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Transfer Your Life Insurance Policy to Lower Your Estate Tax

First off, you likely won't need to worry this issue if you do not think that your estate will be subject to the federal estate tax. As of 2010, only estates worth over $5 million are subject to any estate taxes.

If your estate will be taxed by the federal government, then it is worthwhile to know that only things that you own at your death will be counted towards the value of your estate. If you transfer your life insurance policy away before your death, the insurance proceeds at your death are someone else's property and will not be included in the total value of your estate.

To illustrate this point, let's look at an example. Suppose that Darla bought an insurance policy that covered her life and had a face value of $400,000 with Darla's son Sam as the named beneficiary. Darla's business partner Frank buys a life insurance policy on Darla that has a face value of $500,000, with Frank as the named beneficiary. Frank is planning on using this money to buy out Darla's half of the business when Darla dies and leaves her half of the business to Sam.

Darla tragically dies on the way to work one day and the $400,000 that is paid to Sam from her life insurance is included in her taxable estate. However, the $500,000 that is paid out to Frank is not part of the estate because Darla did not own that life insurance policy at her death -- her death only triggered the policy.

This illustrates the point that if you do not want to have the proceeds of your life insurance policy included in your federal estate, then you should transfer ownership of it. In general, there are two ways that you can accomplish this goal. First, you can transfer ownership of the policy to another adult, even the named beneficiary. Second, you can create an irrevocable life insurance trust and transfer the policy to the ownership of the trust. Be aware, however, that if you get life insurance through a group plan at work, you may not be able to transfer ownership rights of your policy.

It is worth bearing in mind that if you leave your entire estate to your spouse at your death, you will avoid all federal estate taxes, no matter the size of the estate. However, by transferring such a large estate, you will most likely make your spouse's estate much larger upon their death, which could lead to very high estate taxes.

Transferring Ownership to Other Adults

Although it can be easier than setting up a life insurance trust, transferring ownership of your life insurance policy to another adult has its own drawbacks. Perhaps most significantly is that once you transfer ownership of the policy you can't go back and change your mind. You cannot alter your life insurance policy once you have transferred it, either.

For example, if you transfer your life insurance policy to your best friend, but then you have a falling out, you cannot get your life insurance policy back. However, these transfers do work well in situations when you transfer a policy to an adult child with whom you have a solid relationship.

Three-Year Rule from the IRS

Among the myriad federal agencies, it is perhaps the Internal Revenue Service that loves rules the most. The IRS has promulgated a rule that determines who owns a life insurance policy for the purposes of calculating the total value of an estate. Under this rule, if a transfer of a life insurance policy took place within the three years preceding death, then the transfer is void and the proceeds from the life insurance policy are counted into the estate.

As an example: Suppose Mary bought a $1 million life insurance policy that had her daughter, Micky, named as the beneficiary. Mary is worried about estate taxes, so she transfers ownership of the policy to Micky in 2001. In 2002, Mary is killed by a drunk driver. Because the transfer of ownership took place within three years of Mary's death, the transfer is void for tax purposes and the $1 million is counted into Mary's estate.

So it is pretty clear that if you are considering transferring ownership of your life insurance policy, you should do it sooner rather than later.

Other IRS Rules Concerning Transfer of Ownership of Life Insurance Policies

There are other rules and regulations that the IRS follows that determine the ownership of life insurance policies for the purpose of calculating the federal estate tax. If a deceased person kept any "incidents of ownership" of the life insurance policy, then the policy is still considered to be owned by the deceased upon their death.

This strange term can be loosely defined as a situation where the deceased person still had power over the policy as if he or she were still the true owner (in effect making the transfer a sham). In particular, the life insurance policy will be counted into the deceased estate if the deceased retained the power to do any of the following after transferring ownership:

  • Cancel, surrender or convert the life insurance policy;
  • Use the policy as collateral in order to borrow money;
  • Change the named beneficiary of the policy; or
  • Select the method of payment that the policy will pay out in (installments or a lump sum).

Concerns over Gift Taxes

Under current laws (as of 2009), any gift of more than $13,000 is subject to a gift tax. Therefore, if you transfer a life insurance policy that has a present value of more than $13,000, any amount over that $13,000 will be taxed when the policy is paid out (after your death).

