By Bruce Bechhold, CPA, Walthall CPAs
Maximizing the estate planning value of life insurance means getting the most for your money and keeping as much of the proceeds as possible away from the IRS.
You want your money to go to your beneficiaries. When you pass away, all of your assets (e.g., your money, house, car, stocks, bonds, as well as your life insurance proceeds) get lumped together and divided. Part goes to your heirs and beneficiaries, part to the federal government, part to creditors, etc.
The part that goes to the government can be as high as 40 percent – that is money not going to your heirs and beneficiaries. It is best to plan now to ensure the part that goes to the federal government is as small as possible.
In order to reduce estate taxes, you should first understand how estate taxes work. While this can be quite technical and best left to professionals, a basic understanding can give you direction on making sound arrangements.
The person who owns the policy, and the length of time can affect how life insurance is taxed for estate tax purposes.
If you own a life insurance policy on yourself when you die, the proceeds are then part of your gross estate for estate tax purposes. If you own a policy and transfer it to another owner within three years of your death, the transfer is not recognized for estate tax purposes, and the proceeds are still included in your gross estate.
However, if the ownership of your policy is transferred to someone else more than three years before you die, the transfer is recognized for estate tax purposes, and the proceeds are not included in your estate. What does this mean? That if the proceeds are not included in your estate, they may not be subject to estate tax.
Someone other than you, or your spouse in a community property state, should own the policy if you want to avoid subjecting the proceeds of your life insurance policy to estate tax. The owner can be either another individual or a trust such as an irrevocable life insurance trust.
Who your life insurance beneficiaries are can also affect how life insurance is taxed for estate tax purposes. If your estate or executor is the beneficiary of your life insurance policy, the proceeds are usually included in your gross estate for estate tax purposes even if you do not own the policy on your death (or did not own it within three years of your death).
The main reason for not naming your executors or estate as the beneficiaries of your life insurance policy is that it subjects the proceeds to probate and creditors. If you own the policy, regardless of who your beneficiaries are (even a third party), the proceeds will be included for estate tax purposes and subject to estate tax, but they will pass by the probate process and creditor claims. Proceeds payable to your children are not subject to estate tax unless you own the policy on your death (or within three years of your death).
If you name your children as beneficiaries, they will receive a greater benefit from the policy than if you named your estate as the beneficiary and then directed that the proceeds be distributed from your estate to your children. Proceeds paid to your estate will be reduced by probate expenses and claims of creditors while proceeds paid directly to your children will not.
This is a lot to digest. It is best to talk with an adviser to determine what works best for you.