Preserving and Transferring Wealth: Life Insurance

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Chapter 3
Life Insurance
Giving It To Your Heirs

Preserving Wealth

When Is Life Insurance Included in My Estate?

Preserving and Transferring Wealth focuses on protecting the value of your assets.

To get an overview of estate planning, see our Estate Planning Guide for tips on wills, recordkeeping, probate and more.

Life insurance proceeds are a large portion of many estates. Typically, when life insurance is acquired by a couple, one member is listed as the owner of the policy and the other as the beneficiary. Under these circumstances, the life insurance proceeds will be included in the purchaser’s gross estate and taxed accordingly. If not consumed, those same proceeds will be subject to estate tax again in the survivor’s (beneficiary’s) estate.

Of course, the best way to avoid estate taxes is to keep valuable property out of the estate. The introduction of the unlimited marital deduction has eliminated the tax savings available under prior law for gifts of life insurance to one’s spouse. This is true because simply naming one’s spouse as beneficiary results in 100 percent of the proceeds qualifying for the marital deduction. Thus, it would seem that current planning techniques suggest the use of an irrevocable life insurance trust (discussed below) for the married couple. If the insured is single, an outright gift of the life insurance policy to the beneficiary continues to be an attractive estate planning tool.

Example:

Don Decedent, a widower, dies in 2006, and his estate includes $200,000 in life insurance, a $400,000 house, $1,000,000 in other assets, a $50,000 debt, and $50,000 in administrative expenses. His son inherits everything.

Gross estate	x	$ 1,600,000
Less:	x	x
Debts	$ 50,000	x
Administrative expenses	__50,000	___(100,000)
Adjusted gross estate	x	1,500,000
Marital deduction	x	_____zero
Taxable estate	x	$ 1,500,000
Estate tax after unified credit	x	$ 210,000

If the son were the owner of the policy:

Gross estate	x	$ 1,400,000
Less:	x	x
Debts	$ 50,000	x
Administrative expenses	__50,000	__(100,000)
Adjusted gross estate	x	1,300,000
Marital deduction	x	_____zero
Taxable estate	x	$ 1,300,000
Estate tax after unified credit	x	$ 124,000

The potential tax savings is $86,000 ($210,000 minus $124,000).

An existing life insurance policy may be transferred to a beneficiary and therefore not be includable in your estate if (1) no incidents of ownership in the policy are retained, (2) the beneficiary of the policy is not your estate, and (3) the transfer of the policy is not within three years of your death. The gift tax on the lifetime transfer will be less significant than the cost of retaining the policy in your estate. The annual gift tax exclusion (discussed later) may be used to reduce the value of the gift. Your life insurance consultant will be able to advise you of the value of your policy for gift tax purposes.

What Is an Irrevocable Life Insurance Trust?

For a married couple, significant savings may be obtained by assigning the life insurance on either spouse’s life or on the death of the survivor of both spouses (as in a second-to-die life insurance policy) to an irrevocable life insurance trust for the benefit of the surviving spouse and the insured’s other heirs. Typically, the terms of such a trust are

The surviving spouse receives income for life. Upon his or her death, the trust terminates and distributes its assets to the surviving heirs.
The trustee has the power to invade principal for the benefit of the surviving spouse.

Example

Don Decedent dies in 2006, his wife survives him, and his estate includes $500,000 in life insurance, a $400,000 house, $1,800,000 in other assets, debts of $75,000, and $25,000 in administrative expenses. His will provides for marital and residuary trusts, with all but $1,000,000 funding the marital trust.

Don’s estate: Gross estate	x	$ 2,700,000
Less:	x	x
Debts	$ 75,000	x
Administrative expenses	__25,000	__(100,000)
Adjusted gross estate	x	2,600,000
Marital deduction	x	(1,600,000)
Taxable estate	x	$ 1,000,000
Estate tax after unified credit	x	____ zero
Wife’s estate:	x	x
Inherited from Don	x	$ 1,600,000
Estate tax after unified credit	x	$ 255,000

If Don had assigned his life insurance to an irrevocable trust giving up all incidents of ownership, with terms as set forth above, the taxable estate and estate taxes would be as follows:

Don’s estate: Gross estate	x	$ 2,200,000
Less:	x	x
Debts	$ 75,000	x
Administrative expenses	25,000	(100,000)
Adjusted gross estate	x	2,100,000
Marital deduction	x	__(1,100,000)
Taxable estate	x	$ 1,000,000
Estate tax after unified credit	x	____ zero
Wife’s estate:	x	x
Inherited from Don	x	$ 1,100,000
Estate tax after unified credit	x	$ 41,000

The potential savings is $214,000 ($255,000 minus $41,000).

These savings can be accomplished without any real economic detriment to the surviving spouse, since he or she not only has the right to receive income from the trust for life, but also has, at the trustee’s discretion, the ability to invade principal if necessary.

This kind of transfer in trust raises problems with respect to the payment of future premiums. These problems require careful analysis and planning to avoid related income and gift tax implications.

Normally, the transfer of ownership of a group term life insurance policy will not produce a significant gift tax liability, but any policy having a cash surrender value may create gift tax problems. One may borrow the cash surrender value before the transfer or simply pay the gift tax, if any.

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Disclaimer: This guide is not intended to be a substitute for specific individual tax, legal, or investment planning advice, as certain of the described considerations will not be the same for every taxpayer or investor. Accordingly, where specific advice is necessary or appropriate, consultation with a competent professional adviser is strongly recommended.

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