Life insurance allows you to make available to your heirs a significant amount of money upon your death. When life insurance benefits are paid to your designated beneficiary, they pass free of income tax. However, unless you take the proper estate and gift tax planning measures, it is possible those benefits will be taxed as part of your estate, but only if your estate exceeds $5.4 million (for a single person) or $10.98 million (for a married couple).
If you have what is called "incidents of ownership" in your life insurance policy, the proceeds of the policy may be subject to federal estate taxes upon your death. What are "incidents of ownership?" Essentially, any means by which you can exercise control over the insurance policy, whether borrowing against it, changing the beneficiary, canceling it, or pledging or assigning it to another party.
In addition, Internal Revenue Code §2042 makes the proceeds of life insurance that are payable to your estate subject to estate tax. If your entire estate is small enough that it does not consume your lifetime estate and gift tax exemption, this won't be a problem. But you can't be sure what the value of your estate will be, so fortunately there are ways to keep your life insurance policy from becoming subject to tax.
One way to keep your life insurance proceeds from being taxed is to transfer all incidents of ownership to someone else. Not so fast, though—there are some things to think about before taking this step. First and foremost, choose a competent, trustworthy adult as the new owner. There is an emphasis on trustworthy here; transfer of ownership is irrevocable. Therefore, you don't want to choose a spouse if there is even a remote possibility of divorce. Because the transfer cannot be revoked, you cannot make any changes to the policy after you transfer it, although the transferee may do so at your request.
Also, the new owner of the policy must pay the premiums on the policy; you can't transfer ownership and continue to write the premium checks on your own bank account. That said, there's nothing to prevent you from gifting funds to the new owner that they can use to make the payments. Returning to the concept of trustworthiness, make sure the new owner is responsible enough to make those payments on time.
If transferring ownership of your life insurance policy sounds like a good idea to you, you'll need to contact your insurer for the proper assignment documents, and you'll want written confirmation from them that the assignment has been completed. Because the transfer is irrevocable, it's highly advisable to speak to an estate planning attorney to make sure this is the path you want to take before you begin.
The preferred way to prevent the proceeds of your life insurance policy from being subject to federal estate tax is to place the policy in an irrevocable life insurance trust (ILIT). An ILIT is another mechanism for transferring incidents of ownership of the policy away from you.
Because you must not have control of the policy, you cannot serve as the trustee of an ILIT as you can with a revocable living trust. Why bother creating an ILIT rather than just directly transferring the policy ownership to another person? An ILIT affords you a little more control than a direct transfer; you are able to arrange for timely payment of premiums, for example. If you are looking to provide for minor children with the life insurance policy, especially those from a previous relationship, an ILIT allows you to name someone in whom you have confidence as trustee to manage any funds for the children. Without the ILIT, the children's other parent—whom you may or may not trust—might be in charge of the funds.
In any case, if you want your heirs to reap the full, tax-free benefits of your life insurance policy, don't make your estate the beneficiary. Your best move is to speak with your estate planning attorney to learn how to incorporate your life insurance policy into your estate plan.
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