Federal estate tax applies only to estates of people who are very wealthy. The threshold limit is in the millions of dollars, and it is over $10 million for couples. You should find out whether you are likely to owe federal estate tax before devising an estate planning strategy and deciding how to handle life insurance proceeds. If your estate will owe federal estate tax, life insurance proceeds will be included in the taxable estate if you own the policy. They will not be included in the taxable estate if you do not own the policy. Moreover, they will not be subject to tax if your spouse is the sole beneficiary of the policy.
If you own a life insurance policy that has a beneficiary other than your spouse, and federal estate tax will apply to your estate, you may be able to avoid tax on the proceeds by transferring the ownership of your policy to another adult, such as the named beneficiary of the policy. Alternatively, you may be able to transfer the ownership of the policy to an irrevocable life insurance trust. You should review the terms of your policy to make sure that it permits a transfer of ownership. A group policy through your employer may not include this feature.
Federal estate taxes only apply to estates over a certain value ($12.06 million for individuals or $24.12 million for married couples in 2022).
Transferring Ownership to a Person
This involves a certain amount of risk because you cannot undo the transfer. For example, if you transfer ownership to a child from whom you later become estranged, you cannot regain control of the policy or cancel it. If you have a strong, stable relationship with an adult child or another loved one, however, this may be a smart way to reduce the tax burden on your estate. You must make sure to transfer the policy as soon as possible, since the IRS has established that a gift must be made more than three years before the original owner’s death. (Some state estate tax systems apply this rule as well.)
Also, a more complex IRS rule negates a policy transfer when the original owner retains significant control (“incidents of ownership”) over the policy. If they still have the right to change or add beneficiaries, borrow against the policy, choose payment options for beneficiaries, surrender or cancel the policy, or convert the policy, they will be considered the effective owner notwithstanding the transfer. Federal estate tax still will apply.
You may want to be aware that your estate will need to pay gift tax if you transfer a policy to its beneficiary, and it reaches a certain threshold value. The amount of gift tax will be significantly lower than the amount of federal estate tax that would have been due, though, and it will not need to be paid until the original owner’s death.
Assignments of Ownership
You will need to complete an assignment of ownership to transfer the ownership of a policy. The insurance company can provide this form. You also will need to change the policy to state that the owner is someone other than the insured. The new owner will need to start making premium payments to prevent the rule regarding incidents of ownership from applying. However, the initial owner can give the new owner money to pay premiums if needed. If you have a single-premium policy, no further premiums will need to be paid. This can make the process of transferring the policy simpler, although sometimes a greater amount of gift tax will need to be paid.
Transferring Ownership to a Life Insurance Trust
If you still want to keep control over a policy and avoid the risks of transferring ownership to another person, you can create an irrevocable life insurance trust and place the policy in it. You technically will not be the owner of the policy. The terms of the trust may provide that the policy will remain effective for as long as you live.
The owner of a policy must meet certain requirements to prevent federal estate tax from applying to the proceeds. They must make sure that the trust is irrevocable, or otherwise they still will be considered the owner. Also, they must name someone else as the trustee, and they must establish the trust at least three years before their death. You may want to consult an estate planning attorney who is skilled in tax issues to better understand which method of transferring ownership works for you.
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