Strategically Manage Your Life Insurance to Minimize Estate Taxes

Your Life Insurance Policy Can Be Excluded From Your Estate for Tax Purposes

When considering the impact of federal estate taxes, it’s pivotal to ascertain if your assets place you within the taxation threshold. This is in the millions of dollars, and the threshold doubles for couples.

For those whose estates may incur such taxes, the ownership status of life insurance policies at the time of the insured’s death is critical. Policies owned by the deceased contribute to the taxable estate’s total value. However, policies held by others remain separate and exempt from estate taxes.

Take, for instance, the case of Melissa, who secured a $200,000 life insurance policy naming her son Jeff as the beneficiary. Concurrently, her business partner Juanita purchased another life insurance policy on Melissa’s life, worth $400,000, to facilitate the acquisition of Melissa’s share of the business upon her passing. Upon Melissa’s demise, only the $200,000 from the policy she held is counted towards her taxable estate, whereas the $400,000 policy owned by Juanita is not.

Therefore, if you aim to bypass federal estate taxation on life insurance proceeds, transferring policy ownership may be a prudent move. This can be done either by assigning the policy to another individual, possibly a beneficiary, or by establishing an irrevocable life insurance trust to hold the policy. However, please be advised that some employer-provided group policies may prohibit ownership transfers.

Bequeathing property to your spouse, including life insurance proceeds, sidesteps estate taxes upon death. These proceeds become taxable elements of your estate only if designated for non-spousal beneficiaries such as children or friends.

Method One: Updating Policy Ownership

Altering life insurance policy ownership implies an irrevocable trade-off—once reassigned, you renounce all authority over the policy indefinitely. This action precludes you from altering beneficiaries or cancelling the policy, a crucial consideration particularly in changing personal circumstances like divorce.

One IRS regulation of note states that life insurance policies gifted within three years prior to one’s death are revertible for estate tax considerations—meaning such policies remain part of the taxable estate as if ownership had never been relinquished.

The IRS also addresses “incidents of ownership,” a term denoting any substantive control retained over a transferred policy. If at your passing, you held any legal rights to alter beneficiaries, borrow against, or effectuate changes to the policy, the proceeds will be factored into your taxable estate.

Gift Tax Considerations

Transferring your life insurance policy equates to a taxable gift when the present value surpasses a certain ceiling. Taxation for such gifts, however, is deferred until the benefactor’s death. Noteworthy is that gift taxes are substantially less imposing than estate taxes that would accrue if the policy remained within the estate.

Further intricacies emerge when discussing single-premium policies, which once gifted, no longer necessitate ongoing premium payments. Nevertheless, should the policy’s value at the gift’s timing exceed the gift tax exemption, IRS taxes will apply.

Method Two: Using Life Insurance Trusts

An alternative path to policy transfer involves establishing an irrevocable life insurance trust to hold the policy. This method relinquishes your ownership, consequently excluding the proceeds from your taxable estate.

Trust-based transfers are beneficial in scenarios lacking a trustworthy individual to inherit policy ownership. The trust can be structured to ensure policy maintenance and premium payment, circumventing potential policy encashment by an unreliable new owner.

A legal consultation is essential to understand the intricacies and to fulfill all rigid requirements stipulated for a life insurance trust. Ensuring its irrevocable nature, appointing a non-beneficiary trustee, and instituting the trust a minimum of three years before death are mandatory for the desired tax exclusion.

Goldberg & Goldberg are dedicated to assisting clients in estate planning matters, including strategic life insurance management. Should you require further elucidation or seek to establish a life insurance trust, kindly reach out to us at (301) 654-5757 for a complimentary consultation.