The Gift of Life Insurance

Most people don’t like to think much about life insurance because it involves two unpleasantries: dealing with insurance companies and thinking about their own deaths. Life insurance can make a great tax-saving gift because it is valued for tax purposes not at what the proceeds will be when you die, but at the cash value--a far smaller amount. And the beneficiary doesn’t pay income tax on the proceeds either. You can also use life insurance to help your charitable giving.

Many people think life insurance proceeds aren’t taxable. Wrong! The recipient of life insurance proceeds will not pay income taxes on the receipt of the proceeds, but will pay taxes on any income earned on the proceeds after receipt. Also, the cash value of a life insurance policy counts as an asset of your estate, and so might be subject to the federal estate tax if your estate is large enough.

If you own life insurance, the death benefit is included in your estate for estate tax purposes. If your spouse is the beneficiary, the value of the proceeds will be included in the spouse’s estate for estate tax purposes at the death of the spouse. (We will discuss how you can address this problem in the next section.)

Insurance Can Benefit Your Tax Situation

Life insurance proceeds paid to a bona fide charity will create a charitable deduction that will reduce the federal estate tax liability for the estate. Unlike the income tax side, there is no limit to the charitable deduction that can be applied to reduce, or eliminate, the estate tax.

The best way to reduce estate tax liability that may be created by life insurance is to change the ownership of the policies. Remember, if you own the policies, the death benefit is included in your estate for estate tax purposes. There are two common ways to change ownership of insurance policies:

Third party owners. In the first method, you take out a policy on your life that benefits your children or other beneficiaries.

Next--this is the critical move--you place ownership of the policy not in your name, but in your beneficiaries’ names--usually your children. You can then give them the money each year to pay the premiums, making sure to keep your total gift to each person below $12,000 per year to avoid the gift tax. In general, as long as you live more than three years after transferring ownership, the policy is out of your estate.

You will lose control over the policies. For example, if third parties own the policy they have certain rights, including the right to change beneficiaries.

Life insurance trusts. These are a popular way of accomplishing the same goals while maintaining effective control over the policies and their disposition. Remember you do not need to own something to control it.

Here’s how life insurance trusts work: A married couple has a combined taxable estate that is greater than their combined exemption amounts after using other tax-avoidance devices. They set up a life insurance trust in which the trust owns the policy on their lives--they do not. They can do this with an existing policy (by transferring ownership to the trust) or a new one.

Each year, for example the husband buys $11,000 worth of premiums in the policy. When he dies, the policy pays off $400,000--none of it taxable as a part of his gross estate--to the trust. (The premium payments and death benefits are determined by a number of factors and will vary with each case.) The wife lives off the income from the trust. When she dies, the children take the principal remaining--again, tax-free—because the wife didn’t own the proceeds, and only had a life interest in them. Or the trust may provide for a continuing trust or trusts to benefit the children.

You must follow strict requirements to keep the value of the proceeds from being included in your estate:

• The life insurance trust must be irrevocable (see chapter 9).

• You cannot retain any kind of ownership (the technical term is incidents of ownership), such as making decisions about the policy, or name yourself trustee.

• You must transfer the ownership at least three years before you die; otherwise, the proceeds will be taxed as part of your estate. The three-year rule doesn’t apply if you were never the owner of the policy; for example, you could originally take out the policy in the name of the trust or of your spouse.

• It is imperative that your attorney, insurance advisor, and trustee work together to ensure that all of the rules that govern the establishment and management of these trusts are carefully followed. While these trust are commonly used, if the rules are broken the many advantages of these trusts will be lost.

Do It Right

Certain factors must be considered when transferring an existing policy. Your lawyer can address these factors while working with a qualified insurance professional.