Basics of Life Insurance and Federal Estate Tax
Jun 15, 2011
The Federal Estate Tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death. The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your "Gross Estate." The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets. Also, surprisingly to most, life insurance proceeds are among the types of property that are subject to estate tax. Estate taxation of life insurance proceeds centers around ownership of the policy and payment of the proceeds. If the proceeds of a policy are paid to the insured person's estate, then they will be fully subject to tax on the insured person's death.
If you own a life insurance policy, upon death, your estate will be fully subject to tax if:
v the proceeds of the policy are payable directly or indirectly to your estate, or
v if you, while alive, held any ownership in the property, such as the right to charge a beneficiary, surrender or cancel the policy or borrow against the policy.
If you have a life insurance policy covering you and you do not own it, then the proceeds of the policy will not be subject to estate tax. It is not unusual for an insurance policy to be taken out on someone else. An option here is for a farming child to have a policy on their farming parent, where the child is the owner, not the parent. This is an option, but it does not give the insured much choice as to what the proceeds go towards at death. There is another option that can help with that – an irrevocable life insurance trust.
An irrevocable life insurance trust ("ILIT") is a tool that one can use to designate what happens to the death benefit proceeds at death; specifically, to help beneficiaries fight the federal estate tax burden, if applicable. The trust "owns" your life insurance policy, pays the premiums and gives the death benefit to your beneficiaries when you die. By placing ownership of the policy with a trust — not the insured — it removes the death benefit from your estate. They are a good tool, but there are many requirements associated with them in order for them to work properly. Set up properly, the trust can cover the tax bills of an estate, or other goals. In my next posting, I will cover the requirements of and ILIT specifically. Stay tuned.
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Required Disclosure Pursuant to IRS Circular 230: Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code; or (2) promoting, marketing or recommending to another party any transaction or matter addressed in this communication.