The Life Insurance Rescue Plan

life insurance rescue plan

If you’re thinking about estate planning, chances are you already own life insurance. If so, good job! Life insurance proceeds are generally not taxable, and you are taking steps to protect your wealth for future generations.

But before you pat yourself on the back and go for another round of golf, you need to know this: some life insurance proceeds will still become a taxable part of your estate, and thereby lose the main benefit (a predetermined, tax-free payout to your beneficiaries). You probably were not planning for Uncle Sam to become one of your life insurance beneficiaries.

Take the Test

Life insurance benefits become taxable as part of your estate in two cases:

  • When your spouse is named as your sole beneficiary.

If they die after you (as the policy expects), the money that they received from your death benefit (assuming they haven’t spent it all) will become part of the taxable estate when they die. If they happen to die before you, the proceeds go back to your estate.

  • When the total estate exceeds the federal estate tax exemption limit.

From now through the end of 2025, that limit is about $22 million per couple, but reverts to about $11 million per couple in 2026 (see our  estate tax blog). Let’s say you have an $11 million estate, plus a $10 million life insurance policy. If you die after 2026, that $10 million will be taxed at 40% (even though it is a life insurance death benefit), so $4 million would go to pay federal estate taxes (not to mention state taxes, if applicable).

Don’t Drop it Like it’s Hot

If your life insurance policy will be taxable, you may want to remove the policy from your estate. But do you give it away? If so, you run the risk of it still being considered part of your taxable estate; you need to live at least 3 years after the transfer for the policy to be removed from your estate. And if you let the policy lapse or sell the policy through a life settlement, you may trigger capital gains or income taxes.

Enter the Rescue Plan

This is where the life insurance rescue plan swoops in to save the day. Here is how it works:

  1. Exchange your current plan for an immediate annuity. This exchange is tax free (also known as a 1035 exchange).
  2. The immediate annuity will pay you an income that’s part taxable, part tax-free. You can use the after-tax proceeds for a gift to an irrevocable trust.
  3. The trustee of your new trust can use the money to buy life insurance on your life, or for both you and your spouse.
  4. Now the insurance proceeds will avoid estate tax and income tax. Congratulations! You can now pat yourself on the back and go for another round of golf.

Set it to Warp Speed

But wait! Let’s take our example even further. Let’s say you have a $10 million policy that you paid into for 30 years (on top of an $11 million estate, as per above). After you complete the life insurance rescue plan, you find that the annuity payout is enough to actually increase your life insurance coverage to $14.5 million. In this example, you not only save $4 million from taxation (by removing the policy from your taxable estate), but you add $4.5 million to the death benefit, for a total savings of $8.5 million!

You won’t have to pat yourself on the back anymore once that is set up; your kids will do it for you. By taking some time to plan, you may be able to leave a much larger legacy to your family.

If you are interested in discussing how the life insurance rescue plan could work for you or your affluent clients, let us know. Axia Global would love to help. Our goal is to make a measurable difference in your financial life.

Note: the statements above should not be considered financial, legal or tax advice, but ideas for careful consideration with your trusted financial advisors and lawyers. For current tax or legal advice, please consult with an accountant or an attorney.