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Estate Planning

Debunking Estate Planning Myths & Developing Wealth, Pt 2

By March 28, 2012No Comments

As mentioned in Part 1 of this series, powers of attorney last until death, so they protect you and your loved ones now.  The other tool that can protect your loved ones immediately upon death is life insurance.  From a very basic perspective, life insurance is used to replace the income of a loved one. If you’re a single parent, I need not tell you how absolutely critical it is to have life insurance, because for single parents, life insurance can provide a lot more, which involves the intermediate techniques I will  discuss in Part 3.

Some things cost twiceHowever, before I continue, another myth needs debunking: Life insurance IS considered part of your estate for estate tax purposes.  Most people think it is not but that is because typically life insurance proceeds aren’t considered taxable for income tax purposes.  However, income taxes and estate taxes are two separate issues.  So what does this mean?  If you currently have or are close to having a taxable estate when considering the value of your home, retirement accounts, investment accounts, and other assets, then if you include a sizable life insurance policy with those assets, you will likely pass the taxable estate threshold.

Right now, few individuals come close to having a taxable estate because the federal tax exemption is high right now – $5.12M, and the marginal tax rate is relatively low – 35%.*  Additionally, Illinois, which is not linked (or “coupled”) with the federal tax system is also relatively high – $3.5M and our marginal tax rate is 16%.*  Now, I’m going to save the bulk of what this means in terms of planning for the next blog entry, but know that if Congress doesn’t do anything by December 31 of this year, the federal exemption is going to be reduced to $1M and the tax rate increased to 55%.  That means that if someone dies in 2013 with $1.8M or more in assets, their beneficiaries may likely face a federal tax bill on the $800,000 excess!

Let’s look at this example:

Single Parent Sheila owns a 6 flat that’s worth about $700,000, has about $250,000 in retirement benefits, and then has $500,000 worth of life insurance and, unfortunately dies next year, those life insurance proceeds and part of those retirement benefits will be needed to pay taxes if Congress or Sheila doesn’t do anything.

Lesson: Parents should be careful when purchasing life insurance because life insurance is necessary but it is not always ignored by Uncle Sam.

* 2013 update: The federal estate tax exemption is $5.25M indexed for inflation with a marginal rate of 40%; and the Illinois estate tax exemption is $4M.

Part 1 | 2 | 3 | 4 | 5

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