Life insurance can play an important role in preserving your wealth. It can provide your beneficiaries with the cash necessary to pay estate taxes and may be a solution if the estate includes a family-owned business, real estate, or other assets that cannot be readily liquidated.
Though life insurance proceeds generally pass free of income tax to beneficiaries (see IRC Section 101(a)), the proceeds are not necessarily free of estate taxes. If you, the insured, had any incident of ownership in the policy in the three-year period prior to death, the proceeds are considered an asset of your estate and are subject to estate tax.
Generally, incidents of ownership include any direct or indirect right to name beneficiaries, borrow against the policy, or make cash surrenders from it. To eliminate this problem, it is important that you do not individually own or control the policy. A trust or other third party, such as your children or other family members, should be the owner of your life insurance policy if you no longer need to personally control the policy or its values. This way, death benefit proceeds will not be counted as part of your estate for estate tax purposes and will be received by the beneficiaries, free of both income and estate taxes.
Life insurance may be an important tool for providing cash for the following reasons:
- It can help maintain your heirs' lifestyles in the event of your death. The lost earning power resulting from your death can have a devastating effect on your family's lifestyle. Life insurance can help ease that burden by providing a sum of cash to your heirs that can be drawn upon as needed.
- Insurance is sometimes the best solution for liquidity problems. Estates are often cash poor if they are comprised primarily of assets such as closely held business interests, real estate, or collectibles. The assets in your estate may be difficult to sell or, for personal reasons, you may not want them sold. Life insurance can help preserve your estate by providing your heirs with the cash they need to pay liabilities, any federal and state estate taxes, administrative costs, and funeral expenses.
- Insurance can be an excellent vehicle for equalizing distribution of your estate among heirs. If you have a small business with one child active in the business, you can distribute the business to that child and use life insurance to equalize the distribution to your other child or children not in the business.
Keep Life Insurance Proceeds from Adding to Your Estate Tax
If you own a life insurance policy at your death, the proceeds are included in your taxable estate. Ownership is usually determined by who has the right to name the beneficiaries of the policy proceeds. The way around this problem? Don't own the policies when you die. One way is to create an Irrevocable Life Insurance Trust (ILIT). This is most effective for estates with values higher than the applicable exclusion amount.
Here's How: The grantor(s) make tax-free gifts to the trust using the $13,000 (2010 and 2011, indexed in future years) annual gift exclusion. For the gift to qualify as a present interest gift (a requirement for the exclusion), the beneficiaries of the trust must have a limited opportunity to withdraw the money. If not taken, the trustee uses the cash to pay premiums on a life insurance policy purchased by the trustee and owned within the trust. In turn, the grantor's spouse and children can be the beneficiaries of the trust, so when the insured dies, the death benefit is paid to the ILIT and the proceeds can be available for the benefit of the spouse and children.
- Using a single life policy—Insured spouse can make gifts, and the trust can benefit the non-insured spouse and children.
- Using a survivorship policy—Both parents can make gifts, and the trust can only benefit the children.
Separate trusts must be used for single life and survivorship policies. If properly structured, the life insurance proceeds are generally income tax-free and should not be taxed in the insured's or surviving spouse's estate.
Insurance is issued by The Prudential Insurance Company of America, Newark, NJ, and its affiliates. Each is a Prudential Financial company that is solely responsible for its own financial condition and contractual obligations. Our policies contain exclusions, limitations, reduction and terms for keeping them in force. A licensed financial professional can provide you with cost and complete details.