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. Do beneficiaries pay taxes on life insurance?

    Learn how life insurance proceeds are generally not taxable to the beneficiary, but understand the unique situations in which ... Read Answer >>
  2. What are the restrictions for naming a given individual as my contingent beneficiary?

    Understand what restrictions may exist, depending on your state and the policy you choose, on naming your life insurance ... Read Answer >>
  3. What are the keys to setting up a trust fund?

    Setting up a trust to secure your assets for a beneficiary allows you to set the terms under which the beneficiaries are ... Read Answer >>
  4. What are the pros/cons of naming a trust as the beneficiary of a retirement account?

    This has been the topic of an ongoing debate in the financial community between estate planning attorneys and financial advisors. ... Read Answer >>
  5. How are contingent beneficiaries informed of a payout?

    Understand how contingent beneficiaries are made aware of a policy payout, and learn what policy owners can do to ensure ... Read Answer >>
  6. What types of insurance policies have contingent beneficiaries?

    Learn what types of insurance policies use contingent beneficiaries and what conditions must be met for the contingent beneficiary ... Read Answer >>
Related Articles
  1. Retirement

    Estate Planning: Life Insurance In Estate Planning

    by Cathy Pareto, CFP®, AIF® (Contact Author | Biography) Uses of Life InsuranceLife insurance is present in almost every estate plan and serves as a source of support, education-expense ...
  2. Home & Auto

    Intro To Insurance: Life Insurance Considerations

    By Cathy ParetoThere are other important considerations that you should know about life insurance before you buy it. (For more insight, read Life Insurance Clauses Determine Your Coverage.) Tax ...
  3. Professionals

    Insurance Ownership and Beneficiaries

    Insurance Ownership and Beneficiaries
  4. Insurance

    Use Life Insurance to Help Those With a Disability

    Why and how to use permanent life insurance to help provide for a family member with a disability or special needs
  5. Financial Advisors

    Passing an IRA to a Trust: The Good and Bad

    Creating a trust is a common estate planning tactic, but naming a beneficiary to an IRA to a trust may have unintended consequences.
  6. Insurance

    Who is a Beneficiary?

    A beneficiary is a person or entity that receives funds, assets, property or other benefits from a trust, will, or life insurance policy.
  7. Financial Advisors

    How to Handle Client Beneficiary Designations

    Beneficiary designations are a critical financial planning step that can be easily overlooked. Here's how to ensure they are properly done.
  8. Professionals

    Ownership and Beneficiary Consideration

    Ownership and Beneficiary Consideration
  9. Professionals

    Irrevocable Life Insurance Trust

    Irrevocable Life Insurance Trust
  10. Retirement

    Life Insurance: How To Get the Most Out Of Your Policy

    There are many benefits to owning a life insurance policy - if you get the right one for you.
RELATED TERMS
  1. Insurance Trust

    An irrevocable trust set up with a life insurance policy as the ...
  2. Named Beneficiary

    This term refers to any beneficiary named in a will, a trust, ...
  3. Beneficiary

    Anybody who gains an advantage and/or profits from something. ...
  4. Contingent Beneficiary

    1. A beneficiary specified by an insurance contract holder who ...
  5. Charitable Lead Trust

    A trust designed to reduce beneficiaries' taxable income by first ...
  6. Primary Beneficiary

    A beneficiary in a will, trust or insurance policy that is first ...

You May Also Like

Trading Center