The sunset of the Tax Cuts and Jobs Act (TCJA) in 2026 may have a significant impact on estate taxes, particularly for individuals with sizable estates. Here’s how the sunset may affect estate taxes and why life insurance is a critical tool in planning for this change:
1. Reduced Estate Tax Exemption After 2025
Under the Tax Cuts and Jobs Act (TCJA) of 2017, the federal estate tax exemption was significantly increased, which means estates valued below $13.61 million per individual and $27.22 million per married in 2024 are not subject to the tax. However, this provision is set to expire after 2025, and the exemption amount will revert to pre-TCJA levels of 6 Million per person and 12 Million per couple, adjusted for inflation.
This means estates exceeding these lower thresholds will be subject to a 40% federal estate tax.
Example of Impact:
- If someone has an estate worth $15 million and the estate tax exemption in 2026 is reduced to $6 million, $9 million of the estate would be subject to federal estate taxes at a rate of up to 40%. This could result in a federal estate tax bill of $3.6 million.
2. Higher Estate Tax Liability
With a lower estate tax exemption, more estates will become taxable, and those that are already taxable will face higher taxes. The difference between the current exemption and the post-2025 exemption could lead to a significant tax burden for heirs and the decimation of a legacy that took a lifetime to build.
Without proper planning, the estate’s assets may need to be sold expeditiously to cover these taxes, potentially at unfavorable times or prices.
Why Life Insurance is Critical to Cover the Estate Tax:
Life insurance plays a crucial role in addressing the potential for higher estate taxes after the TCJA sunsets. Here are the key reasons why:
1. Liquidity to Pay Estate Taxes
Life insurance can provide immediate liquidity to pay estate taxes without forcing heirs to sell illiquid assets, such as real estate, family businesses, or investments. Since the IRS requires estate taxes to be paid within nine months of the decedent’s death, life insurance ensures that cash is readily available, reducing financial stress on heirs and maintaining the legacy the decedent has worked hard to build.
- Example: If an estate owes $3 million in taxes, a life insurance policy can be used to cover this cost, avoiding the need to liquidate assets.
2. Tax-Free Payout
Life insurance death benefits are generally income tax-free, which makes them an efficient way to provide liquidity for estate taxes. This means the payout can be used directly to cover estate tax liabilities without adding additional tax burdens.
4. Estate Equalization
If you have multiple heirs, but not all of your estate is easily divisible (for example, if much of it consists of a business or real estate), life insurance can provide a way to equalize the inheritance. One heir can receive the business, while the other receives the life insurance proceeds, helping avoid disputes and keeping the estate intact.
5. Potential for Discounted Coverage Now
By purchasing life insurance before the TCJA sunsets in 2026, you can lock in coverage at today’s premiums, which may be more favorable because you will never be as young as you are today.
6. Estate Planning Flexibility
In combination with other estate planning tools (such as trusts or gifting strategies), life insurance can offer flexibility to manage your overall estate tax liability. For example, life insurance owned by an irrevocable life insurance trust (ILIT) can be structured so that the death benefit is excluded from your taxable estate, providing additional tax savings.
Planning Before the Sunset
The period before the TCJA sunsets in 2026 presents a window of opportunity to maximize estate planning strategies. Qualified estate planners and life insurance professionals who are experienced in individual life insurance suited for estate tax purposes or Survivorship life insurance for high net-worth couples will be hard-pressed to come by in the next year as many people have started their planning already. This stresses the importance of talking to a life insurance professional like the ones at E&Y Insurance.
Individuals with estate values above the reduced exemption should consider buying life insurance now to protect their heirs from substantial estate tax bills. Even if future legislative changes extend the higher exemption, life insurance remains a valuable tool for estate liquidity and peace of mind.
