If you have done everything possible to minimize any estate tax liability and ultimately still owe estate tax, the question that often arises is “what is the best way to pay the estate tax?”
One of the most important goals of estate planning is to provide for sufficient liquidity in a decedent’s estate. In addition to probate costs, funeral expenses, legal fees and debt that may come due at death, the federal estate tax is generally due nine months after the date of death. Without liquidity in the estate, the executor and the heirs of the estate may need to sell illiquid assets such as real estate, or liquidate marketable securities in an unfavorable market, such as we are experiencing now, to raise cash within a short period of time.
I will explore some funding options for paying the federal estate tax:
- Borrow money to pay the estate tax liability: Most banks and financial institutions will provide an individual or an estate loan as long as there is sufficient collateral (estate assets) against the loan. If the estate tax liability is $1,000,000, you may be able to get a loan for the $1,000,000 estate tax liability, but it comes at a price… large payments of interest.
- Selling estate assets to pay the estate tax liability: This is the often the most logical choice to fund the liability when no formal plans have been made to pay the tax. It can, however, have drastic financial consequences. On the same $1,000,000 estate tax liability, the executor or trustee would need to sell $1,000,000 of the estate assets to pay the tax. The problem with this approach is that you may be forced to sell property and securities possibly at depressed values. Housing values and investment portfolios have taken a severe beating over the last few years.
- Use discounted dollars: By setting up an Irrevocable Life Insurance Trust (ILIT) with crummy provisions, you could fund the potential $1,000,000 estate tax liability in a more cost efficient manner. For most clients, it would work like this: You and/or your spouse would set up the ILIT and fund it with annual gifts of $13,000 each totaling $26,000 per year. These gifts are gift tax free. The life insurance death benefit is income tax free. The trust, because it is outside of your estate, is estate tax free. The trustee would purchase an insurance policy on one or both spouses and use the annual gifts to fund the premiums. For example, a couple, both age 70 and in average health, gifts $26,000 per year could allow the trustee of the ILIT to purchase a life insurance policy with a death benefit of $1,250,000. This death benefit would be income and estate tax free as it would be owned by the trust and outside of their estate. So in this situation, if both spouses died at age 90, they would have paid $520,000 ($26,000 x 20) and the death benefit would be $1,250,000. Thus they have funded their estate tax liability and saved $730,000.00.
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