Life Insurance: It Could Cost – or Save – Your Family Thousands By Courtney E. Boniface, Esq.
Like many clients who come into my office, John and Sally Smith* were shocked to hear that their estate would likely face significant estate taxes without careful planning. Even more shocking to them was the fact that their life insurance was considered part of their taxable estate. “But I thought life insurance was tax free!” John exclaimed.
Well, John was partially right. Proceeds from a life insurance policy will pass to your beneficiaries free of income taxes. However, life insurance proceeds can be subject to significant estate taxes. At the end of the day, John and Sally’s family could lose approximately half of the insurance proceeds to estate taxes!
During our meeting, I explained to John and Sally that all of their assets, including real estate, investments, bank accounts, retirement accounts, and yes, life insurance, were part of their taxable estates. After they got over the initial shock, I explained several options available to them to reduce estate taxes and maximize what they could eventually pass to their loved ones.
One option we discussed was an irrevocable trust designed to own life insurance as well as other assets. I explained that John’s current $1,000,000 policy would be part of his taxable estate because he owned the policy and had the right to change the beneficiaries. If John was willing to surrender ownership of the policy to an irrevocable trust, and give up all “incidents of ownership”, his family could eventually receive all of the proceeds. The same principal applies for the life insurance policy that Sally was thinking of purchasing. Because John already owned his policy, he would probably want to transfer it into a trust designed to hold life insurance. If he died within three years of the transfer, the policy would be included in his taxable estate – but of course, he would be no worse off than he is now. Because Sally hadn’t yet purchased a policy, I advised her to create a trust first and then let the trustee she chose for her trust purchase the policy so that its proceeds would never be part of her taxable estate.
There are rules John and Sally and their trustees will need to follow when establishing an irrevocable trust, encouraging their trustee to purchase a life insurance policy, transferring life insurance policies to their trustee, and making gifts to their trustee so that the trustee can pay insurance premiums. While these rules can seem formalistic and downright pesky, and John and Sally will need guidance from their lawyer and other advisors along the way, the benefits can be enormous. Of course, John and Sally will need to name trustees who are responsible and will follow all of the rules…and carry out their wishes. Knowing that their family will not lose a penny of the insurance proceeds to estate taxes prompted the Smith’s to make every effort to dot their I’s and cross their T’s!
* The names have been changed to protect client confidences.
To comply with IRS requirements, we must inform you that any tax advice in this article is not intended or written to be used, and cannot be used for the purpose of avoiding penalties. It is intended for general informational purposes only. You should seek advice based upon your particular circumstances from an independent tax advisor.
© Courtney E. Boniface, 2007.