Life insurance proceeds paid upon the death of the insured person generally are exempt from federal income tax. But income taxes aren't the end of the story. When death benefits go directly to a beneficiary other than a surviving spouse - such as a child or a sibling — the proceeds potentially are subject to federal estate tax.
Strategy: Set up an irrevocable life insurance trust (ILIT). If things are handled properly, the life insurance proceeds won't be included in the client's taxable estate because the client won't be considered the owner of the policy.
For these purposes, an insured person is treated as the owner of a life insurance policy if he or she possesses any “incidents of ownership” in the policy. It doesn't take much to trigger this rule. For instance, you're treated as having incidents of ownership if you retain the power to change policy beneficiaries, change coverage amounts, cancel the policy, etc.
In other words, if a client names someone other than a spouse as the eneficiary of a sizable life insurance policy — or the spouse predeceases the client and the funds go to a contingent beneficiary — the end result could be a hefty estate tax bill.
With an ILIT, the trust pays the premiums and the death benefit ultimately goes to the person named as the beneficiary of the trust. Key point: The insured person doesn't possess any incidents of ownership, so there's no federal estate tax on death benefits from the policy.
Caution: Be aware of two potential tax pitfalls. First, the client might face gift-tax complications (see box, below). Second, if a client transfers ownership of a life insurance policy to an ILIT and dies within three years of the transfer, the death benefit is still included in the client's taxable estate.
Advisory: To avoid this result, have the trust buy a new policy. Alternatively, transfer an existing policy immediately to start the three-year clock running.
Sidestep gift-tax problems on transfers
How does an ILIT pay the premiums on a life insurance policy? The insured person has to funnel cash into the trust year after year. Naturally, these transfers are potentially subject to gift tax.
Strategy: Shelter transfers from gift tax with the annual gift-tax exclusion. For 2008, an individual may provide up to $12,000 a year to the trust without paying any gift tax ($13,000 for 2009).
Say the ILIT you set for Jack Britton buys a $1 million term policy on his life. Based on Jack's age and health, the policy costs $2,500 a year. So Jack is way under the annual gift-tax exclusion limit.
What if someone transfers an existing policy to the trust? To the extent that the policy has a cash value, the transfer could trigger gift-tax liability.
Advisory: Gift tax can still be avoided through a combination of the annual exclusion and the $1 million lifetime gift-tax exemption.
Reprinted with permission from The Tax Strategist, November 2008. For continuing advice on this and numerous other tax strategies, go to www.TaxStrategist.net. Receive 2 FREE Bonus Reports and a 40 percent discount on The Tax Strategist when you use Promo Code WN0013.