Strategize Your Estate Planning: Transfer Life Insurance to Limit Estate Taxes

The Smart Move: Transfer Your Life Insurance to Mitigate Estate Tax Liability

Before we delve deeper into this subject, an initial, crucial point needs consideration: the information outlined here is pertinent exclusively to individuals whose estates could potentially incur federal estate taxes upon their passing. An exemption worth several million dollars applies, and it is doubled for couples.

For estates required to pay these taxes, whether life insurance proceeds are counted within the taxable estate hinges on the entity that holds the policy’s ownership at the time of the insured individual’s demise. When the policy is owned by the deceased, the entire proceeds are taxable. Conversely, if another party owns the policy, it is exempt from the taxable estate.

Example:

Consider Melissa’s situation: she has purchased a life insurance policy with a $200,000 value, designating her son, Jeff, as the beneficiary. Meanwhile, Juanita, Melissa’s business associate, holds a separate policy on Melissa’s life worth $400,000, which is payable to Juanita and will facilitate the purchase of Melissa’s business interest after her passing for Jeff’s benefit.

Upon Melissa’s death, the complete $200,000 from her policy is incorporated into her federal taxable estate. Yet, the $400,000 from Juanita’s policy is omitted from Melissa’s estate since Melissa did not possess ownership of that particular policy.

For individuals aiming to prevent their life insurance from being taxable within their estate, transferring ownership of their policy to another person or a separate entity may be advisable. You can transfer ownership to another adult, even the policy’s beneficiary, or establish an irrevocable life insurance trust for this purpose. However, note that certain group insurance plans provided by employers may not permit ownership transfers.

Life insurance benefits left to a spouse typically are not subject to estate taxes. In contrast, if the policy beneficiaries are anyone other than your spouse, such as children, friends, or other relatives, the proceeds could be taxed as a component of your estate.

Method One: Assigning Ownership to Someone Else

Transferring your policy’s ownership to another individual entails an important caveat: you forfeit all control over the policy. Once reassigned, you can no longer change beneficiaries or cancel the policy— even after significant life events, such as divorce. Despite this, such transfers can be quite successful in certain familial scenarios.

IRS Regulations for Life Insurance Policy Transfers

The IRS stipulates ownership criteria for life insurance policies at the insured’s time of death. If a policy is gifted and the original owner passes away within three years of the transfer, the gift is disregarded for estate tax purposes, meaning the full proceeds are part of the owner’s estate.

Example:

Louise gifts a $300,000 life insurance policy to her friend Leon, but she passes away two years later. The gift is nullified for estate tax reasons, and the entire $300,000 is included in Louise’s estate. Had Louise lived beyond three years following the policy’s transfer, none of the proceeds would’ve been counted in her estate.

Remember, proper timing is essential when gifting life insurance policies to mitigate estate taxes. The longer you live post-transfer (minimum three years), the better for estate tax purposes.

Another rule to consider is the retention of any “incidents of ownership” over the policy; should this occur, the policy is still considered under your ownership for estate tax purposes.

Gift Tax Implications

Policy transfers are regarded as gifts for tax reasons, and gifts exceeding a certain threshold may trigger gift taxes, which will only be due after your death. The important point here is that the gift tax value is typically far less than potential estate taxes on the policy proceeds.

Method Two: Life Insurance Trusts

Creating an irrevocable life insurance trust is an alternative method for transferring a life insurance policy. Once the policy is within the trust, it ceases to be considered your personal asset, and thus the trust will not be taxed as part of your estate.

Setting up a life insurance trust might be a suitable option in the absence of a trusted individual to whom you can transfer your policy directly. This approach ensures the policy remains active and minimizes the risk that a new owner might surrender the policy for its cash value.

For a life insurance trust to be effective in avoiding estate taxes, it must be irrevocable, you cannot serve as the trustee, and the trust must be set up at least three years prior to your death.

Considering the complexities associated with life insurance trusts, it is essential to consult with a qualified attorney. To discuss creating a life insurance trust and other estate planning strategies, don’t hesitate to reach out to the experienced team at James H. Wilson Law Firm by calling 804.740.6464.