Myth Busting: Life insurance is not necessarily estate tax free

Okay, this one will be short to make up for last night’s lengthy, difficult post. The myth: some folks seem to believe that life insurance proceeds are automatically exempt from estate taxes. Not true.

Life insurance is income tax free when paid to a beneficiary. But, they are included in your estate for estate tax purposes if the proceeds are payable to your estate or if they are payable to a beneficiary and you possessed “incidents of ownership” in the policy at the time of your death. If you are the “owner” of the policy in the eyes of the insurance company, your insurance proceeds count as part of your estate. In other words, if you called the company, requested the policy, and pay the premiums, it’s taxable.

Oh no! What to do? One approach is to irrevocably transfer ownership to someone else. “Here, junior, you now own my life insurance policy. Don’t forget to pay the premiums and good luck!” Actually, this can be a pretty good option in certain circumstances, but it can also result in a gift tax at the time of the transfer.

Your other option is to transfer ownership to an ILIT (Irrevocable Life Insurance Trust). If it is done right, the ILIT will “catch” the life insurance benefit and exclude the life insurance money from your taxable estate.

One problem in either instance is the IRS three-year look-back rule: if you give something away within three years of your date of death, the IRS will pull it back into your estate for tax purposes. So if you transfer your old insurance contract to your new ILIT and die tomorrow, your ILIT will be ignored and the policy value will be included in your estate. So if you are going to get an ILIT, do it now and start that three year clock running!

Better yet, before you buy that life insurance policy, get an ILIT and have the ILIT buy the policy. That way you never owned the policy and there will be no look-back. Yippee! Who knew saving taxes could be so much fun?

One comment

  1. Nancy BRIGGS · · Reply

    Love it!

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