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Avoiding Estate Tax on Life Insurance

K Kinney 2014
Kevin D. Kinney, CTFA
Vice President, Trust Officer
[email protected]
(585) 419-0670 x50622

Life insurance makes up a large portion of the estate assets of most individuals. However, many people are unaware that life insurance proceeds may be subject to federal estate taxes.

Essentially, insurance on your life will be included in your estate for estate-tax purposes if:

  • Your estate is the beneficiary of the insurance proceeds or
  • You possess certain ownership rights in the policy at death (or within three years of your death).

You can avoid the first situation by simply making sure your estate is not designated as beneficiary of the policy. Circumventing the second situation is more complex, however.

If you are the owner of the policy at death, the proceeds will be included in your estate regardless of who the beneficiary is. Moreover, simply having another person own legal title to the policy will not prevent this result if you retain certain economic ownership rights (called "incidents of ownership"). These incidents of ownership include:

  • The right to change beneficiaries
  • The right to assign the policy (or revoke an assignment)
  • The right to pledge the policy as security for a loan
  • The right to borrow against the policy's cash surrender value
  • The right to surrender or cancel the policy.

Keep in mind that merely possessing one of the above rights will cause the policy to be included in your estate, even if you never exercise it.

How can you avoid having life insurance taxed as part of your estate? One way is by transferring all incidents of ownership to another person. Another way is through a life insurance trust. A life insurance trust is an effective vehicle for keeping life insurance proceeds from being included in an insured's estate. Typically, the policy is transferred to an irrevocable trust along with assets, which can be used to pay future premiums. Or the trust purchases the insurance itself with contributed funds. As long as the trust document gives the insured none of the incidents of ownership described above, the proceeds will not be included in his/her estate.

If you are considering assigning away your ownership rights in a policy or are thinking of setting up a life insurance trust with a policy you currently own, be careful. You must survive for at least three years after either step is taken or the proceeds will be included in your estate. If you never held incidents of ownership in a policy, the three-year rule doesn't apply.

Remember that, if life insurance will be paid to a spouse, the estate-tax marital deduction will effectively eliminate estate tax on the proceeds even if they are included in your estate.

Even though the federal estate tax is scheduled to be repealed in 2010, it remains a threat until then ~~ especially to larger estates. If you have questions about removing life insurance from your taxable estate or estate-tax planning in general, call us. CNB can provide professional guidance geared to your specific circumstances. For further information, please call Kevin Kinney, AVP, Business Development Officer, (585)419-0622 or email [email protected].