Transfer Your Life Insurance Policy to Lower Your Estate Tax

As of 2013, only estates that are worth over $5.25 million will be subject to federal estate tax. So if you are confident that your estate does not exceed that value, then you wouldn’t need to worry about estate taxes.

But if your estate is subject to federal tax, then you need to realize that only the properties that you own at the time of your death will be included as part of your estate. Therefore, if you transfer the ownership of life insurance policy proceeds to another before your death, then that counts as that other person’s property, ergo, it will not be added on to the value of your estate.

You could transfer the ownership of an insurance policy to another person. Another option is the creation of an irrevocable life insurance trust and transfer the policy to the trust. However, it may not be applicable on certain group life insurance policies such as insurance from employment in which you may not transfer the ownership rights to another.

You may also transfer your entire estate to your spouse upon your death, and that would be free from federal taxes regardless of the value. But keep in mind that doing so will increase your spouse’s estate and they may end up being the one to pay large estate taxes.

Transferring Ownership to Other Adults

Transferring of ownership of a life insurance policy is relatively easier than setting up a life insurance trust. But this option has some disadvantages–once you transfer the ownership of a life insurance policy, you will no longer have the power to amend it.

To illustrate, if you transfer your life insurance to your cousin and afterwards you had an argument and never reconciled, you cannot get your life insurance policy back and change ownership again. Doing such transfers is more advisable if the transfer is made to a person with whom you have a very good and close relationship.

Three-Year Rule from the IRS

The IRS has policies and rules to determine who is the owner of a life insurance policy in order to calculate the total value of an estate. This rule has a provision that the transfer is void if the ownership of a life insurance policy is transferred within three years after the person’s death. In such a case, the proceeds of the insurance policy is included to value of the estate.

If Raphael bought a $1 million life insurance policy that named his child, Katrina, as the beneficiary. Raphael, worried about estate taxes, transferred in 2009 the ownership of the insurance policy to Katrina. Then in 2010, Raphael suffered a massive heart attack and died. Since the transfer happened only a year before his death, or within three years of Raphael’s death, then the transfer is void and $1 million is counted to Raphael’s estate for tax purposes.

Looking at this example, it is better to transfer the ownership of your life insurance policy as soon as possible.

Other IRS Rules Concerning Transfer of Ownership of Life Insurance Policies

The IRS has rules and regulations that are followed in order to determine, for tax purposes, who is the owner of a life insurance policy.

If a deceased person kept any “incidents of ownership” of the life insurance policy, then the policy is still considered to be owned by the deceased upon their death. The incidents of ownership refers to situations that make the power over the policy still in the hands of the deceased, and the policy still considered as owned by the decedent. It is considered that the deceased still had the power over the insurance policy if, after the transfer of the ownership, they were still able to do any of the following:

  • Cancel, surrender or convert the life insurance policy;
  • Use the policy as collateral in order to borrow money;
  • Change the named beneficiary of the policy; or
  • Select the method of payment that the policy will pay out in (installments or a lump sum).

Concerns over Gift Taxes

Under current laws (2013), the gift tax applies to any gift that exceeds $14,000.  The same applies to the transfer of an insurance policy, where if you transfer a policy worth more than $14,000, then any amount in excess is subject to gift tax when the money is paid out after your death.

Even so, it is still better to transfer the policy instead of keeping the ownership because if your estate is already subject to the estate tax, then the full amount will be included in your estate, instead of being able to get at least $14,000 exempted.

If, for example, Ed transfers the ownership of his life insurance policy to his daughter Joan. The value of the insurance policy during transfer was $30,000. When Ed died, the policy paid out $400,000, and because Ed transferred it when it was much lower in value, he will only pay the gift taxes on $17,000 (assuming that Ed died before 2013 when the gift tax exemption was set at $13,000), and the $400,000 pay out will not be included to Ed’s estate.

How to Transfer Life Insurance Policies

By signing an assignment of rights or a transfer, you may be able to bestow upon another the ownership of life insurance policies. Contact your life insurance company for this because most insurance companies could provide their own transfer of ownership forms, so make use of those.

If the transfer is complete, then whoever owns the policy now is in charge of paying for the premiums. However, note that if you are the one who will still be making the payments on the policy, the IRS will consider this as an evidence that you are still the true owner of the policy.

Generally the two types of policies that can be transferred are the prepaid single-payment policy and the one that requires premium payments. Transferring a prepaid single-payment insurance policy means that the new owner need not pay any more premium after the transfer. But if the policy is worth more than $14,000, then the amount in excess of that is subject to gift tax.

Life Insurance Trusts

Another way of transferring the ownership of a life insurance policy is through a trust. This way, the proceeds from the insurance will not be included to your estate. To do this, you must execute an irrevocable life insurance trust and then place that policy into the trust. Note that after this, it is now the trust that owns the policy and is no longer part of your estate.

One reason why people choose to create a trust is because they may not have a specific person to whom they want to transfer the policy, and are just doing so to lower the estate’s value. Another reason is maybe they don’t want to take the risk of putting the control of the policy into someone else’s hand.

Here is an illustration of the reasons one person may want to create a trust. Carlo is a single father of two adult sons, both of which cannot be trusted with money. Frank has a large estate and is afraid that his $1 million life insurance policy will push his estate past the estate tax limit. So Carlo creates an irrevocable life insurance policy trust, transfers the policy to the trust and names his financial advisor as the trustee, instead of transferring the insurance ownership directly to his sons. Upon Frank’s death, his financial advisor is charged with the duty of managing the funds inside of the trust account for Frank’s two sons.

There are three requirements that you must follow in order to create a valid life insurance trust. These requirements are:

  • You must put your life insurance policy in an irrevocable trust.
  • Somebody else, and not you, must be the trustee.
  • And, like transferring a life insurance policy to a person, the trust must be created at least three years prior to your death. If the trust that contains your life insurance policy is not at least three years old at the time of your death, the benefits from your life insurance policy will be counted towards the value of your estate.

Irrevocable life insurance trusts could be complex. So it is advisable to work with your financial advisor and/or lawyer who could help you through this process.

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