Wouldn't it be nice if you could pass on your entire estate free of taxation? While this scenario is highly unlikely, there are some smart decisions that you can make to avoid future tax consequences. One poor decision that investors seem to make frequently is the naming of "payable to my estate" as the beneficiary of a contractual agreement such as an IRA account, an annuity or a life insurance policy. However, when you name the estate as your beneficiary, you take away the contractual advantage of naming a real person and subject the financial product to the probate process. Leaving items to your estate increases the estate's value, and it could subject your heirs to exceptionally high estate taxes. Here we show you some of the ways that you can reduce the taxes on your estate and ensure that your heirs will benefit from it as much as possible.

Tutorial: Estate Planning

Taxation of Life Insurance Death Benefits
One of the benefits of owning life insurance is the ability to generate a large sum of money payable to your heirs in the event of your death. An even greater advantage is the federal income-tax free benefit that life insurance proceeds receive when they are paid to your beneficiary. However, although the proceeds are income-tax free, they may still be included as part of your taxable estate for estate tax purposes. (For further reading, see Buying Life Insurance: Term Versus Permanent and A Look At Single-Premium Life Insurance.)

Section 2042 of the Internal Revenue Code states that the value of life insurance proceeds insuring your life are included in your gross estate if the proceeds are payable: (1) to your estate, either directly or indirectly; or (2) to named beneficiaries, if you possessed any incidents of ownership (we'll discuss this more below) in the policy at the time of your death.

In 2011, Congress and the president extended the Economic Growth and Tax Relief Reconciliation Act of 2001 through 2011 and 2012. Whereas the federal tax exclusion amount was increased to $5 million per person with an estate tax rate of 35% in years 2011 and 2012. On January 1, 2013, the examption and rate are scheduled to revert back to the 2002 figures of a $1 million exemption and a 55% estate tax rate. (To learn more, check out Get Ready For The Estate Tax Phase Out and Getting Started On Your Estate Plan.)

Ownership Transfer
For those estates that will owe taxes, whether life insurance proceeds are included as part of the taxable estate depends on the ownership of the policy at the time of the insured's death. If you want your life insurance proceeds to avoid federal taxation, you'll need to transfer ownership of your policy to another person or entity. Here are a few guidelines to remember when considering an ownership transfer:

  1. Choose a competent adult/entity to be the new owner (it may be the policy beneficiary), then call your insurance company for the proper assignment, or transfer of ownership, forms.
  2. New owners must pay the premiums on the policy. However, you can gift up to $13,000 per person in 2010-2011, so the recipient could use some of this gift to pay premiums.
  3. You will give up all rights to make changes to this policy in the future. However, if a child, family member or friend is named the new owner, changes can be made by the new owner at your request.
  4. Because ownership transfer is an irrevocable event, beware of divorce situations when planning to name the new owner.
  5. Obtain a written confirmation from your insurance company as proof of the ownership change.

Life Insurance Trusts
A second way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT). In order to complete an ownership transfer, you cannot be the trustee of the trust and you may not retain any rights to revoke the trust. In this case, the policy is held in trust and you will no longer be considered the owner. Therefore, the proceeds are not included as part of your estate. (For more insight, read When is it a good idea to use an irrevocable life insurance trust?)

Why choose trust ownership rather than transferring ownership to another person? One reason might be that you still wish to maintain some legal control over the policy. Or perhaps you are afraid that an individual owner may fail to pay premiums, whereas in the trust you can ensure that all premiums are paid in a timely manner. If the beneficiaries of the proceeds are minor children from a previous marriage, an ILIT will allow you to name a trusted family member as trustee to handle the money for the children under the terms of the trust document.

IRS Regulations
The IRS has developed rules that help to determine who owns a life insurance policy when an insured person dies. The primary regulation overseeing proper ownership is known in the financial world as the three-year rule, which states that any gifts of life insurance policies made within three years of death are still subject to federal estate tax. This applies to both a transfer of ownership to another individual and the establishment of an ILIT. So, if you die within three years of the transfer, the full amount of the proceeds are included in your estate as though you still owned the policy.

