The proceeds from a life insurance policy are part of the financial legacy you leave behind after your death. Do what you can now to protect those proceeds from taxes, so that you’re able to leave behind as much as you can for your beneficiaries.
Avoiding estate taxes
Many taxpayers mistakenly believe that life insurance proceeds are estate-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.
Funding an ILIT generally involves using your annual exclusion amount of $14,000 per beneficiary to make gifts to the trust. If you are married and your spouse also makes gifts to the trust — or consents to split gifts with you — the amount can be doubled to $28,000 per year. You may even decide to use your lifetime exemption amount, which is up to $5.43 million, or $10.86 million if you’re combining with your spouse, for 2015.
Risks of 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 son in exchange for $50,000 and his agreement to take over the premium payments. If he pays a total of $100,000 in premiums before you die, he’ll have $850,000 in taxable income ($1 million less his $150,000 investment). If he’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 son are partners in a partnership, an exception might apply (provided it’s a bona fide partnership with a legitimate business purpose).
Whether you leave the proceeds from your life insurance policy to family members, friends or a charity is your decision. Likewise, it’s prudent to take steps that will maximize your life insurance proceeds.