Life Insurance Benefits: How to Avoid Estate Taxes

The reason that most people buy life insurance benefits is to provide for their family after their death.

Yet, in some cases, if the life insurance benefits your family receives after your death are included in your estate, the benefits will also be subject to federal estate tax.

When Are Life Insurance Benefits included in a Taxable Estate?

Under the estate tax rules, 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 (known as “incidents of ownership”) in the policy at your death (or within three years of your death).
   

How to keep Life Insurance Proceeds Out of Your Estate

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

The second rule is more complex. Clearly, if you are the owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is.

However, having someone else possess legal title to the policy will not prevent this result if you keep “incidents of ownership” in the policy.

Incidents of ownership include the right to:

• Change beneficiaries
• Assign the policy (or to revoke an assignment
• Pledge the policy as security for a loan
• Borrow against the policy’s cash surrender value
• Surrender or cancel the policy.
  

Remember that merely having any of the above ownership powers will cause your life insurance benefits to be taxed in your estate even if you never exercise the power.

Solutions to Ownership Rights to Avoid Estate Tax

Buy-sell agreements

Life insurance obtained to fund a buy-sell agreement for a business interest under a “cross-purchase” arrangement will not be taxed in your estate (unless the estate is named as beneficiary).

Example

For example, say Allen and Betty are partners who agree that the partnership interest of the first of them to die will be bought by the surviving partner.

To fund these obligations, Allen buys a life insurance policy on Betty’s life. Allen pays all the premiums, retains all incidents of ownership, and names himself or herself as beneficiary. Betty does the same regarding Allen. When the first partner dies, the insurance proceeds are not taxed in the first partner’s estate.

Life insurance trusts

An irrevocable life insurance trust (often referred to as an “ILIT”) 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. If the trust agreement gives the insured none of the ownership rights described above, the proceeds will not be included in the insured’s estate.

The Three-Year Rule

If you are considering setting up a life insurance trust with a policy you own currently or simply assigning away your ownership rights in such a policy, be aware of the Three-Year Rule.

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.