Another IRS regulation will look for any incidents of ownership by the person who transfers the policy. In transferring the policy, the original owner must forfeit any legal rights to change beneficiaries, borrow against the policy, surrender or cancel the policy or select beneficiary payment options. Furthermore, he or she must not pay the premiums to keep the policy in force. These actions are considered to be a part of ownership of the assets and if any of them are carried out, they can negate the tax advantage of transferring them. However, even if a policy transfer meets all of the requirements, some of the transferred assets may still be subject to taxation. If the current cash value of the policy exceeds the $13,000 gift tax exclusion, gift taxes will be assessed and will be due at the time of the original policyholder's death. (To learn more, read Problematic Beneficiary Designations - Part 1 and Part 2.)

Conclusion
Today, it's not uncommon for individuals to be insured under a life insurance policy for $500,000 to $1 million in death benefits. Once you add in the value of your home, your retirement accounts, savings and other belongings, you may be surprised by the size of your estate. If you factor in several more years of growth and the fact that the estate tax exclusion will drop to $1 million in 2013, it is clear that many of us are facing an estate tax issue. A viable solution to this is to maximize your gifting potential and to transfer policy ownership whenever possible at little or no gift-tax cost. As long as you live another three years after the transfer, your estate could save a significant amount of tax.

Related Articles
  1. Insurance

    Beware the Sneaky Math of Universal Life Insurance

    Universal life insurance's cash value can be a cash cow – if there's any left. Read on to see if it'll work as an income source after you've retired.
  2. Term

    How Traditional IRAs Work

    A traditional IRA is a tax-advantaged retirement account that includes stocks, bonds, mutual funds and other investments.
  3. Taxes

    Why People Renounce Their U.S Citizenship

    This year, the highest number of Americans ever took the irrevocable step of giving up their citizenship. Here's why.
  4. Personal Finance

    The Top 6 Books for Estate Planning

    Here are six outstanding books that can help you with your estate planning.
  5. Estate Planning

    Estate Planning: 16 Things To Do Before You Die

    If you don’t plan your estate, your surviving family may have to deal with disputes and probate that were avoidable.
  6. Your Practice

    Advisors: $240B in Fees Up for Grabs by 2030

    Advisors have an opportunity to win generational assets over the next 15 years. Here are some tips on how to cater to different demographics.
  7. Products and Investments

    Cash Value vs Term Life Insurance: Which is Best?

    The debate between cash value life insurance and term insurance plus an investment plan is an ongoing one. Here's a look at both sides of the argument.
  8. Personal Finance

    Want Your Will to Prevail? Don't Die Intestate

    If you die without making a last will and testament, you are said to have died intestate. What happens to your assets in this case?
  9. Insurance

    Getting Your (Insurance) House in Order

    From starting a family to retirement, insurance can play a role in taking care of financial needs. This piece looks at some of the choices you can make.
  10. Tax Strategy

    A Beginner’s Guide To Tax-Efficient Investing

    Tax-efficiency is a measure of how much of an investment’s return remains after taxes are paid.
RELATED FAQS
  1. How do I file taxes for income from foreign sources?

    If you are a U.S. citizen or resident alien, your income (except for amounts exempt under federal law), including that which ... Read Full Answer >>
  2. Are estate planning fees tax deductible?

    Estate planning fees may be tax deductible, but only if certain conditions have been met. Internal Revenue Service (IRS) ... Read Full Answer >>
  3. Can personal loans be included in bankruptcy?

    Personal loans from friends, family and employers fall under common categories of debt that can be discharged in the case ... Read Full Answer >>
  4. How much money does Texas make from unclaimed property each year?

    In 2014, the office of the Texas Comptroller of Public Accounts reported $234 million in unclaimed property claimant liabilities, ... Read Full Answer >>
  5. Are Cafeteria plans subject to FICA, ERISA or FUTA?

    Cafeteria plans are employer-sponsored benefit plans that provide both taxable and nontaxable, or qualified, benefit options ... Read Full Answer >>
  6. How much money does Michigan make from unclaimed property each year?

    According to the 2013-2014 Annual Report of the State Treasurer, the state of Michigan earned only $82,875 in abandoned and ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  6. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
Trading Center