Although your life insurance policy may pass to your heirs income tax-free, it can affect your estate tax. If you are the owner of the insurance policy, it will become a part of your taxable estate when you die. While the federal estate tax is currently zero, the exemption will be $1 million and the rate will increase to 55 percent on January 1, 2011, if Congress fails to act in the interim. And state estate taxes are still in effect now. You should make sure your life insurance policy won’t have an impact on your estate’s tax liability.
If your spouse is the beneficiary of your policy, then there is nothing to worry about. Spouses can transfer assets to each other tax-free. But if the beneficiary is anyone else (including your children), the policy will be a part of your estate for tax purposes. For example, suppose you buy a $200,000 life insurance policy and name your son as the beneficiary. When you die, the life insurance policy will be included in your taxable estate. If the total amount of your taxable estate exceeds the estate tax exemption, then your policy will be taxed.
In order to avoid having your life insurance policy taxed, you can either transfer the policy to someone else or put the policy into a trust. Once you transfer a policy to a trust or to someone else, you will no longer own the policy, which means you won’t be able to change the beneficiary or exert control over it. In addition, the transfer may be subject to gift tax if the cash value of your policy (the amount you would get for your policy if you cashed it in) is more than $13,000. If you decide to transfer a life insurance policy, do it right away. If you die within three years of transferring the policy, the policy will still be included in your estate.
If you transfer a life insurance policy to a person, you need to make sure it is someone you trust not to cash in the policy. For example, if your spouse owns the policy and you get divorced, there will be no way for you to get it back. A better option may be to transfer the life insurance policy to a life insurance trust. With a life insurance trust, the trust owns the policy and is the beneficiary. You can then dictate who the beneficiary of the trust will be. For a life insurance trust to exclude your policy from estate taxes, it must be irrevocable and you cannot act as trustee.
To discuss transferring a current life insurance policy to someone else or set up a trust to purchase a policy, please email the Elder Law Center or call 630-844-0065. The Elder Law Center is located in Aurora, IL, Kane County, in the Chicago Western Suburbs.