Life insurance is a powerful financial and estate planning tool. It allows you to accumulate tax-deferred savings for retirement or other needs. The death benefits provide instant liquidity to pay estate taxes and other expenses as well as provide for your loved ones after you’re gone.
Contrary to popular belief, however, life insurance isn’t always tax-free. But if you plan carefully, you can avoid or minimize negative tax consequences and maximize the amount available for your family. There are a couple of ways to get the most out of life insurance.
Use an ILIT
Many taxpayers mistakenly believe that life insurance proceeds are tax-free, so long as you name someone other than your estate as beneficiary. But if you own the policy, the proceeds will be included in your taxable estate even if they’re paid directly to someone else. And if the benefits are large enough, they can turn an otherwise nontaxable estate into a taxable one.
If you own any life insurance policies on your life, consider transferring them to an irrevocable life insurance trust (ILIT) to remove the policy, and the death benefits, from your estate. To ensure that the benefits avoid estate taxes, you can’t retain any control over the policy, such as the right to change beneficiaries or borrow against its cash value.
For an ILIT to be successful, you must survive for at least three years after you transfer your policy to the trust. Otherwise, the proceeds will be pulled back into your estate under the “three-year rule.” If you don’t currently have life insurance but plan to get it, consider funding an ILIT first and then having the trust buy the policy. That way, the policy bypasses your estate, so the three-year rule won’t apply.
Avoid the transfer-for-value rule
One of the advantages of life insurance is that the proceeds are tax-free to your beneficiaries. But you can inadvertently lose this advantage if you run afoul of the “transfer-for-value” rule.
The rule provides that, if you transfer a policy (or an interest in a policy), the proceeds are taxable to the transferee (to the extent they exceed any consideration paid by the transferee). There are exceptions to the rule for certain transfers, including transfers to a partnership in which you’re a partner (or to one of the other partners), transfers to a corporation in which you’re a shareholder or officer, and certain gratuitous transfers.
The transfer-for-value rule was designed to discourage speculation in life insurance policies, but it’s broad enough to ensnare innocent transactions. For example, suppose you transfer a $1 million life insurance policy (with a $25,000 tax basis) to your daughter in exchange for $50,000 and her agreement to take over the premium payments. If she pays a total of $100,000 in premiums before you die, she’ll have $850,000 in taxable income ($1 million less her $150,000 investment). If she’s in the top tax bracket, the transfer-for-value rule will trigger more than $336,000 in federal income taxes, plus the net investment income tax (NIIT) of 3.8%.
It may be possible to structure such a transfer to fall within one of the exceptions to the transfer-for-value rule. For example, if you and your daughter are partners in a partnership, an exception might apply (provided it’s a bona fide partnership with a legitimate business purpose).
Handle with care
If you own life insurance or plan to purchase a policy, plan carefully to avoid inadvertently triggering estate or income taxes. Your tax advisors can help you maximize the benefits by setting up an ILIT and avoiding the transfer-for-value rule.
If you have any questions regarding this article, please contact Friedman LLP at firstname.lastname@example.org or 877-538-1670.