Many people automatically assume that the life insurance death benefit they leave over to their loved ones will not be taxed. This common misconception can result in the unnecessary payment of tens or hundreds of thousands of dollars of estate taxes.
The Rule: The IRS (Section 2042) states that the death benefit of your life insurance policy is included in your estate if the proceeds are payable either (1) to your estate or (2) to your beneficiaries if you possessed any incidents of ownership in the policy at the time of your death. Incidents of ownership include the right to (1)change/add beneficiaries (2) transfer ownership of the policy (3) borrow against the policy, among other rights. Basically, if you retain control over the policy, it will be includable in your estate.
The Problem: Many New Yorkers who own their own home, have some savings, and own a life insurance policy may be subject to estate taxes. For example, the estate of a New York resident. At a time when your loved ones need money the most, you need to make sure that more money goes to them as opposed to the state and federal governments.
The Solutions: There are effective and legal ways to avoid paying any estate taxes on insurance proceeds.
Solution A: An insured can transfer ownership of his/her policy to the beneficiaries and thereby relinquish incidents of ownership. However, since the money will be paid outright to the beneficiary, there are many drawbacks to this solution, including the lack of creditor protection for the beneficiary, the fact that the beneficiary may be a minor or may be unable to manage large sums of money, and that the proceeds will be includable in the beneficiary's estate for estate tax purposes.
Solution B: Instead of you owning the life insurance policy in your own name or transferring ownership to a beneficiary, an estate planning attorney can set up an irrevocable life insurance trust (ILIT) to own the policy which will pay the death benefit into into the trust. Therefore, since you don't own the policy, you don't have "incidents of ownership" according to the IRS, and consequently your estate is not taxed on the proceeds of the death benefit.
The Practicalities: An irrevocable life insurance trust is just that, irrevocable. This means that the trust can not generally be undone and the terms can not be altered by you. You may set the terms of the trust, decide who the beneficiaries will be, and appoint any trustee you desire, including a spouse and/or children. The trust may specify who gets the money and under which circumstances. This provides potential asset protection for your beneficiaries and can protect them from creditors, ex spouses, and their own immaturity when it comes to spending the money. The trust can accept an existing life insurance policy or can purchase a new one. If an existing policy is transferred, the IRS will wait three years before it will be considered owned by the trust. If you pass away before that time, the proceeds will be counted in your gross estate. This is why it is highly recommended that an ILIT is set up contemporaneously with the purchase of any significant life insurance policy. Premiums will be paid by the trust with funds which you may want to gift to the trust. You can utilize your annual gift tax exemption amount of up to $13,000 which can be doubled to $26,000 for spouses. Your ILIT will be listed as the designated beneficiary under your policy and upon your passing, the insurance policy will pay out to the ILIT, which will in turn distribute the funds as per your original instructions. All of this will be overseen by the trustee(s) which you selected. Best of all, none of the proceeds will be taxed by the government. It is important to keep in mind that if an existing life insurance policy is transferred into the trust there is a three year look back period, during which the IRS will include the death benefit in the original owner's estate. Therefore, it is generally recommended to establish an ILIT and subsequently purchase a new policy in order to avoid this three year look back period.
The Bottom Line: The whole idea behind life insurance is to provide the financial resources your loved ones need when you pass away. With the use of an irrevocable life insurance trust you can make sure that your loved ones get the maximum amount possible without Uncle Sam dipping his hands into the pot.
Utilizing any of the solutions mentioned above should be done as part of a comprehensive estate plan and should not be undertaken without at least speaking with an attorney. Feel free to contact our office for a free consultation.