However, even with this tax, it is still worthwhile to transfer the policy instead of keeping it within your estate. If your estate will already be subject to the estate tax, then the full amount of your life insurance policy will be included in your estate and be subject to the 45% estate tax at your death. However, if you transfer the policy before your death, only the amount that the policy was worth at transfer will be taxed.

This is a confusing subject and an example will probably be beneficial here. Suppose that Jeremy transfers the ownership of his life insurance policy to his daughter when the value of the insurance policy is $30,000. When Jeremy dies, the insurance policy pays out $400,000. Because Jeremy transferred the policy when it had a lower value, Jeremy's daughter will only have to pay gift taxes on $17,000 of the gift (the amount of the $30,000 that exceeded the $13,000 gift limit), and the $400,000 will not be included in Jeremy's estate.

How to Transfer Life Insurance Policies

Much like giving other pieces of property, you can give away your life insurance policies by simply signing a document called an "assignment of rights" or a "transfer." Most life insurance companies have their own forms to transfer ownership, and it is always best to use their forms instead of making your own. Simply contact your life insurance company and request an assignment or transfer form. You may also have to change the policy to indicate that the insured person is no longer the owner of the policy.

After the transfer has been completed, the new owner of the policy is responsible for making all premium payments on the life insurance policy. If you continue to make the payments on the policy, the IRS may take this as evidence that you are still the true owner of the policy and will count the benefits towards your estate.

In general, there are two types of life insurance policies that can be transferred. The first type is a prepaid, single-payment policy. The upside of transferring this type of policy is that there are no premiums that the new owner must continually pay. However, if the policy is worth more than $13,000 when it is transferred, a gift tax will be assessed on your death. The second type is a policy that asks for yearly premium payments. If the policy is worth less than $13,000 each year, then there will be no gift tax assessed upon your death because you are giving a gift of less than $13,000 each year.

Life Insurance Trusts

This is the second way of transferring ownership of a life insurance policy so that the benefits are not included in your estate for estate tax purposes. In order to transfer your policy to a trust, you must create an irrevocable life insurance trust and then place the policy inside of the trust. After you transfer the policy, you are no longer the policy owner and the policy benefits will not be included in your estate.

You may wonder why you would want to create a trust instead of simply transferring the policy to a person. First of all, there may be no one that you want to transfer your policy to and you simply want to lower the value of your estate. Or, you want to avoid the risks associated with having your life insurance policy controlled by someone else (perhaps you cannot trust your child to continue to pay the policy premiums). In addition, by placing the life insurance policy inside of a trust, you may continue to have some control over the policy remotely. For example, you can set up the trust in such a way that you guarantee that the policy will continue to have its premiums paid while you are still alive by simply putting those conditions inside of the documents that create the trust.

Here is an example of a situation in which someone may wish to create a life insurance trust. Frank is a single father of two adult sons, both of which are horrible with money. Frank has a large estate and is afraid that his $1 million life insurance policy will push his estate past the estate tax limit. So instead of transferring the policy to his sons, he creates an irrevocable life insurance policy trust, transfers the policy to the trust and names his financial advisor as the trustee. Upon Frank's death, his financial advisor is charged with the duty of managing the funds inside of the trust account for Frank's two sons.

There are three requirements that you must follow in order to create a valid life insurance trust. These requirements are:

  • The trust that you place your life insurance policy in must be irrevocable. This means that you will not have the right to revoke the trust. If you do retain that right, you are still considered the owner of the trust and it will be counted towards the value of your estate.
  • You cannot be the trustee of the trust.
  • And, like transferring a life insurance policy to a person, the trust must be created at least three years prior to your death. If the trust that contains your life insurance policy is not at least three years old at the time of your death, the benefits from your life insurance policy will be counted towards the value of your estate.

Irrevocable life insurance trusts also bring up tricky tax issues that must be contended with. If you are thinking of setting up such a trust, you should consult with your financial advisor and/or lawyer.

Next Steps
Contact a qualified estate planning attorney to help you ensure
that your loved ones are cared for and your wishes are honored.
(e.g., Chicago, IL or 60611)

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