Shield Life Insurance From Estate tax

Typically, you can provide protection for your family by securing life insurance coverage. But how much will they actually receive after Uncle Sam claims his fair share? It depends on how you handle things.


     Avoid potential estate tax problems. As long as you stay within the prescribed tax law boundaries, not a penny of the life insurance proceeds will be included in your taxable estate. However, the full amount is subject to estate tax if you don’t observe the rules.

     Assuming you have a sizable policy and the top federal estate tax is 40%, the difference between doing things the “right way” and the “wrong way” could be worth hundreds of thousands of estate tax dollars.

The Whole Story

     Your gross estate includes proceeds from a life insurance policy if the proceeds are payable to your estate or even to a designated policy beneficiary without ever passing through your estate (unless the proceeds go to your surviving spouse and qualify for the unlimited marital deduction privilege). You can designate beneficiaries like your spouse and children and give them full control over the proceeds. An irrevocable life insurance trust (ILIT) is often used for this purpose.

     It sounds easy enough to do, but there’s more. The proceeds are generally still included in your taxable estate if you possessed any “incidents of ownership” in the policy upon death. This also applies to any ownership rights transferred within three years of your death.

     On the other hand, the right to receive dividends or the right to veto the sale of an insurance policy by a trustee of an irrevocable trust isn’t treated as an incident of ownership.

     As long as you transfer all incidents of ownership in your policy more than three years before your death, all the proceeds are removed from your estate. Although the transfer is subject to the gift tax, it can be sheltered by the $14,000 annual gift tax exclusion and the unified federal gift and estate tax exemption ($5.45 million in 2016).

Tip: The sooner you start the three year clock, the better.

— This article is a contribution from a Business Management Daily Production.

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