What Role Does Life Insurance Play in My Estate Planning?

Life insurance has many benefits in estate planning: it provides liquidity to pay estate taxes, it can provide an income stream for a surviving spouse, and it increases the inheritance left to heirs…all income tax free.

One of the most attractive features of life insurance is that the death benefits are sheltered from income taxes. However, insurance is not free from estate taxes (unless you give up all of the control and ownership rights in the policy). Insurance is taxed in the estate of the owner of the policy. Even if you are not the owner on paper, if you have any incidents of ownership, i.e., you pay the premiums, you direct who are the beneficiaries, or you borrow against the cash value, the Internal Revenue Service will treat you as the policy owner and will add the life insurance proceeds to your estate and tax it accordingly.

Since the policy owner generally does not receive the insurance proceeds, this tax may seem illogical. But from the Internal Revenue’s point of view, life insurance is an asset. It is therefore added to the value of the owner’s estate even though the owner never reaps the benefit of it.

There are two ways to keep the benefits of your insurance without paying the estate taxes:

Make Someone Else the Owner

To take the value of life insurance out of your estate and avoid taxation, you can make someone else the owner. Transferring ownership is very simple. But you must act cautiously. Transferring a life insurance policy with value may be subject to gift taxes if its value exceeds the annual gift tax exclusion. In addition, if the owner of the policy dies within three years of transferring it to someone, the value of the policy remains in the owner’s estate.

Also, you must have confidence that the new policy owner will carry out your wishes. The policy owner will have complete control over the policy and can designate beneficiaries, borrow against the cash value and choose whether and when to pay the premiums. This is the simple approach, but it is risky.

Further, if your life insurance is provided to you as a benefit of your employment, most companies require that the employee be the owner. Therefore, you would not be able to transfer the ownership of the policy.

Irrevocable Life Insurance Trust

An irrevocable life insurance trust is a vehicle for holding life insurance policies. The primary goal of such a trust is to eliminate the estate tax on the life insurance, and allow the insured’s family to benefit from it at the time of the insured’s death. This is accomplished by making the trust the policy owner.

This approach insures that the death benefit is not included in the estate of the insured. The death benefits are paid into the trust which provides the family with cash that can be used to pay estate taxes, or be used to provide an annuity to a surviving spouse.

A life insurance trust is usually a better alternative to simply changing ownership because it allows for more flexibility in using the policy and assures that the policy will be kept in force and not converted to cash by the owner-beneficiaries. A trust permits the proceeds to remain in trust until the beneficiaries reach a certain age or until all of the estate taxes are paid.

It is important to remember that in order for the IRS to exclude the life insurance from your estate, the trust must be irrevocable which means once the trust agreement is made, it cannot be changed. Also, if you are transferring existing policies into the trust or into someone else’s name, and you die within three years of the transfer, the IRS will add the value of the policy back into your estate.

If you are a married couple and are concerned about paying estate taxes, or you want to provide liquidity for your children so they don’t have to divide up real estate, or you just want to increase your heir’s inheritance without increasing your taxes, you should consider a last to die life insurance policy. This type of insurance pays a death benefit after both of the insured parties have died. Last to die life insurance is usually far less expensive than life insurance on one life.

Whatever type of insurance you purchase to fund an irrevocable life insurance trust, the insurance application and the policy itself should not be issued until the trust is in existence to be sure the trust is the owner.

To establish an irrevocable life insurance trust, an attorney drafts a legal document called the trust agreement. A Trustee, who is not the insured, must be appointed who is responsible for making premium payments and for maintaining the policy. A typical irrevocable life insurance trust will call for the insured to make annual gifts to the trust to cover the premium payments. In order for the gifts to qualify for the annual gift exclusion, the beneficiaries must have a “present interest” in the gift, which means they must have a temporary right to demand withdrawal of the gift made to the trust on their behalf. The Trustee must therefore notify the beneficiaries annually that a gift has been made on their behalf and the beneficiaries must be given a period of time to exercise their right to withdraw the gift.

If it sounds very technical, it is. Before venturing into this, you should seek the counsel of a competent lawyer and have your estate planning needs reviewed. An irrevocable life insurance trust may not meet your needs, but it is certainly something to consider as part of your estate plan.