A:

Because

most states protect life insurance policies from creditors, most buyer questions come from the confusion created with ownership and beneficiary designations because of tax treatment. This is a rather complicated issue when it comes to life insurance proceeds, because there are two tax issues that raise their head: U.S. ordinary income taxes (for the beneficiary) and federal estate taxes (on the estate tax return of the deceased).

Ownership of the Policy
If your life insurance beneficiary is your spouse, generally there's no issue; assets pass estate-tax free between husbands and wives no matter what the amount (as long as the spouse is a U.S. citizen). However, if your estate is large (more than $2 million), you may want to consider putting ownership of your life insurance policy in an irrevocable life insurance trust in anticipation of the taxes due at the death of the surviving spouse.

Why? By having the irrevocable trust own the policy, the proceeds of the death benefit payout will not be included as part of your taxable estate, which can be taxed as high as 45%. Revocable trusts will not qualify for the exclusion. If the policy is a new policy, name the trust as owner immediately. If the policy is existing, you can transfer ownership to the trust. Beware: to eliminate deathbed transfers, the government mandates that you must survive the transfer by three years or your estate will be taxed anyway. Also, if the cash value of the policy that you would get if you cashed in now instead of when you die is more than $14,000 (as of 2013), the transfer may use up part of your gift and estate tax exemptions.

Life Insurance Beneficiaries
In most cases, it makes better sense to name your beneficiaries individually on life insurance policies versus naming a trust as beneficiary. If your beneficiaries have creditor issues, mental health problems, can't be trusted with large sums of cash or their primary beneficiaries are minors or have drug issues, or there other special scenarios, then naming the trust as beneficiary might be a better route.

For federal tax purposes, if a spouse is named as beneficiary then life insurance proceeds received upon the death of the insured are generally income and estate tax free (if paid in lump sum). Trusts are not considered individuals; therefore, life insurance proceeds paid to trusts are generally subjected to estate tax. Also, the proceeds payable to a trust may not qualify for the inheritance tax exemption provided by some states for insurance payable to a named beneficiary. In such states, a higher tax may be owed.

For more insight, read Establishing A Revocable Living Trust and Pick The Perfect Trust.

RELATED FAQS
  1. How much life insurance is enough?

    There are many factors to consider when calculating life insurance. Some of those factors include marital status, dependents, ... Read Full Answer >>
  2. Upon my death, will the beneficiaries of my IRA be compelled to take the entire amount ...

    It depends. If the beneficiary of your IRA is your spouse, he or she will be eligible to transfer the amount to his or her ... Read Full Answer >>
  3. What is variable life insurance?

    Variable life insurance is a permanent life insurance policy with an investment component. The policy has a cash value account, ... Read Full Answer >>
  4. If a trust is named as the beneficiary of an IRA, can the trustee of that trust become ...

    While the IRA owner is alive, only the IRA owner can change the designated beneficiary of the IRA. Exceptions may apply ... Read Full Answer >>
  5. If an individual still has his or her former spouse as the beneficiary of an IRA, ...

    It depends. Generally, divorce does not effectively change a beneficiary designation unless the divorce decree makes a stipulation ... Read Full Answer >>
  6. 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 >>
Related Articles
  1. Tax Strategy

    Profit from Art with a Charitable Remainder Trust

    With a CRUT, art collectors can avoid capital gains taxes on the sale of art– while also leaving their favorite charity a legacy.
  2. Estate Planning

    Before You Agree to Be an Executor: Know This

    How to avoid 5 surprising hazards of being the executor of an estate.
  3. Personal Finance

    The Top 6 Books for Estate Planning

    Here are six outstanding books that can help you with your estate planning.
  4. 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.
  5. 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.
  6. 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?
  7. Your Clients

    When to Trust a Revocable Trust

    Unsure of how your assets will be dispersed once you're gone? Here's how setting up a revocable trust while you're here can be a big benefit.
  8. Retirement

    Your Retirement-Planning Team

    As you accumulate wealth, retirement planning can be too complex for just one person. The right team can help you avoid headaches and reach your goals.
  9. Personal Finance

    How Survivorship Life Insurance Works

    Should you buy a survivorship life insurance policy?
  10. Insurance

    Dividend-Paying Whole Life Insurance: What to Know

    Many whole life insurance policies pay dividends. Here are what policyholders need to consider.
RELATED TERMS
  1. Fiduciary

    A fiduciary is a person who acts on behalf of another person, ...
  2. Taxes

    An involuntary fee levied on corporations or individuals that ...
  3. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. ...
  4. Wealth Management

    A high-level professional service that combines financial/investment ...
  5. See-Through Trust

    A trust that is treated as the beneficiary of an individual retirement ...
  6. Settlor

    The entity that establishes a trust. The settlor also goes by ...
Trading Center