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Life Insurance and Estate Planning

"Everyone gets organized at some point. They just might not be around for it." —Sue DeRoos

When it comes to estate planning, you probably think it's all about wills and probate and attorneys. That's a part of it, of course, but more and more people are using life insurance as a way to transfer their estate to their heirs—with big tax advantages. This strategy works if you are:

  • married
  • married with kids
  • single
  • near retirement
  • retired and worried about estate taxes

How can you and your family take advantage of these great tax benefits? Keep reading to find out!

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Is life insurance subject to estate tax?

Bills stacked with piles of coins.
If you "own" your life insurance policy, your beneficiary is subject to estate tax.

It doesn't have to be.

If you've spent time looking at estate planning, you're probably aware that whoever inherits your estate may have to pay tax on the value of that inheritance. This depends on the overall value of your estate, and whether it hits the minimum estate value required for the government to tax it.

In 2011 and 2012, this amount totaled $5 million per person. (It's scheduled to drop to $1 million per person on January 1, 2013.) If your estate is valued at more than this amount, it will be subject to a particular percentage of tax (35% in 2011 and 2012, with a 55% tax rate scheduled for January 1, 2013).

In some situations, your life insurance policy will be included in the value of your estate. But there are ways to change this and make sure the person who receives your life insurance death benefit gets it without the burden of high estate tax rates. Here's how it works:

Ownership Matters
If you take out a life insurance policy on yourself, the payout that goes to your beneficiaries when you die will be subject to estate tax. The Internal Revenue Code stipulates that the value of your policy must be included in your estate if you retain any "incidents of ownership" in the policy.

Basically, the government uses these "incidents of ownership" to figure out how involved you are in the policy. If you do things like select or change beneficiaries, take out or borrow against any cash value the account has, or change the account's payment schedule (a cool feature of universal life insurance), they'll determine that you have "ownership" of this life insurance policy. If you own it and pass it on to your heirs, it's considered part of your estate...and taxed as such.

To keep your heirs/beneficiaries from having to pay estate tax on your life insurance policy, you need to give up ownership of that policy. Instead of you making decisions about the policy like those mentioned above, you need to transfer the right to make those decisions to someone else. You can choose a child, spouse, other relative, or set up a trust. If you aren't the owner of the policy, it can't be taxed as part of your estate when you pass away. Your beneficiaries get the full sum of the death benefit without paying estate tax!


Are there any other taxes I need to know about?

Yes. You may still have to contend with the federal gift tax.

If you give a gift that's worth more than $13,000, the recipient will need to pay gift taxes. This applies to life insurance policies, too.

The good news is that your gift recipient won't have to pay the gift tax until you pass away, and the taxable amount is the value of the policy at the time the gift was given.

This means that the only value you need to worry about is the cash value of your life insurance policy at the time you sign away your ownership. If you have a term life policy with no cash value, you do not have to worry about this at all. Even if your permanent life insurance policy has accumulated a good amount of cash value, the tax on it is still likely to be less than the estate tax would be, if your estate included your life insurance policy.


How do I transfer ownership of my policy?

A couple walking on a beach.
You can transfer your policy to a spouse, adult child, relative, or trust.

It's easy—it's just a matter of filling out some paperwork with your insurance agent.

  1. First, you'll need to select a person or trust to take ownership of the policy. They have to agree to the switch because they'll now be responsible for paying the policy premiums (monthly payments). You can't assign someone without asking them, or they won't know that they have to make these payments. The payments absolutely must come from the new owner. You can't make the payments on their behalf, in other words.
  2. Second, you'll need to get the transfer of ownership forms from your insurance agent. When you sign these forms, you're giving up any and all right to make decisions regarding this policy. Be absolutely sure you've chosen a trustworthy person or entity to own this policy. It's perfectly fine for the new owner to make changes you suggest, but the paperwork for that change must come from the new owner and not from you. Fill out the forms your agent gives you and return them promptly.
  3. Third, get written confirmation from your insurance carrier that your paperwork went through and the new owner has been assigned.

When should I make the transfer?

Timing is important here. You want to do it as soon as you decide this is a good idea—the IRS has you on a three-year clock.

The IRS created another rule you need to be aware of, called the "three-year rule." This rule states that the person who transfers ownership of the policy must live for three more years before the proceeds of the policy can be exempt from estate tax. If you transfer ownership of your policy and die a year later, your policy is still considered part of your estate—and subject to estate tax.

If you're sure you want to transfer ownership, it's best to do it while you still have a number of healthy years ahead of you, just to be sure you outlive the three-year rule.


What kind of tax benefits will my beneficiary get?

Let's look at an example.

Say John, an elderly man, has a permanent life insurance policy worth $500,000. He's been smart with his money and his estate, counting property, stocks, and other assets, amounts to $5,000,000. He plans to leave everything to his adult daughter, Mary.

Scenario A: John retains ownership of his policy
If John holds onto his policy, its value will be added to the total of his estate at his death. That brings the total of his estate to $5,500,000. His daughter Mary will now owe estate tax. For the year 2012, the estate tax exemption is $5.12 million. The portion of John's estate that is taxable is $5,500,000 minus the federal exemption of $5,120,000, or $380,000. That amount would be taxed at the current rate of 35% (for 2012). Mary would have to pay $133,000.

Scenario B: John "gifts" his policy to his adult daughter, Mary
If John signed over his policy to Mary more than three years ago, the value of that policy will not be added to the total of his estate. His total estate remains valued at $5,000,000, which is just below the federal exemption amount of $5.12 million. Mary does not owe any estate tax.

If you were Mary, which would you rather pay: $133,000 or $0?

Think of your children or other beneficiaries in this situation. If you could save them money by taking one simple action now, would you do it?

Get insider advice and strategies for securing your family's financial future through life insurance. You can use our Live Chat feature to ask questions or pick up the phone and call us at 800-823-4852. To get an instant quote for a life insurance policy, just click the orange button below.

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Sources:
Montana State University Extension: Life Insurance: An Estate Planning Tool
EstatePlanning.com: What Is Estate Planning?
EstatePlanning.com: Understanding Life Insurance Trusts


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