If You Own Life Insurance, Half the Proceeds May Be Going to Uncle Sam

                             Here’s How to Keep It All for Your Family

Over the years, you may have purchased life insurance policies as a quick way to build up your estate for your family in the event of your untimely death.  You own the policy and you named your estate as the beneficiary.  While a good thought, you could be giving half the proceeds to the government.  Reason:  The life insurance benefits your family receive after your death could be subject to as much as a 45% federal estate tax this year.  Let’s take a step back and go over the basics.

Insurance on your life will be included in your taxable estate if either:

(1) Your estate is the beneficiary of the insurance proceeds, or
(2) You possessed certain economic ownership rights (“incidents of ownership”) in the policy at your death (or within three years of your death).

Avoiding the first situation is easy: Just make sure your estate is not designated as beneficiary of the policy.

The problem is that many people, hearing of the possible inclusion of life insurance proceeds in their estates,  try to avoid this result by assigning the policy’s ownership to, say, their children.  But, they don’t cut all the “strings” on the policy.  Here is where the second rule for inclusion of the proceeds comes into play.  

Clearly, if you are the owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is.  However, simply having someone else possess legal title to the policy will not prevent this result if you keep so-called “incidents of ownership” in the policy.  “Incidents of ownership” are rights that, if held by you, will cause the proceeds to be taxed in your estate.  These rights include:

•        the right to change beneficiaries,
•        the right to assign the policy (or to revoke the assignment),
•        the right to pledge the policy as security for a loan;
•        the right to borrow against the policy’s cash surrender value, and
•        the right to surrender or cancel the policy.

Merely having any of these powers will cause the proceeds to be taxed in your estate, even if you never exercise the power.

So, now that you know the downside to owning life insurance in your own name, or even the name of a son or daughter, how can you keep the proceeds all for your family?  

Life Insurance trusts.  A life insurance trust is an effective vehicle that can be set up to keep life insurance proceeds from being taxed in the insured’s estate.  Typically, the policy is transferred to the trust along with assets that can be used to pay future premiums.  Alternatively, the trust buys the insurance itself with funds contributed by the insured.  As long as the trust agreement gives the insured none of the ownership rights described above, the proceeds will not be included in his or her estate.

The three-year rule.  Timing is important in setting up insurance trusts.  If you are considering setting up a life insurance trust with a policy you presently own by assigning away your ownership rights in such a policy, starting the process is critical.  Reason:  Unless you live for at least three years after these steps are taken, the proceeds will be taxed in your estate.  For policies in which you never held incidents of ownership, the three-year rule doesn’t apply. But, in either event, the process of setting up a well- thought-out trust and taking the administrative steps to either (1) assign the existing policy to the trust, or (2) purchase a new policy by the trustee can take longer that most people anticipate.  So starting the process as soon as you are able to is important.                         

626 Reckson Plaza
Uniondale, NY  11556

Telephone
(516) 522-2575

Copyright © 2007 STEPHEN C. SILVERBERG, PLLC  All rights reserved.
Last modified: December 27, 2007

Lawyer Advertising.  This web site is designed for general information only. The information presented at this site should not be construed to be formal legal advice nor the formation of a lawyer/client relationship. See full Disclaimer.

"The opinions set forth in this website are subject to the disclaimer pertaining to IRS Circular 230 set forth herein."