Using Life Insurance to Cover Estate Taxes


Probably the most underrated – an under-used – benefit of having a life insurance policy is having it to cover estate taxes. These are taxes that are levied on estates transferred from one generation to another, above a certain minimum dollar threshold amount.

Depending on how large your estate will be, the taxes may or may not apply to your estate. But if they will be a factor, life insurance is the best way to pay them without having to disturb the actual assets that you plan to pass on to your heirs.

The cost of estate tax rates

At the federal level in the United States, the estate threshold is high. Under current law, an estate is not taxed unless the amount transferred exceeds $5.25 million. However once that threshold is exceeded, the taxes can be steep. They can top out as high as 40%.

These taxes can come as a shock to the heirs of a large estate. A person can amass a fortune in excess of $5.25 million without even realizing it. Though assets are easy to see when they’re sitting in stocks and bonds in an investment portfolio, or in bank assets like certificates of deposit, there are other places where they are not so obvious.

For example, real estate purchased 30 or 40 years ago for just a few hundred thousand dollars may now be worth well into millions of dollars. An even bigger hiding place is the value of a business. A very successful, but privately held business can quietly grow to be worth millions of dollars.

The combination of a portfolio of financial instruments, real estate equity, and business interests can cause an estate to be deceptively large. If that is the case, estate taxes may apply.

Estate taxes at the state level

Though the threshold for estate taxes at the federal level is over $5 million, most states also levy estate taxes, and they may apply on much lower amounts. This can catch the unwary estate owner – or the estate beneficiary – by complete surprise. Just because they are under the threshold for estate taxes at the federal level doesn’t mean that the estate will pass tax-free. The state tax rates are lower than the 40% levied at the federal level, but they can still cause problems for beneficiaries.

This is particularly true if most of the estate is tied up in physical assets, such as real estate and business equity. Generally speaking, estate taxes will be due (within nine months at the federal level) even if the bulk of the estate’s assets are not in liquid form. This can force the beneficiaries of the estate to scramble to find ways to raise cash to pay the tax bill.

But a sufficiently large life insurance policy will eliminate the need for this liquidation. It may even help to preserve the value of the estate assets by preventing the need to hold a “fire sale“, in which physical assets are sold for substantially less than the true value in order to pay an impending tax bill.

Determining how much life insurance you need

It’s often not possible to determine an accurate estimate of the tax consequences when it comes to estate planning. This is because both the estate thresholds and estate tax rates do change periodically. In addition, asset values can fluctuate wildly between now and the time of death – an estate can be worth substantially more, or substantially less, than what it is right now. Determining a reasonable figure for estate tax is at best an educated guess.

If it looks as if you have sufficient assets that may trigger the estate tax – certainly anything in excess of $1 million – you should sit down with an estate planner and work out some likely projections as to what your tax liability might be in your state. Armed with that knowledge, you can take a life insurance policy that will be sufficient to pay the tax burden, and allow all of your assets to transfer to your beneficiaries in the amounts that you plan.

Other estate issues

When it comes to transferring estates at death, there is another issue that goes beyond income taxes, and life insurance can help with this is well.

If an estate contains a significant amount of physical assets – again, like real estate and business equity – and it is to be split among multiple beneficiaries, there may be insufficient liquid assets in the estate make the division equitable.

Let’s say that you have an estate that’s 20% liquid assets, 40% real estate equity, and 40% business equity. You have three children – three heirs – that you want to split the assets between equally. But one child has expressed interest in the business, one in the real estate, and the third in neither. Since there is an imbalance in the valuation of the assets, the only way to make an equitable distribution – to split the estate in three equal parts – will be liquidate certain assets.

But a sufficient amount of life insurance can eliminate the need for liquidation. You can use a life insurance policy to increase the amount of liquid assets that are in the estate, which will make splitting the estate in equal parts much easier to do.

Moral of the story: just because your estate will be below the threshold for estate taxes doesn’t mean that there won’t be estate-related problems. Whether it’s estate taxes or equitable distribution of estate assets, a life insurance policy can help settle your estate with a minimum amount of stress and financial disruption.