Perhaps the biggest estate-planning mistake I see is people owning their own life insurance policies. Many people assume, and rightly so, that by taking out an insurance policy on themselves, they are creating a liquid asset for their heirs to pay any estate taxes. This is an admirable sentiment; and it will work that way. However, that doesn’t mean that you want to actually own the policy. If you have a large estate and own your own life insurance policy, you will only be making your estate larger when you die. This is why, although the government has decreed that life insurance policy benefits may pass to the beneficiaries tax free, the death benefit will be included as part of the estate of the policy owner.

For example, Alice and Tom Client have a joint net worth of $8 million. They have split up their estate into two bypass trusts, so each estate is worth $4 million. However, they are both pretty sure that they won’t live long enough to see the repeal of the estate tax in 2010. Therefore, their beneficiaries will have to pay some estate taxes when either one (or both) of them dies. Tom takes out a life insurance policy on himself for $750,000. While he’s not sure how much his estate taxes will be, he feels comfortable that the death benefit from the insurance policy will cover most, if not all, of the taxes due. Alice also takes out a $750,000 policy on herself. Both Alice and Tom own their own policies. If Tom were to die today, only $1 million of his estate would pass to his heirs tax free. The remaining $3 million will be taxed.1  Plus, since he is the owner of his insurance policy, his estate has now increased by $750,000 overnight, making his total gross estate worth $3,750,000! If Alice were also to die right now, her estate would be the same. Their beneficiaries would have to pay estate taxes on her $3.75 million. They would have the two death benefits of  $750,000 each, but would have to come up with the remaining tax money on their own or directly from the estates.

Now, if Tom and Alice were to die at the same time, their heirs would have to pay estate taxes on the two estates combined. That would mean a total taxable estate of $7.5 million. If Tom and Alice’s estates were to fall into the top estate tax bracket (50 percent in 2002), their heirs would be responsible for $2.42 million in taxes. The beneficiaries would have the combined death benefits of $1.5 million to help pay the taxes, but they would be left to come up with $920,000 on their own.

Combined estates

But, if neither Tom nor Alice owned their insurance policies, their taxable estates would not include the death benefit. So continuing with our example, both Tom’s and Alice’s taxable estates would be $3 million apiece. If they were both to die at the same time, and assuming top tax rates, the estate tax due would be $1.56 million. Their heirs would only have to come up with $6000 for the rest of the taxes.

One of the best ways to have your life insurance policy, but not actually own it yourself, is to have one of your heirs own the policy. If you have children, you could ask one of them to own the policy, which would cover your life and name all the beneficiaries you wanted. In order to pay for the policy, you could then gift that child the money necessary to pay the premiums (up to the maximum gift allowance per year), which would not only help provide liquidity at your death, but would also help lower the amount of your estate through your annual gifts. Plus, depending on how long the policy is in force, your total premiums paid will be much less than the death benefit.

Another way not to own your own insurance policy is to have your trust own it. We have already discussed the irrevocable life insurance trust, but by placing your insurance policy within your trust, you remove it from your estate, which will lower your taxable estate at your death.