Life insurance has long been a staple in basic estate planning. Life insurance can provide an income tax-free death benefit* far in excess of the premiums paid. However, much of the life insurance proceeds can be wasted if the ownership and beneficiary designations are not properly structured.
The federal estate tax may impose a tax on all the property that you own at your death**. This tax must be paid from your estate. This tax does not attach if, as a general rule, your property is valued at less than your estate tax exemption amount*** at death. If you own a life insurance policy, or name either yourself or your estate as beneficiary, the policy death benefit will increase your estate. If, after including your life insurance death benefit proceeds, your estate is still valued at less than your estate tax exemption amount***, no federal estate tax will be assessed. Therefore, your policy death benefit proceeds can be directed to any of your heirs, and need not be used to pay your estate tax liability.
If you own property in excess of your estate tax exemption amount***, you may have a taxable estate. If you own a life insurance policy or name either yourself or your estate as beneficiary, you may have exposed the policy's death benefit to estate taxes.
For this reason, when estate tax is a concern, an insurance policy on your life is usually best owned by someone else. You can establish an irrevocable trust to be the owner and beneficiary of your life insurance policy. Alternatively, you might have your adult children own, and be beneficiaries of, the policy. Either will avoid inclusion of policy proceeds in your estate. Meanwhile, third-party owners may be able to lend these proceeds to, or purchase assets from, your estate to provide cash to satisfy your estate tax liability. (If you make your spouse the owner of a policy on your life, you should ensure that, if your spouse dies before you, you will not end up owning the policy either through a provision in your spouse's will or a living trust.)
Even where the owner is a third party, if the beneficiary dies before you (the insured), the proceeds may be paid to your estate. Naming a contingent beneficiary to the policy will ensure that the proceeds will go directly to that person, thus avoiding probate and estate taxes. The "Rule of Two" holds that a policy should always have at least two contingent beneficiaries in order to avoid such problems.
You should remember that any gift of life insurance to a third party (except to your spouse) may carry with it gift tax consequences. Additionally, if you fail to survive your gift by three years, the policy will be brought back into your estate. Because of these pitfalls, you should always seek tax and legal advice prior to any transfer. But keep in mind, an improperly structured life insurance contract effectively takes money out of your heirs' pockets.
* For federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC Sec. 101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2) (i.e. the “transfer- for- value rule”); arrangements that lack an insurable interest based on state law; and an “employer-owned” policy unless the policy qualifies for an exception under IRC Sec. 101(j).
*** The federal estate tax exemption amount is $2,000,000 in 2006 increasing to $3,500,000 in 2009. The highest federal estate tax rate is 46% in 2006 and decreases to 45% in 2007-2009. The federal estate tax will be repealed on 1/1/10 until 12/31/10. Beginning 2011, the federal estate tax will be reinstated with a federal estate tax exemption amount of $1,000,000 and a maximum estate tax rate of 55%. Currently, bills are pending in Congress that, if passed, would permanently repeal or otherwise lessen the impact of the federal estate tax.
The concepts contained herein are not intended to serve as advice and may have legal, tax and accounting implications. Consult your Attorney and CPA for advice.
CWEB-L-120A