by Cathy Pareto, CFP®, AIF®

Uses of Life Insurance
Life insurance is present in almost every estate plan and serves as a source of support, education-expense coverage and liquidity to pay death taxes, pay expenses, fund business buy-sell agreements and sometimes to fund retirement plans.

For small estates, the amount of applicable exclusion ($2 million per person per estate), death taxes are not a significant consideration. For this reason, insurance ownership as a tax-savings device is not critical. The main item that policy owners should be aware of is to ensure that the beneficiaries are well provided for by the chosen insurance policy.

For larger estates with more assets than the amount of the applicable exclusion of $2 million, life insurance is an essential component of the estate plan.

Tax Implications of Life Insurance and Your Estate
Proceeds from life insurance that are received by the beneficiaries upon the death of the insured are generally income tax-free. However, there are three circumstances that cause life insurance to be included in the decedent's estate:
  1. The proceeds are paid to the executor of the decedent's estate.
  2. The decedent at death possessed an incident of ownership in the policy.
  3. There is a transfer of ownership within three years of death (three-year rule must be observed).
An incident of ownership includes the right to assign, to terminate, to name beneficiaries, to change beneficiaries and to borrow against the cash reserves.

Planning Objectives for Insurance
Life insurance has many uses in an estate plan, including estate liquidity, debt repayment, income replacement and wealth accumulation. There are many different types of policies to consider, at different price levels, which are beyond the scope of this article. Policies can be owned in many ways, as outlined below. (To read more about different types of available life insurance, check out Buying Life Insurance: Term Versus Permanent, Permanent Life Policies: Whole Vs. Universal and Variable Vs. Variable Universal Life Insurance.)

Types of Insurance

First-to-Die Life Insurance Policy
Also known as joint whole life insurance, this is a group insurance policy where benefits are paid out to the surviving insured upon the death of one of the insured group members. The insurance policy can be designed as either a whole life or universal life policy. A first-to-die policy can reduce taxes upon the death of the first spouse if the unlimited marital deduction is not fully used.

Survivorship Life Insurance Policy
Survivorship life insurance, also know as second-to-die, is similar to joint life in that the policy insures two or more people. However, survivorship life pays out upon the last death instead of the first one. Because the benefit is not paid until the last insured dies, the life expectancy is greater and therefore the premium is lower. Survivorship policies are typically either whole or universal life policies and are usually written to insure husband and wife or a parent and child.

The proceeds of the policy can be used to cover estate taxes, to provide for heirs or to make a charitable contribution. The premium on a second-to-die policy is generally lower than for separate policies because the premium is based on a joint age and the insurance company's administrative expenses are lower with one policy.

Types of Life Insurance Trust Arrangements
Revocable Life Insurance Trust
In this arrangement the grantor names the trust as beneficiary of life insurance policies, retaining the right to revoke the trust and other rights of ownership.

This is often recommended for younger families with relatively modest assets but substantial life insurance policies.

Irrevocable Life Insurance Trust
The purpose of this arrangement is to exclude life insurance proceeds from the estate of the first spouse to die and from the estate of the surviving spouse. The spouse may be the life income beneficiary, but may not have any right to or power over trust principal except per the discretion of the trustees.

Ownership Considerations
The big question with regard to insurance in estate planning is who should own the policy. The following are some advantages and disadvantages of ownership scenarios:

  • If a life insurance policy is owned by the insured, the advantage is that he has continued control of the policy and any ownership in the associated cash values of a permanent policy. However, the death benefit of this policy would be subject to estate tax and the three-year inclusion would apply if it's transferred out of the estate.
  • If the spouse of the insured owns the policy, you could argue that the insured does have some indirect control of the policy and any associated cash value. The downside is that the replacement cost of the policy would be included in the estate of the spouse, and if the spouse dies before the insured, it's possible that the policy might revert to the insured and be included in his or her estate.
  • If the children of the insured owned the policy, the advantage is that the death benefit would be included in the children's estate, not the parent's. But here again, the insured has zero control over the policy, and if the children are minors it would require the costly appointment of legal guardians before benefits can be paid.
  • The policy might also be owned by a revocable trust, where the insured might still control the policy and the death proceeds are shielded from potential creditors of the insured. But, because the insured has an incident of ownership through the revocable trust, the death benefit is includable in the insured's gross estate and could be accessible to the estate's creditors.
  • If the policy is instead owned by an irrevocable trust as mentioned above, there is no inclusion in the gross estate, and there is an embedded mechanism via the trust language for continuation of the policy if the insured becomes incompetent. The downside is that the insured does not regain any control over the policy and cannot revoke the trust.
(Read Shifting Life Insurance Ownership to find out how to reduce your taxable estate and leave more to your heirs.)

Naming Beneficiaries for Life Insurance
If an individual is named as beneficiary of a policy, while cheap to execute since a trust was not used, it could lead to some challenges. The biggest problem with this strategy is that the decedent cannot exert any control over the death proceeds. The individual that inherits the death benefits can use the money for any reason, even if the money was earmarked to pay estate taxes or settlement costs. If the beneficiary is a minor, the challenges will likely escalate.

If an estate is named beneficiary of the policy, the death benefits are includable in the decedent's gross estate and are subject to the claims of the estate's creditors, and this will no doubt increase probate costs. If, however, the beneficiary is an irrevocable trust, the trustee can be given broad powers to distribute or withhold benefits available to the insured's estate, the assets are protected from creditors and oversight of the trust's assets can be assigned to professional money managers.

Individuals should consult an experienced financial planner to determine their needs for life insurance and the types of policies that are suitable for their estate planning needs.


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