If you transfer a life insurance policy to a beneficiary, tax authorities regard the transaction as a gift. Under current gift tax rules, if you transfer a policy with a present value of more than $14,000 to another person, gift taxes will be assessed. However, the gift tax won't have to be paid until your death.
And keep in mind that the amount of gift tax will be far less than the amount of estate tax that would be due if your policy remained in your name and in your estate. This is because the policy proceeds (the amount the insurance company pays at death) are always considerably more than the value of the policy while the insured is alive. To find out the present worth of an insurance policy for gift tax purposes, ask your insurance company.
The Nuts and Bolts of Transferring Ownership
You can give away ownership of your life insurance policy by signing a simple document, called an "assignment" or a "transfer." To do this, notify the insurance company and use its form. There's normally no charge to make the change. Also, you usually have to change the policy itself to specify that the insured is no longer the owner.
After the policy is transferred, the new owner should make any premium payments due. If you make payments, the IRS might contend that you're keeping an "incident of ownership" (as discussed above) and include the proceeds in your federally taxable estate -- precisely what you're trying to avoid. If the new owner can't make the payments, you can give her money for them.
If you give a paid-for single-premium policy to a new owner, there are no future payments to worry about. Because it's paid for in full once it's purchased, single-premium life can be a particularly convenient type of policy to give away. However, there can be a drawback here, too. If the value of the policy at the time of the gift exceeds the amount that is exempt from gift tax (currently, $14,000), the IRS will assess gift tax on the excess amount. By contrast, if you transfer ownership of a policy that has premiums due each year, and then every year you give the recipient a gift of less than $14,000 to pay for those premiums, no gift tax will be assessed.
Method Two: Life Insurance Trusts
The second way to transfer a life insurance policy is to create an irrevocable life insurance trust and then hold the policy in trust. Once you transfer ownership of life insurance to the trust, you're no longer the owner, and the proceeds won't be part of your estate.
Why create a life insurance trust, rather than simply transfer a life insurance policy to someone else? One reason can be that there's no one you want to give your policy to. In other words, you want to get the proceeds out of your taxable estate, but you want to exert legal control over the policy and avoid the risks of having an insurance policy on your life owned by someone else -- perhaps a spouse or child you don't trust to pay policy premiums. For example, the trust could specify that the policy must be kept in effect while you live, eliminating the risk that a new owner of the policy could decide to cash it in.
If you don't want the proceeds from your life insurance policy to be subject to estate taxes, you must comply with the following strict requirements:
- The life insurance trust must be irrevocable. If you have the right to revoke it, you will be considered the owner of the policy, and the proceeds will be subject to estate taxes.
- You cannot be the trustee.
- You must establish the trust at least three years before your death. If the trust has not existed for at least three years when you die, the trust is disregarded for estate tax purposes, and the policy proceeds are included in your taxable estate.
Life insurance trusts raise complex tax issues ad other tricky matters. If you want to explore using a life insurance trust, you'll need to see a lawyer.
To learn more about tax planning for your estate, read Plan Your Estate, by Dennis Clifford (Nolo).
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