You can lower your beneficiaries' estate tax burden by making sure you don't own your life insurance policy when you die.
First things first: You don't have to read this article unless your estate is likely to owe federal estate taxes at your death. Currently, the estate tax affects only people who die leaving a taxable estate of more than a million dollars.
For those estates that do owe taxes, whether or not life insurance proceeds are included in the taxable estate depends on who owns the policy when the insured person dies. If the deceased person owned the policy, the full amount of the proceeds are included in the federal taxable estate; if someone else owned the policy, the proceeds are not included.
Example
Melissa buys an insurance policy covering her life, with a face value of $200,000. Her son Jeff is the beneficiary. Melissa's business partner, Juanita, buys a second policy, also covering Melissa's life, for $400,000, payable to Juanita. (She will use the proceeds to buy Melissa's half of the business after Melissa dies and leaves it to Jeff.)
Melissa dies. All the proceeds of Melissa's policy, $200,000, are included in her federal taxable estate. However, none of the $400,000 from the policy Juanita owns is part of Melissa's federal taxable estate, because Melissa did not own the policy.
It follows that if you want your life insurance proceeds to avoid federal estate tax, you may wish to transfer ownership of your life insurance policy to another person or entity. There are two ways to do it. You can transfer ownership of your policy to any other adult, including the policy beneficiary. Or, you can create an irrevocable life insurance trust, and transfer ownership to it. (But be aware that some group policies, which many people participate in through work, don't allow you to transfer ownership at all.)
Method One: Transferring Ownership to Other People
Transferring ownership of your policy to another person involves a trade-off: Once the policy is transferred, you've lost all your power over it, forever. You cannot cancel it or change the beneficiary. Suppose, for example, you transfer ownership of your policy to your spouse, and later get divorced. You cannot cancel the policy or recover it from your ex-spouse. In many situations, however, these gifts work well -- for example, when you transfer policy ownership to an adult child with whom you have a close and loving relationship.
IRS Rules Governing Life Insurance Transfers
The IRS has rules that determine who owns a life insurance policy when the insured person dies. Gifts of life insurance policies made within three years of death are disallowed for federal estate tax purposes -- and often for state death tax purposes, too. This means that the full amount of the proceeds are included in your estate, as if you had remained owner of the policy.
Example
Louise gives her $300,000 term life insurance policy to her friend, Leon. She dies two years later. For federal estate tax purposes, the gift is disallowed, and all of the proceeds, $300,000, are included in Louise's taxable estate. If Louise had transferred the life insurance policy more than three years before her death, none of the proceeds would have been included in her taxable estate.
The message here is obvious: If you want to give away a life insurance policy to reduce estate taxes, give the policy away as soon as is feasible. (And then don't die for at least three years.)
Another IRS regulation provides that a deceased person who kept any "incidents of ownership" of a transferred life insurance policy is still considered the owner. The term "incidents of ownership" is simply legalese for significant power over the transferred insurance policy. Specifically, the proceeds of the policy will be included in your taxable estate if you have the legal right to do any one of the following:
* change or name beneficiaries of the policy
* borrow against the policy, pledge any cash reserve it has or cash it in
* surrender, convert or cancel the policy, or
* select a payment option -- that is, decide if payments to the beneficiary can be a lump sum or in installments.
Gift Tax Concerns
If you transfer a life insurance policy to a beneficiary, tax authorities regard the transaction as a gift. Under current gift tax rules, if you transfer a policy with a present value of more than $11,000 to another person, gift taxes will be assessed. However, the gift tax won't have to be paid until your death. And keep in mind that the amount of gift tax will be far less than the amount of estate tax that would be due if your policy remained in your name and in your estate. This is because the policy proceeds (the amount the insurance company pays at death) are always considerably more than the value of the policy while the insured is alive. To find out the present worth of an insurance policy for gift tax purposes, ask your insurance company.
Example
Eugene transfers ownership of his universal life insurance policy to his son, David. The value of the policy when he transfers it is $22,000. Under IRS rules, $11,000 of this is subject to gift tax. Eugene dies four years later, and the insurance policy pays $300,000. None of this $300,000 is included in Eugene's federal taxable estate. (Nor are the proceeds considered income to David, for federal income tax purposes.)
The Nuts and Bolts of Transferring Ownership
You can give away ownership of your life insurance policy by signing a simple document, called an "assignment" or a "transfer." To do this, notify the insurance company, and use its form. There's normally no charge to make the change. Also, you usually have to change the policy itself to specify that the insured is no longer the owner.
After the policy is transferred, the new owner should make any premium payments due. If you make payments, the IRS might contend that you're keeping an "incident of ownership" (as discussed above) and include the proceeds in your federally taxable estate -- precisely what you're trying to avoid. If the new owner can't make the payments, you can give her money for them.
If you give a paid-for single-premium policy to a new owner, there are no future payments to worry about. Because it's paid for in full once it's purchased, single-premium life can be a particularly convenient type of policy to give away. However, there can be a drawback here, too. If the value of the policy at the time of the gift exceeds the amount that is exempt from gift tax (currently, $11,000), the IRS will assess gift tax on the excess amount. By contrast, if you transfer ownership of a policy that has premiums due each year, and then every year you give the recipient a gift of less than $11,000 to pay for those premiums, no gift tax will be assessed.
Method Two: Life Insurance Trusts
The second way to transfer a life insurance policy is to create an irrevocable life insurance trust and then hold the policy in trust. Once you transfer ownership of life insurance to the trust, you're no longer the owner, and the proceeds won't be part of your estate.
Why create a life insurance trust, rather than simply transfer a life insurance policy to someone else? One reason can be that there's no one you want to give your policy to. In other words, you want to get the proceeds out of your taxable estate, but you want to exert legal control over the policy and avoid the risks of having an insurance policy on your life owned by someone else -- perhaps a spouse or child you don't trust to pay policy premiums. For example, the trust could specify that the policy must be kept in effect while you live, eliminating the risk that a new owner of the policy could decide to cash it in.
Example
Marcie is the divorced mother of two children in their 20s, who will be her beneficiaries. Neither is sensible with money. Marcie has an estate of $700,000, plus universal life insurance that will pay $500,000 at her death. She wants to be sure her estate will not be liable for estate taxes, and so desires to transfer ownership of her policy. However, there's no one Marcie trusts enough to give her policy to outright.
She decides to create a life insurance trust, however, with her sister as trustee. She transfers ownership of the life insurance policy to her sister as trustee. After Marcie's death, her sister will handle the money for the children under the terms of the trust document.
If you want estate tax savings from the life insurance trust, you must comply with the following strict requirements:
* The life insurance trust must be irrevocable. If you have the right to revoke it, you will be considered the owner of the policy, and the proceeds will be subject to estate taxes.
* You cannot be the trustee.
* You must establish the trust at least three years before your death. If the trust has not existed for at least three years when you die, the trust is disregarded for estate tax purposes, and the policy proceeds are included in your taxable estate.
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