Life insurance.
This probably ranks up there with one of the most mis-understood products of all time. And for good reason too – it is more often sold than purchased. In other words, people are convinced to purchase what to buy because they don’t know how to do it on their own. We all lean into advice and trust the process.
Now that doesn’t mean people don’t know they need it. It just means they don’t know how much or what type is best for them. Instead, someone sells them otn the right amount and type of insurance. Yet, the math is fuzzy and one salesperson will recommend something while another will recommend something completely different. And thus, we end up with a misunderstood product.
Life insurance has several real practical uses – and I’ll be blasted for narrowing it down to these things: (1) provide for family if current and future income is lost, (2) provide liquidity for a business owner(s) or others in need of liquidity if a person dies, and (3) help pay estate taxes.
Most people don’t have to worry about estate taxes as currently a married couple can pass nearly $26 million to heirs without paying estate taxes (and individuals can pass $12.9 million). Providing liquidity for a business owner is something we will address separately in a discussion on key-man insurance and buy-sell agreements.
So most people are in it for #1 – to provide for the family if an income is lost due to death. This concept is simple. If someone makes $100,000/year and they are gone then the family likely needs to have something to tap into to pay for that. Life insurance fills that void. We take the income over a period of years and essentially capitalize it to get an amount of life insurance you need.
For entrepreneurs and founders, there’s a bit of a problem in this simple line of thinking.
One, your income is likely artificially low as you expect the business you are building to generate a large amount of financial wealth – above and beyond the income it is providing you.
And the estate tax exemption amount is scheduled to be cut in half on January 1, 2026. This means that a couple will only be able to pass approximately $12.9 million to heirs (and an individual only able to pass approximately $6.5 million).
Many startup founders have a paper net worth near or above that based on their capital raises. When potential growth of company stock over the next 5-10 years is taken into account, the likelihood is an even greater amount of net worth will exceed the estate tax exemption amount.
What does this mean? Let’s take a simple example and assume on January 2, 2026 Johnny dies with an estate (i.e., net worth) of $6.5 million – and for oversimplification we are going to assume the estate tax exemption amount is also $6.5 million. He’s not married but leaves behind two kids (15 and 12). They’ll each receive $3.25 million – hopefully in Trust since they are minors. Given his estate is at or under the exemption amount, they will not have to pay any estate taxes.
Now, let’s assume Johnny also had a $2 million life insurance policy he bought years ago. Johnny is the owner of the policy and the insured while his two kids are beneficiaries of the policy (again hopefully through trusts). Unfortunately, Johnny’s kids won’t benefit from the full $2 million. The federal government is now going to step in and ask for their fair share of the proceeds. In this instance, the government will look at a total estate of $8.5 million and subtract the Federal exemption amount of $6.5 million. This leaves Johnny with a taxable estate of $2 million. The 40% tax will leave the true net benefit of the life insurance proceeds at $1.2 million – and the government will take the other $800k (and that’s assuming the state Johnny lives in doesn’t also have an estate tax).
The hard truth is Johnny was paying for a $2 million life insurance policy but the true net benefit to his heirs was only $1.2 million. Clearly Johnny was paying for more benefit than he received.
Fortunately, it doesn’t really take much to make the estate tax disappear. Johnny can set up an Irrevocable Life Insurance Trust (ILIT). Johnny makes annual gifts to the insurance trust and the insurance trust uses the gift to purchase and make premium payments on a life insurance policy on Johnny. At this point, the Trust is the owner and beneficiary of the policy, Johnny is the insured, and his children are the beneficiaries of the Trust.
Now when Johnny passes away, his estate is worth $6.5 million and the insurance Trust he set up now received the $2 million life insurance proceeds. But Johnny doesn’t own the policy – the Trust does – so the death benefit is not included in Johnny’s estate tax calculation. Johnny’s two kids still receive the $6.5 million (hopefully in a trust) AND they receive the $2 million in proceeds from the Trust (hopefully not outright). And the best part is the Federal government gets $0.
The good news is this can work with a spouse too. The surviving spouse can be the income beneficiary of the ILIT so s/he receives distributions during the rest of his/her life with any principal going to their kids (as set out originally when Johnny establishes the ILIT).
Naturally, there is more to it than that. The gifts Johnny makes to the Trust should qualify as current year income gifts. This means the beneficiaries of the Trust need to have access to the gift for a period and receive written notification when a gift has been made. This is handled fairly easily, though, and your estate attorney, financial planner, or accountant should be able to assist with the process.