Shifting Life Insurance Ownership
by Steven Merkel,CFP®, ChFC (Contact Author | Biography)
Wouldn't it be nice if you could pass on your entire estate free of taxation? While this scenario is highly unlikely, there are some smart decisions that you can make to avoid future tax consequences. One poor decision that investors seem to make frequently is the naming of "payable to my estate" as the beneficiary of a contractual agreement such as an IRA account, an annuity or a life insurance policy. However, when you name the estate as your beneficiary, you take away the contractual advantage of naming a real person and subject the financial product to the probate process. Leaving items to your estate increases the estate's value, and it could subject your heirs to exceptionally high estate taxes. Here we show you some of the ways that you can reduce the taxes on your estate and ensure that your heirs will benefit from it as much as possible.
Taxation of Life Insurance Death Benefits
One of the benefits of owning life insurance is the ability to generate a large sum of money payable to your heirs in the event of your death. An even greater advantage is the federal income tax-free benefit that life insurance proceeds receive when they are paid to your beneficiary. However, although the proceeds are income tax free, they may still be included as part of your taxable estate for estate tax purposes. (For further reading, see Buying Life Insurance: Term Versus Permanent and A Look At Single-Premium Life Insurance.)
Section 2042 of the Internal Revenue Code states that the value of life insurance proceeds insuring your life are included in your gross estate if the proceeds are payable: (1) to your estate, either directly or indirectly; or (2) to named beneficiaries, if you possessed any incidents of ownership (we'll discuss this more below) in the policy at the time of your death.
In 2006, the federal estate tax exclusion amount increased to $2 million per person. This will be in effect until 2009, when the amount will increase again - to $3.5 million. In 2010, there will be no federal estate tax, but for all years after that, the exclusion amount will be reset to $1 million per person. This means that if your taxable estate exceeds $2 million, you will most likely be subject to estate taxes; these taxes can be as high as 46%, but this rate will fall to 45% in 2007, where it will remain until 2009. These changes in federal estate tax come from the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which expires at the end of 2010. After its expiration, the exclusion amount will be $1 million (as mentioned above) and the highest rate will be 55%, assuming no further changes are made. (To learn more, check out Get Ready For The Estate Tax Phase Out and Getting Started On Your Estate Plan.)
Ownership Transfer
For those estates that will owe taxes, whether or not life insurance proceeds are included as part of the taxable estate depends on the ownership of the policy at the time of the insured's death. If you want your life insurance proceeds to avoid federal taxation, you'll need to transfer ownership of your policy to another person or entity. Here are a few guidelines to remember when considering an ownership transfer:
Choose a competent adult/entity to be the new owner (it may be the policy beneficiary), then call your insurance company for the proper assignment, or transfer of ownership, forms.
New owners must pay the premiums on the policy. However, you can gift up to $12,000 per person in 2006, so the recipient could use some of this gift to pay premiums.
You will give up all rights to make changes to this policy in the future. However, if a child, family member or friend is named the new owner, changes can be made by the new owner at your request.
Because ownership transfer is an irrevocable event, beware of divorce situations when planning to name the new owner.
Obtain a written confirmation from your insurance company as proof of the ownership change.
Life Insurance Trusts
A second way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT). In order to complete an ownership transfer, you cannot be the trustee of the trust and you may not retain any rights to revoke the trust. In this case, the policy is held in trust and you will no longer be considered the owner. Therefore, the proceeds are not included as part of your estate.
Why choose trust ownership rather than transferring ownership to another person? One reason might be that you still wish to maintain some legal control over the policy. Or perhaps you are afraid that an individual owner may fail to pay premiums, whereas in the trust you can ensure that all premiums are paid in a timely manner. If the beneficiaries of the proceeds are minor children from a previous marriage, an ILIT will allow you to name a trusted family member as trustee to handle the money for the children under the terms of the trust document. (To read more, see Skipping-Out On Probate Costs.)
IRS Regulations
The IRS has developed rules that help to determine who owns a life insurance policy when an insured person dies. The primary regulation overseeing proper ownership is known in the financial world as the three-year rule, which states that any gifts of life insurance policies made within three years of death are still subject to federal estate tax. This applies to both a transfer of ownership to another individual and the establishment of an ILIT. So, if you die within three years of the transfer occurring, the full amount of the proceeds are included in your estate as though you still owned the policy.
Another IRS regulation will look for any incidents of ownership by the person who transfers the policy. In transferring the policy, the original owner must forfeit any legal rights to change beneficiaries, borrow against the policy, surrender or cancel the policy or select beneficiary payment options. Furthermore, he or she must not pay the premiums to keep the policy in force. These actions are considered to be a part of ownership of the assets and if any of them are carried out, they can negate the tax advantage of transferring them. However, even if a policy transfer meets all of the requirements, some of the transferred assets may still be subject to taxation. If the current cash value of the policy exceeds the $12,000 gift tax exclusion (limit per person is $12,000 in 2006), gift taxes will be assessed and will be due at the time of the original policyholder's death. (To learn more, read Problematic Beneficiary Designations - Part 1 and Part 2.)
Conclusion
Today, it's not uncommon for individuals to be insured under a life insurance policy for $500,000 to $1 million in death benefits. Once you add in the value of your home, your retirement accounts, savings and other belongings, you may be surprised by the size of your estate. If you factor in several more years of growth and the fact that the estate tax exclusion will drop to $1 million in 2011, it is clear that many of us are facing an estate tax issue. A viable solution to this is to maximize your gifting potential and to transfer policy ownership whenever possible at little or no gift-tax cost. As long as you live another three years after the transfer, your estate could save a significant amount of tax.
by Steven Merkel (Contact Author | Biography)
Steven T. Merkel, CFP®:, ChFC, is the vice president of portfolio management for Financial Advisory Consultants LLC in Naples, Fla. Steve is a former U.S. Army air defense artillery officer and has been giving financial advice for more than 12 years. He is a Certified Financial Planner® practitioner and a Chartered Financial Consultant. Merkel has been featured and widely quoted in numerous publications including The New York Times, BusinessWeek, Entrepreneur, Consumer Reports, Investment News, Financial Planning Magazine and Fidelity's Stages Quarterly. He enjoys fishing, golf, military history, Miami Hurricane football and relaxing on the beaches of South Florida.
