Life insurance, which can help to provide for your heirs in the event of
your death, can be an important estate planning tool. It can provide funds to
loved ones when they need it most and help meet your family’s financial
obligations.
One issue overlooked by many people, however, is that life insurance can
add significant wealth to an overall estate, potentially causing assets to
exceed the 2021 applicable exclusion amount of $11.7 million (per individual),
the amount that can be sheltered from estate taxes. Fortunately, with proper
guidance, it is possible to keep your life insurance policy proceeds out of your
estate and to also provide immediate funding for short-term financial needs.
Know the Rules
You may already know that the inclusion of life insurance policy benefits
in your taxable estate is contingent partly on incidents of ownership. Policy
proceeds cannot be excluded from estate taxation if you have held any incidents
of ownership on the policy during the three-year period preceding your death.
In general terms, an incident of ownership is the right to exercise
control over the policy or to receive an economic benefit from the policy,
including any powers to surrender the policy, to pledge the policy as
collateral, or to assign the policy and any reversionary interest equal to 5%
or more of the value of the policy before death.
An incident of ownership also
exists on a policy if you have any power to act as a fiduciary of a trust that
holds insurance on your life if you established the trust, if you transferred
the policy or consideration for the policy to the trust, or if you could have
exercised any fiduciary power over the trust for your own benefit. However,
your estate may not include your life insurance proceeds merely because you
planned to purchase the insurance or gifted money used to pay premiums within
three years prior to your death.
Again, entire policy benefits may be included in your estate unless all
incidents of ownership are transferred more than three years before your death.
In practice, the application of this rule is not always clear. Therefore, it is
important to consult with your tax and legal advisors to ensure that your
actions are consistent with your desired objectives.
A Plan of Action
Here is some
additional information that you may want to discuss in detail with your
advisor: for new life insurance policies, insurance proceeds are not included
in the estate of the insured when another person (often an adult child or an
irrevocable trust created by the insured) is the initial applicant on, and
owner of, the policy, or when the insured never possessed an incident of
ownership on the policy.
If you want to keep
life insurance proceeds on existing policies out of your estate, you need to
transfer any incidents of ownership on the policy to another person at least
three years before your death. In addition, make sure that your estate is not
the beneficiary of the policy and that the policy beneficiary is not required
to use policy proceeds to pay estate claims and expenses.
Keep the above in
mind as you develop a plan for keeping your life insurance proceeds out of your
estate. Remember, before you take any action that might affect your policies,
consider carefully all of the alternatives and seek professional counsel on how
to best achieve your specific objectives.
