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While you may know that taking out a life insurance policy on yourself is one of the easiest ways to pass on income tax-free wealth to your beneficiaries, you may not know that it can also be a convenient way to escape estate taxes.
But don't misunderstand: Life insurance proceeds will be taxed as part of your estate if you own the policy when you die. However, if you're not the policy owner of record, the proceeds will not be considered part of your estate and consequently will not be subject to death taxes upon your death. Nor will your beneficiary have to pay additional income taxes on the proceeds.
There are two ways to avoid estate taxes on a life insurance payout. Either place the policy in an irrevocable trust, or simply transfer ownership of the policy to someone else. The latter option is a relatively simple process; you don't even need an attorney or estate planner to complete the transaction.
There are a few issues of which you need to be aware, but your insurance company can help you address them. First of all, ask your insurer to provide you with an estimate of the current cash value of your policy prior to the transfer, for the purpose of determining whether you'll owe gift taxes. Next, sign the company's "assignment" or "transfer" form to have the policy reflect that you are no longer the owner.
If you purchased a single-premium life insurance policy, the transfer is easy. This is typically the best type of policy to take out if you're planning on giving it to someone else. However, if the policy requires ongoing premiums after the transfer, the new owner will be responsible for keeping up the payments.
The IRS requires that the new owner own the policy for at least three years before the insured dies, or else the proceeds will still be considered part of the insured's estate for death tax purposes. Obviously, it's in your beneficiary's best interest to make the transfer as soon as possible.
It's also necessary that you give up complete control of the policy. The IRS will impose estate taxes on your policy proceeds if you maintain certain rights after the transfer, which it refers to as "incidents of ownership." These include your ability to:
Lastly, you must deal with the gift tax issue if your policy is valued at more than $14,000 when you transfer it. Any amount over the $14,000 annual gift limit is subject to gift taxes, and your insurance company can provide you with the appropriate forms to submit for your gift tax return. Even so, keep in mind that the gift taxes you pay now will be far less than the amount of estate taxes your beneficiary(s) will have to pay if you keep the policy under your name.
If your policy requires ongoing premiums after the transfer, you may not make these payments yourself, as that would be considered an incident of ownership. You may, however, make annual gifts (for less than $13,000 to avoid gift taxes) to the new owner to use for premium payments.
Then again, to whom should your insurance policy go? As a general rule, it should not go to your spouse. That's because if your spouse should die first, the proceeds will become part of his or her estate, and that's not much help. Also, since upon your death your estate transfers estate tax-free to your spouse via the marital deduction, life insurance proceeds are not necessary in this scenario to help pay estate taxes.
The recipient of your policy should most likely be your adult child(ren) or whomever is the beneficiary(s) of your estate, or your estate's executor, provided it is an individual and not an institution. In both situations, the life insurance proceeds go to the beneficiary free of estate taxes and can be used to help pay those taxes on the rest of your estate.
While less complicated than creating an irrevocable trust, transferring ownership of your life insurance policy presents its own set of consequences. For example, you lose complete control over the policy. The new owner may change the beneficiary(s), stop paying premiums, or even surrender the policy for its cash value. You no longer have the power to even cancel the policy, which would be unfortunate if you transfer it to your spouse then later divorce under less than amicable terms.
All things considered, transferring your life insurance policy to someone else is a quick and easy way to remove its proceeds from your estate. Given the uncertainty of laws affecting death taxes, the simplicity of this transaction is one of the least complicated estate planning strategies you can employ.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.