Estate Taxes and Life Insurance Transfers​

Keeping taxes in mind while estate planning can result in major tax savings. This tax planning could decrease the assets in your gross estate. That helps to eliminate the need to file an estate tax return during the probate process, when a court decides whether a will is valid.

The federal estate tax exemption for 2023 is $12.92 million. Estates below the exemption level are not taxed when the owner dies. If your estate exceeds this limit, a life insurance transfer may be a helpful estate planning move.

Three Preliminary Tax-Law Restrictions

There are a few tax rules to remember when transferring insurance policies for estate tax purposes.

1. The Three-Year Rule

When transferring ownership of life insurance policies, the three-year rule applies. Under this IRS rule, the transfer must: (1) take place within three years before the original owner’s death and (2) be made without any consideration. If both are the case, then the proceeds from the policy are counted in the decedent‘s estate for tax purposes.

If you are considering transferring ownership of your life insurance policy, you should do so sooner rather than later. This can help ensure that three years pass before your death so the asset doesn’t count toward your estate.

2. Retaining ‘Incidents of Ownership’

The person covered by a life insurance policy cannot keep any "incidents of ownership" over the policy after a transfer. If they do, the IRS will count the policy as part of their estate for tax purposes. Incidents of ownership exist if, after a transfer, the covered person retains the power to do any of the following:

• Cancel, surrender, or convert the policy
• Use the policy as collateral to borrow money
• Change the named beneficiary on the policy
• Select the method of payment for the policy (e.g., installments or a lump sum)

3. Gift Taxes

Gifts over a certain amount may be subject to the federal gift tax. Therefore, any life insurance policy valued over the federal tax exemption for gifts will be taxed when the policy pays out. Exemption amounts vary by year.

Transferring the life insurance policy may be a smart move instead of keeping it within your estate. If your estate is already subject to estate tax, the full amount of your life insurance policy will be included in the estate and subject to the estate tax when you die. However, if you transfer the policy before your death, only the amount the policy was worth will be taxed at the applicable tax rate.

Two Methods to Transfer Life Insurance Policies

In general, there are two ways to transfer policy ownership. First, you can transfer ownership of the policy directly to another adult. This includes the policy’s named beneficiary. Second, you can create an irrevocable life insurance trust (ILIT). With an ILIT, you can transfer ownership of the policy to the trust. However, if you get life insurance through your job, ownership rights may be nontransferable.

Method 1: Transferring Rights

Transferring ownership using your insurance company’s forms is best to ensure everything is clear. You can request a transfer form directly from your life insurance company. However, you may also have to change the policy to indicate that the insured is no longer the owner.

After the transfer, the new owner is responsible for making all premium payments. If you continue to make the payments on the policy yourself, the IRS may view this as evidence that you are still the true owner. The IRS will then count any life insurance proceeds in your estate for tax purposes.

In general, you can transfer two types of life insurance policies. The first is a prepaid, single-payment policy. The upside of transferring this type of policy is that there are no additional premiums. The second type is a policy that requires annual premium payments. The new owner will be responsible for these payments.

Although transferring ownership of your life insurance policy to another adult is simpler than setting up a trust, it has a drawback. It’s irreversible. For example, if you transfer your policy to your best friend and then have a falling out or grow apart, you can’t regain your policy. At least with a trust, you may be able to change the trust beneficiaries.

Transferring an insurance policy to a new owner works well if it’s a family member (e.g., your adult child) with whom you have a good relationship.

Method 2: Life Insurance Trusts

Transferring your policy to a trust for estate tax purposes can be a wise move to reduce your estate tax liability. You must move the policy to an irrevocable life insurance trust. After you transfer the policy to the ILIT, you are no longer the policy owner. That means the policy benefits will not be included in your estate.

Three requirements must be satisfied to create a valid life insurance trust:

1. It must be an irrevocable trust, meaning that you must not have the power to revoke the trust or alter its terms.
2. The grantor (i.e., the creator) cannot be the trustee.
3. The grantor must create the trust at least three years before the grantor’s death (see the Three-Year Rule above).

There are a few reasons why this method may be better than transferring ownership to another person. First, there may not be someone whom you trust to take ownership and control of the policy. Even if there is someone you trust, you may want to help them avoid having to pay premiums.

Second, by placing the life insurance policy in a trust, you can preserve control over the policy on the front end. Again, the life insurance trust must be irrevocable (i.e., unchangeable). But you have an opportunity to set up the governing terms of the trust at the outset according to your wishes. For example, you can include a provision guaranteeing premiums will be paid while you are alive. You can also change the beneficiaries of the insurance proceeds with a trust. That’s not an option after transferring a policy to another owner.

