) with proper life insurance planning. And it's easy to do.
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. No income tax. No estate 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: This is not a slam dunk. Your professional advisers must have the knowledge and experience required to do it right.
Here's a basic three-step procedure to maximize your family's after-tax life insurance dollars:
1. Write down the total face value of your policies. That number — say, $1 million, for example — is the amount that must go to your family, all taxes paid.
2. Whether your policies are new or very old, have an independent third party analyze all 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. In order to make the proceeds tax-free, ownership must be in an irrevocable life insurance trust, a subtrust, or a family limited partnership or an intentionally defective trust. When done right, that $1 million (or your real number) usually doubles to $2 million or more without an increase in out-of-pocket premium cost.
Remember, life insurance is the easiest asset — if you make a mistake — to give the IRS a big pay day when you finally check out. It is also, when you do it right, the most tax-advantaged, wealth-creation investment you can make.