First things first: You don't have to read this article unless your estate is likely to owe federal estate taxes at your death. Currently, the federal estate tax affects only people who die leaving a taxable estate of more than $5.25 million, or couples leaving more than $10.5 million. (To learn more about estate tax basics, see Nolo's Estate and Gift Tax FAQ.)
For those estates that do owe taxes, whether or not life insurance proceeds are included in the taxable estate depends on who owns the policy when the insured person dies. If the deceased person owned the policy, the full amount of the proceeds are included in the federal taxable estate; if someone else owned the policy, the proceeds are not included.
It follows that if you want your life insurance proceeds to avoid federal estate tax, you may wish to transfer ownership of your life insurance policy to another person or entity. There are two ways to do it. You can transfer ownership of your policy to any other adult, including the policy beneficiary. Or, you can create an irrevocable life insurance trust, and transfer ownership to it. (But be aware that some group policies, which many people participate in through work, don't allow you to transfer ownership at all.)
All property that you leave to your spouse, including insurance proceeds, is not subject to estate taxes when you die. Your life insurance proceeds would be taxed as part of your estate only if the beneficiaries of the policy are your children, friends, or relatives other than your spouse.
Method One: Transferring Ownership to Other People
Transferring ownership of your policy to another person involves a trade-off: Once the policy is transferred, you've lost all your power over it, forever. You cannot cancel it or change the beneficiary. Suppose, for example, you transfer ownership of your policy to your spouse and later get divorced. You cannot cancel the policy or recover it from your ex-spouse. In many situations, however, these gifts work well -- for example, when you transfer policy ownership to an adult child with whom you have a close and loving relationship.
IRS Rules Governing Life Insurance Transfers
The IRS has rules that determine who owns a life insurance policy when the insured person dies. Gifts of life insurance policies made within three years of death are disallowed for federal estate tax purposes -- and often for state estate tax purposes, too. This means that the full amount of the proceeds are included in your estate, as if you had remained owner of the policy.
The message here is obvious: If you want to give away a life insurance policy to reduce estate taxes, give the policy away as soon as is feasible. (And then don't die for at least three years.)
Another IRS regulation provides that a deceased person who kept any "incidents of ownership" of a transferred life insurance policy is still considered the owner. The term "incidents of ownership" is simply legalese for significant power over the transferred insurance policy. Specifically, the proceeds of the policy will be included in your taxable estate if you have the legal right to do any one of the following:
- change or name beneficiaries of the policy
- borrow against the policy, pledge any cash reserve it has or cash it in
- surrender, convert, or cancel the policy, or
- select a payment option -- that is, decide if payments to the beneficiary can be a lump sum or in installments.
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