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Avoid a Commonly Overlooked Estate Tax Blunder: Life Insurance Policy Ownership
Published Date : September 2, 2014
In planning for the event of your passing, you’ve thoughtfully established a living trust, generously gifted to family members along the way, invested wisely, and intend to leave a sizable estate for your heirs. Included in your financial planning has been the purchase of a life insurance policy to provide replacement income at your death. However, appropriate estate planning requires a complete review of tax implications; when purchasing life insurance the question of ownership and its tax impact is important. One missed step in establishing the policy owners could cost your estate a potentially significant amount in estate taxes. Fortunately, with vehicles like an Irrevocable Life Insurance Trust, or ILIT, there are solutions available to avoid a costly burden.
Owners of life insurance policies should be aware that all proceeds received from the policy at death are included in their estate for tax purposes. According to the American Taxpayer Relief Act signed into law on January 2, 2013, an estate that falls under the current $5,340,000 exemption from federal taxation can easily be pushed over that limit when proceeds from a multi-million dollar life insurance policy are included. Therefore, to properly eliminate unnecessary estate taxes, the notion of insurance policy ownership must be addressed.
While direct ownership of an insurance policy is obvious, having “incidents of ownership” is not well understood and could result in a policy unwittingly remaining within an estate. Incidents of ownership refer to the ability of an individual to retain interests or rights in an asset. For an insurance policy, having the power to withdraw cash, change beneficiaries, transfer ownership, or use the policy as loan collateral would constitute incidents of ownership. Should an individual pass away with any of these incidents of ownership, the life insurance policy would be deemed part of the estate, count fully towards the estate tax minimum, and be taxed if that minimum is exceeded.
Transferring ownership to a spouse doesn’t entirely avoid the estate tax issue either. Upon the death of an insured spouse, the value of the policy will be included in the gross estate of the surviving spouse, increasing the possibility of estate taxes being levied upon a larger estate when that surviving spouse passes.
There are ways to better navigate the estate tax with respect to life insurance policies. An ILIT is a type of irrevocable trust that is specifically designed to hold and own life insurance policies. Once the ILIT has been created, ownership of the life insurance policy is transferred to the ILIT and a trustee assumes control of the policy. While the primary insured individual cannot serve as a trustee of the ILIT, lest he/she be deemed to have incidents of ownership in the policy, a spouse or child can serve as trustees. With the insurance policy held in the ILIT, the insured individual will continue to pay the premiums by either making a gift of the premium amount to the trust or directly making payments to the insurer. The estate tax benefits are not compromised in either scenario as the payment of premiums is not considered an incident of ownership.
Establishing an ILIT and transferring ownership of a policy is not a sure-fire way to eliminate the threat of estate taxes. Under Internal Revenue Code Section 2035, should the insured individual die within three years of the ownership transfer to the trust, the IRS will deem the death proceeds part of the original estate. To avoid this three year rule, a life insurance policy can initially be issued to the trust, effectively having the trust buy the insurance policy outright.
Insurance planning is an exceedingly important part of your risk management strategy. A quick review of your insurance policy ownership may help to further preserve your assets for your family.
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