What Should You Do With a Million Dollars (of Life Insurance)?

Here is the short answer – get it out of your estate.

Although life insurance plays a critical role in personal, financial, estate and business succession planning, it can cause estate planning issues if it is not properly owned. Let me explain.

Just the other week I met with a client to update his estate planning documents. We reviewed his assets and his estate planning goals. He was confident that his estate was under the $5 million federal estate exemption (this exemption drops to $1 million in 2013). I then asked him about his $1 million dollar life insurance policy. He insisted that the insurance benefits were not taxable and therefore not includible in his taxable estate. Unfortunately he was only partially right. Although life insurance proceeds are not generally subject to income tax, they are subject to the estate tax. In other words, this client’s $1 million dollar would have been included in his taxable estate assets.

So how can you make sure that your life insurance benefits your family after your death and avoids the federal estate tax (particularly if your other assets are close to the federal exemption threshold)?

Under current estate tax rules, insurance on your life will be included in your taxable estate if you either (1) name your estate as the beneficiary on the policy, or (2) possess certain economic rights in the policy at the time of your death (the IRS refers to these rights as “incidents of ownership”).

Avoiding the first situation is easy. You should simply make sure that your estate is not designated as the beneficiary on the policy. Avoiding the second situation is not as simple because, even if you don’t name your estate as the beneficiary on the policy, proceeds are still includible in your taxable estate if you are the owner of the policy. This is true regardless of who is named as the beneficiary.

So, to avoid any incidents to ownership, just don’t own the policy, right? Well, it’s a little more complex than that. Simply having someone else own the policy will not alone prevent inclusion in your estate if you retain certain incidents of ownership in the policy. These incidents of ownership include the following:

the right to change beneficiaries;
the right to assign the policy (or to revoke an assignment);
the right to pledge the policy as security for a loan;
the right to borrow against the policy’s cash surrender value; and,
the right to surrender or cancel the policy.

Keep in mind that merely possessing any of the above-named powers will cause the proceeds to be included in your taxable estate, regardless of whether you ever exercised the power.

Buy-Sell Agreements. Notwithstanding the above, 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 your estate is named as the beneficiary). For example, suppose Bob and Jeff 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, Bob buys a life insurance policy on Jeff’s life. Bob pays all the premiums, retains all rights incidents of ownership, and names himself beneficiary. Jeff does the same regarding Bob. When the first partner dies, the insurance proceeds are not taxed in his estate.

Life Insurance Trusts. An irrevocable life insurance trust (often called an “ILIT”) is an effective way to keep life insurance proceeds from being taxed in the insured’s estate. The policy is typically transferred to the trust along with sufficient cash to pay future premiums or cash that is specially gifted to the trust beneficiaries to cover the premiums. Alternatively, the trust buys the insurance policy directly with funds contributed by the insured. As long as the trust agreement gives the insured none of the incidents of ownership described above, the proceeds will not be included in the insured’s estate. In a few cases, it may be appropriate for the insured to transfer the policy to mature children (and those who care for their well being) and gift the premiums to the children. Because the children own the policy, it is not included in the insured’s taxed estate. However, the problem with children or anyone else owning the policy is that the insured must give up control over the management and use of the policy.

The Three-Year Rule. You should be cautions if you are considering setting up a ILIT with a policy you own currently or simply assigning away your ownership rights in such a policy. In these circumstances, you must live for at least three years after the transfer of the policy or the proceeds will be taxed in your estate. For policies in which you never held incidents of ownership, the three-year rule does not apply.

If you’re still wondering what to do with a million dollars (of life insurance) or would like more information about this important topic, please contact a member of our Estate Planning group.