Types of Life Insurance

As you decide whether a life insurance transfer is the right move for you, it is helpful to understand the various types of life insurance. There are two primary categories of life insurance: temporary and permanent.

Term Life Insurance

Term life insurance provides coverage for a limited time ("term"). Term lengths can vary widely, usually anywhere from five to 30 years. Life insurance death benefits are only paid if the insured person dies during the term.

Once the term expires, the insurance policy may be renewed, though the monthly premium will likely increase with each renewal. An existing policy may sometimes be converted from term life to permanent. If your policy allows, conversion can be much easier than applying for a new policy.

Permanent Life Insurance and ‘Cash Value’

As the name suggests, permanent life insurance provides lifetime coverage. You pay premiums, and the policy guarantees that benefits will be paid out when you die.

An important feature of permanent life insurance policies is their “cash value." The risk that the holder will die (e.g., due to age or a decline in health) gets higher over time. So it becomes more likely as the years pass that the death benefit must be paid.

With term life insurance, companies may raise premiums over time to match the higher risk of death. With permanent life insurance, the companies charge the same premium throughout the policy’s life.

In theory, this monthly premium is more than necessary to cover the average holder early in the policy. That’s because when people are younger, their risk of death is lower. The excess money they pay can be invested over time. The return on investment is then used to fund the death benefit down the road.

Further, as the cash value grows, it can be used to fund benefits for the policyholder while they are alive. For example, some policies allow the holder to borrow against the policy’s value. Some give them the option to terminate the insurance policy and get money, what’s called the cash surrender value. Thus, permanent life insurance can have the benefit of liquidity, making cash easy to access. The policyholder can also pour back into the cash pool.

The reserve is tax-deferred under federal tax law if the policyholder does not withdraw from the accumulated assets. In some cases, a partial withdrawal may also avoid tax liability.

Types of Permanent Life Insurance

There are many types of permanent life insurance. Each comes with certain benefits.

• Whole life insurance: This is the most straightforward kind of permanent life insurance. The policy provides lifetime coverage as long as the fixed-price premium is paid. Generally, when coverage starts, the younger the policyholder is, the less expensive their annual premiums will be. The cash value builds up as premiums are paid, and the policyholder may borrow from the cash reserve at the policy’s current loan interest rate. They may also surrender the policy and receive the cash value.

• Universal life insurance: The benefits of universal life insurance are largely in its flexibility. These policies provide the same benefits as whole life insurance and more. Universal life insurance may let you make your death benefits bigger or premium payments smaller. You may also be able to earn tax-deferred interest on the account’s value. And you can sometimes borrow money from the cash reserve.

• Variable life insurance: A variable life insurance policy allows you to invest in stocks, bonds, and securities. The cash reserves from your policy can then earn more money. You will bear some of the risk, but the insurance company guarantees a return on the investment. The death benefit amount depends on how well the investments perform.

• Variable-universal life insurance: Variable-universal life insurance can give you the best of two worlds. It combines the flexibility of universal life insurance with the moneymaking potential of variable life insurance.

• Single-premium life insurance: With single-premium life insurance, you pay the full premium just once, upfront. The benefits include the immediate accumulation of cash value. You’ll get security against policy cancellation. And your beneficiaries can receive tax-free proceeds.

• Survivorship life insurance: Survivorship life insurance is a single policy insuring two people, typically married couples. It’s also called "second-to-die" insurance. When the first person on the policy dies, the survivor keeps paying premiums. Only after the surviving spouse dies does the insurance company pay the beneficiaries. This type of policy may make sense for wealthy couples who expect substantial estate taxes. It’s also a good option for those with non-liquid assets. These kinds of assets usually don’t guarantee cash on demand, such as a family business. In this situation, the proceeds from the insurance policy can be used to buy out an ownership interest.

Insurance remains a predictable way to provide for family and loved ones in the event of your death. It is wise to explore ways to ensure your life insurance policy payout does not increase your estate tax liability.

Questions About Life Insurance Policies and Estate Taxes? Talk to an Attorney

A life insurance policy can provide security for your loved ones when you pass away and may even serve as a financial resource during your own life. However, it could also compromise the value of your estate and lead to significant tax consequences. An estate planning attorney can help you develop your estate and financial plan. During this process, your attorney and other advisors can help you understand how various life insurance types work for your situation.