You can stop rubbing your eyes now. Yes, you read the blog title correctly. Unfortunately, that tax advice from your life insurance agent was not fully true (or truly false). With advanced estate planning, however, you can take the teeth out of the tax bite.
I know, I know, another tax day is here and gone. Gretchen always notices that the grass is greener and the birds chirp sweeter every Spring, once the last client tax return is filed. So, since most of you just finished filing your annual income tax return, you may not be in the mood for any further discussion on the topic of taxes… unless, of course, it's all about avoiding them. There that got your attention.
Today, let's take a look at life insurance, taxes and your estate plan.
The primary purpose of life insurance, for most people, is to replace income that would be lost should you die prematurely. In short, life insurance creates an "instant estate" for your loved ones. Good news: The life insurance "death benefits" are generally received by your beneficiaries free of any federal "income tax."
But what about the federal "estate tax"? Hmmmm. Contrary to popular belief and the kitchen table tax advice of many life insurance agents, the death benefit of life insurance could be subject to estate tax. If the tax rules treat you as the "owner" of a policy on your own life, the death benefit is included in your taxable estate – unless the money goes to your surviving spouse (they then will become part of his or her estate). If you are the owner of the policy and the death benefits go to anyone else, a child or sibling even, then money is included in your taxable estate.
Currently, the estate tax exemption is set at $5 million through 2012 only, and although this is historically quite high, a large life insurance policy could push an otherwise non-taxable estate above the limit. And don't forget, that current exemption is in place only through 2012, and there are quite a few who believe lowering the exemption might be the answer to reducing our federal debt.
Smart Money last week laid out pretty clearly how the life insurance / estate tax scenario plays out. To quote the article: "The tax rules say you own a life insurance policy if you possess so-called ‘incidents of ownership.’ You have them if you retain the power to change policy beneficiaries, change coverage amounts, cancel the policy and so forth."
How do you avoid these "incidents of ownership"? You can establish an irrevocable life insurance trust (ILIT) to purchase a new policy on your life. If that's not possible, could consider transferring an existing policy. But watch out! There are some potential land mines awaiting the unwary in that strategy. First, if you transfer the policy and die within three years, the IRS pulls the proceeds back into your estate as if the transfer had not occurred. Second, if you transfer a policy with cash value in excess of $13,000, it could trigger adverse gift tax consequences.
You can read more about irrevocable life insurance trusts in the Fundamental Estate Planning Practice Center on our website. While ythere, be sure to sign up for our free estate planning e-newsletter to stay informed of important matters affecting your estate plan.