There is a common misconception that life insurance policies are not included in a person’s estate and therefore not subject to estate taxes either in Maryland or through the Federal government. I’ve even heard this from fellow attorneys — especially those that practice Maryland Estate Planning. While it is true that life insurance policies that are paid to a named beneficiary (not the estate) are not included in the probate process in Maryland (meaning the money can be paid directly to the beneficiary without court involvement), those insurance proceeds might still be included in the decedent’s estate for estate tax purposes. This is different from probate and carries important consequences.
Life insurance policies are included in a decedent’s estate for estate tax purposes if the decedent owned the policy at the time of death.
John purchases a life insurance policy and names his daughter Susan as the beneficiary. John pays the premiums and can change the beneficiary at any time. John’s employer ABC Company also purchases a policy on John’s life to protect themselves if John dies because John is a key employee. ABC Company pays the proceeds and John has no right to modify the policy or change the beneficiary. When John dies the policy he purchased is part of his estate for estate tax purposes, but the policy purchased by his employer is not because John did not own that policy.
“Owning” an insurance policy is more than a question of who pays the bills. The IRS defines an owner as a person who retains any incidents of ownership. What that means is that if you have any power over the insurance policy, you own it. Specifically, if you have the legal right to do any of the following, you own it:
- Change or name a beneficiary
- Borrow against the policy, pledge any cash reserve it has, or cash it in
- Surrender, convert, or cancel the policy
- Select a payment option (i.e., choose whether payment should be in a lump sum)
Ways Around It
Of course you still want to have life insurance policies. They are an important tool in providing financial security to your family. But, there are ways you can have your cake and eat it too. There are two general ways to avoid having your life insurance policy in your taxable estate:
1. Transfer ownership of the policy to any other adult (including the beneficiary)
2. Create an irrevocable life insurance trust and transfer ownership to it
TIP: Be sure to check the terms of your policy because some policies do not allow you to transfer ownership.
Most policies make it easy to transfer ownership and the insurer probably has a form to do it. Give them a call and inquire. But, be sure that you can’t change your mind later and transfer it back to yourself or someone else. The IRS will view this as retaining ownership in the policy. This is why irrevocable life insurance trusts were created; and an experienced estates and trusts attorney can help you create one.
Another reason to use an irrevocable life insurance trust is when your chosen beneficiary is not a person that you can trust to maintain the policy and pay the premiums. You could establish the trust and place a third party (not the beneficiary) as trustee and you could specify in the trust instrument that the policy must be kept in effect while you live, eliminating the risk that a new owner of the policy could decide to cash it in.
John is the divorced father of two children in their 20s who will be the beneficiaries. John doesn’t think either child is responsible enough with money to manage the policy. John has an estate of $700,000 plus a life insurance policy that will pay $500,000 when he dies. Because John’s estate will be subject to estate taxes if the life insurance policy is included (because it will be higher than the current $1,000,000 limit for Maryland estate taxes), John wants to transfer the policy out of his estate. John creates an irrevocable life insurance trust with his sister Jean as the trustee and transfers ownership of the policy to the trust. When John dies, Jean must follow the terms of the trust document and distribute the money to John’s children as he wanted.
The key components to using a trust to avoid your life insurance policy being included in your estate are:
- The trust must be irrevocable. If you have the right to revoke (i.e., cancel) it, you will be considered the owner of the policy and the proceeds will be subject to estate taxes.
- You cannot be the trustee.
- The policy must be transferred to the trust at least 3 years prior to your death.
Beware of Gifts
If you choose to transfer your policy to a beneficiary, the IRS is likely to consider the transfer a gift, and therefore impose gift taxes. Under current rules, you can give up to $13,000 annually to a person without incurring gift taxes. But, if you transfer a policy with a present value of more than $13,000 gift taxes will be assessed. However, you should keep in mind that gift taxes will be far less than the amount of estate tax that would be due if your policy remained in your estate because the gift tax value is determined at the time of the transfer. And, for most policies, the value of the policy while you’re alive is much less than the amount that will be paid upon your death.
TIP: Using something called a “Crummey Notice” in your irrevocable life insurance trust can help you avoid this problem altogether. We’ll go over Crummey Notices in greater detail in a later post. Stay tuned….
Don’t Die Too Soon
Another possible pitfall when transferring your policy (to a person or to a trust) is that the IRS will disregard any transfer made within 3 years of your death. So, the IRS acts like the transfer never took place and the full amount of the proceeds are included in your estate for tax purposes. So, be sure to hang on and survive at least 3 years after you transfer a life insurance policy!
TIP: One way around this is to have the trust purchase the policy. But, this may require a new application and physical examination and might not be feasible in all circumstances.
Leave it all to your spouse
There is a special exemption that works to protect insurance proceeds from estate taxation when you leave 100% of the proceeds to your spouse. So, even if you own the policy, if you name your spouse as the sole beneficiary, the value (no matter how high) is exempt from federal estate taxes. But, you still might benefit from a life insurance trust or other transfer of ownership.
John purchases a life insurance policy and names his wife Jane as the sole beneficiary and his daughter Susan as the contingent beneficiary. Unfortunately, Jane dies before John, but John did not change his beneficiary designations. When John dies the proceeds are paid to Susan, but are included in John’s estate for estate tax purposes.
I’ll wrap this up on a good note. No matter how you slice it, life insurance proceeds are not considered income for the beneficiary on their annual income taxes.
For more information about insurance policies and estate taxes, visit http://www.irs.gov/ and review the instructions for filing Form 706 – the Estate Tax Return (http://www.irs.gov/pub/irs-pdf/i706.pdf). All insurance policies are to be included on Schedule D of Form 706.