Estate Taxes and Life Insurance Transfers
If your estate is subject to an estate tax, a life insurance transfer may be an effective way of reducing your tax liability. How does this work? Only assets owned or controlled by you at the time of your death count as part of your taxable estate. So, if you transfer title and control of your life insurance policy to someone else, it will not be taxed as part of your estate at your death.
Note that the federal estate tax exemption is currently set at over $12 million, meaning that estates below this value will not be taxed when the owner dies. If your estate exceeds this value, a life insurance transfer may be a useful estate planning move.
Three Preliminary Tax-Law Restrictions
When transferring insurance policies for estate tax purposes, there are a few tax rules to bear in mind. Before exploring methods of transferring your life insurance policy, this section explores three important rules.
1. The Three-Year Rule
When transferring ownership of life insurance policies, the three-year rule applies. Under this IRS rule, if the transfer (1) takes place within the three years before the original owner's death and (2) is made without any consideration, then the proceeds from the policy are counted in the decedent's estate for tax purposes. So, if you are considering transferring ownership of your life insurance policy, you should do so sooner rather than later to better ensure that three years elapse before your death.
2. Retaining “Incidents of Ownership"
If a deceased person kept any "incidents of ownership" over the policy after a transfer, then the policy will be counted as part of the decedent's estate for tax purposes. Incidents of ownership exist where, after a transfer, the deceased retains the power to:
- Cancel, surrender, or convert the policy;
- Use the policy as collateral to borrow money;
- Change the named beneficiary on the policy; or
- 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, if you transfer a life insurance policy valued above the federal gift tax exemption, any amount over that will be taxed when the policy is paid out. Exemption amounts vary by year.
That said, it may still be worthwhile to transfer the policy instead of keeping it within your estate. If your estate will already be subject to the estate tax, then the full amount of your life insurance policy will be included in your estate and be subject to the estate tax at your death. However, if you transfer the policy before your death, only the amount that the policy was worth at transfer will be taxed.
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, including the policy's named beneficiary. Second, you can create an irrevocable life insurance trust and transfer ownership of the policy to the trust. However, note that if you get life insurance through your job, ownership rights may be nontransferable.
Method 1: Transferring Rights
To avoid confusion, it is best to transfer ownership using your insurance company's forms. You can request a transfer form directly from your life insurance company, but you may also have to change the policy to indicate that the insured is no longer the owner.
After the transfer has been completed, the new owner is responsible for making all premium payments. If you continue to make the payments on the policy, the IRS may view this as evidence that you are still the true owner and will count any life insurance proceeds in your estate for tax purposes.
In general, there are two types of life insurance policies that can be transferred. The first is a prepaid, single-payment policy. The upside of transferring this type of policy is that there are no premiums that the new owner must continually pay. The second type is a policy that asks for yearly premium payments for which the new owner will be responsible.
Although transferring ownership of your life insurance policy to another adult is easier than setting up a life insurance trust, it also comes with the drawback of being irreversible. For example, if you transfer your life insurance policy to your best friend and then have a falling out, you can't get your life insurance policy back. These transfers tend to work well when you transfer a policy to a family member (e.g., your adult child) with whom you have a good relationship.
Method 2: Life Insurance Trusts
In order to transfer your policy to a trust for estate tax purposes, you must transfer the policy to an irrevocable life insurance trust. After you transfer the policy, you are no longer the policy owner, and the policy benefits will not be included in your estate.
Three requirements must be satisfied in order to create a valid life insurance trust:
- It must be an irrevocable trust, meaning that you must not have the power to revoke the trust or alter its terms;
- The grantor (i.e., the creator) cannot be the trustee of the trust; and
- The trust must be created at least three years prior to your 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 that you trust to take ownership and control of the policy. Even if there is someone you trust, you may still not want the new owner of the policy to take on the responsibility of paying premiums.
Second, by placing the life insurance policy in a trust, you can preserve a degree of control over the policy. Again, the life insurance trust must be irrevocable (i.e., unchangeable). However, you still have an opportunity to set up the governing terms of the trust according to your wishes. For example, you can include a provision guaranteeing that premiums will be paid while you are still alive.
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 and subtypes of life insurance. There are two primary categories of life insurance: temporary and permanent.
A. Term Life Insurance
Term life insurance provides coverage for a limited amount of time (“term"). Most term lengths range from anywhere between 5 and 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 allowed by your policy, conversion can be much easier than reapplying for a new policy.
B. Permanent Life Insurance and "Cash Value"
As the name suggests, permanent life insurance provides lifetime coverage. In exchange for paying insurance premiums, the policy provides a lifetime guarantee that death benefits will be paid out upon the insured's death.
An important feature of permanent life insurance policies is their “cash value." The more time that passes after a policy is issued, the higher the risk that the holder will die (e.g., due to advanced age or a decline in health) and trigger the death benefit.
Instead of incrementally raising premiums to match the increased risk, insurance companies charge the same premium throughout the life of the policy. In theory, this monthly premium will be more than necessary to cover the holder early on in the policy (i.e., when the risk of death is comparatively lower). The excess can therefore be invested over time and the return on investment 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 value of the policy or terminate the insurance policy altogether to receive the cash surrender value. They can also simply pour back into the cash pool.
Importantly, if the policyholder does not withdraw from the accumulated assets, the reserve is tax-deferred under federal tax law. In some cases, a partial withdrawal may also avoid tax liability.
C. 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. As long as the price-fixed premium is paid, the policy provides lifetime coverage. In general, the younger the policyholder is when coverage starts, 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 center around its flexibility. In addition to providing the benefits of whole life insurance, universal life insurance allows qualifying policyholders to adjust death benefits upward, adjust premium payments downward, earn tax-deferred interest on the account value, and borrow money from the cash reserve.
- Variable Life Insurance. A variable life insurance policy allows the policyholder to invest cash reserves in stocks, bonds, and securities. The policyholder bears some of the risk, but the insurance company guarantees a certain return on the investment. The death benefit amount depends on how well the investments perform.
- Variable-Universal Life Insurance. Variable-universal life insurance combines the flexibility of universal life insurance with the investment options of variable life insurance.
- Single Premium Life Insurance. The policyholder of single premium life insurance will pay the entire premium amount in one up-front payment. The benefits include the immediate accumulation of cash value, security against policy cancellation, and the distribution of tax-free proceeds to the beneficiaries.
- Survivorship Life Insurance. Survivorship life insurance, also referred to as "second-to-die" insurance, is a single policy that insures two people. When the first person on the policy dies, the survivor (e.g., a surviving spouse) continues paying premiums. Only after the survivor dies does the insurance company pay the beneficiaries of the policy. This kind of insurance policy is appropriate for wealthy couples that expect substantial estate taxes or for people with non-liquid assets such as a family business. In this situation, the proceeds from the insurance policy can be used to buy out an ownership interest.
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, if not structured the right way, it could also compromise the value of your estate and lead to significant tax consequences. An estate planning attorney can help you make sure you understand the ins and outs of life insurance as you develop your estate and financial plan.
Can I Solve This on My Own or Do I Need an Attorney?
- DIY is possible in some simple cases
- Complex estate planning situations usually require a lawyer
- A lawyer can reduce the chances of a family dispute
- You can always have an attorney review your forms
Get tailored advice and ask your legal questions. Many attorneys offer free consultations.