Life Insurance and Estate Planning

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Life Insurance and Estate Planning

Life insurance can be an important estate planning tool. As long as insurability requirements are met and premium payments are made, life insurance creates an estate — possibly a sizeable estate — not limited by the insured's net worth or the nature or value of other assets. With few exceptions, the life-insurance-provided liquidity is not subject to income tax for the person (beneficiary) who receives it. Under appropriate arrangements, the face value of life insurance is not subject to estate, inheritance, or gift taxes. Thus, there are tax incentives for including life insurance in your estate plan.

As might be expected with these tax attributes, life insurance use in estate planning occurs within a framework set by many laws, regulations, and Internal Revenue Service rulings, a framework determining the tax status of life insurance proceeds in each situation or set of circumstances. This publication discusses aspects of life insurance and its use as an estate planning tool, aspects frequently mentioned in discussion periods of estate planning meetings. Since this discussion can provide only partial information on a very complex topic, be sure to secure professional advice before making decisions.

Using Life Insurance in Estate Planning

The death benefit from a life insurance settlement has many potential uses. It can pay taxes and related estate settlement expenses, allow fulfillment of business agreements, pay operating expenses during the transition after a family member's death, provide funds for survivors' living expenses, and provide needed liquidity. In family and business situations where the death of a family member could cause financial crisis, life insurance proceeds can support transitions to new work and living arrangements.

Life insurance also can be used to provide the equivalent of a bequest to children or grandchildren who do not inherit other personal or business assets — they often have moved to locations away from the parents' or grandparents' home or business. As life insurance beneficiaries, they receive or share in the death benefit. Other survivors, typically those active in a family business or other aspects of family life, receive tangible and intangible assets important to their future well-being. Family conflicts over ownership and control of income-generating assets often can be minimized or avoided.

Premium costs are balanced against the benefits of life insurance when making decisions about life insurance purchases. If the life insurance premium is to be paid each year until the insured dies, the insurance decision interacts with all other spending and savings decisions. Careful planning and feasibility projections are advised.

Estate Planning Considerations

Internal Revenue Service regulations and rulings define circumstances in which the value of a life insurance death benefit is excluded from the insured's estate. These regulations and rulings are detailed and very complex. This discussion provides only information on the most frequently identified decision-making considerations in estate planning. Be sure to secure expert advice specific to your individual situation while keeping these considerations in mind:

Life insurance proceeds are included in the estate of the insured if the insured owns the policy, pays policy premiums, or the death benefit is payable to the insured or to the insured's estate. However, the proceeds are not subject to Nebraska Inheritance Tax unless paid to the executor or administrator of the estate.

"Incidents of ownership" is a term used by IRS to indicate aspects of the insured's control over a life insurance policy and/or the payment of its proceeds that cause the proceeds to be included in the insured's estate. These attributes go beyond policy ownership, paying premiums, or the death benefit being payable to the insured's estate. They include powers such as the right to influence or determine the economic benefit of the policy, including:

the right to determine or to change the beneficiary(ies) of the policy;
the right to surrender or cancel the policy;
the right to assign the policy or to revoke an assignment;
the right to borrow against the policy's cash value or to pledge the policy as security for a loan;
the right to change the payment procedures used in paying the death benefit;
the holding of a 5 percent or more revisionary interest in the policy (an interest that could result in the policy or its proceeds reverting to the insured);
the insured serving as trustee of a trust that owns the policy;
the insured being the owner of stock in a corporation that owns a policy payable to the corporation for what is called a "noncorporate purpose";
other circumstances specific to the insured's life circumstances.

Transfer of ownership of the policy to a trust or to a person other than the insured within three years of the death of the insured will not remove the policy proceeds from the estate of the insured even if the insured has no "incident of ownership" at the time of death, has not paid premiums subsequent to the transfer, and the estate is not a beneficiary of the policy.

Transfer of ownership of a policy with a named beneficiary other than the insured or the insured's estate to another person who pays the premiums usually will result in the policy proceeds being excluded from the insured's estate when the transfer is accomplished more than three years prior to the death of the insured if no "incident of ownership" is present after the transfer.

When a life insurance policy is to be owned by a trust or an individual other than the insured it may be easier (and exclusion from the estate of the insured may be more certain), if a new policy is purchased rather than transferring ownership of an existing life insurance policy. Surrender of an existing policy with cash value in order to replace it with a new policy may have important income tax consequences for the owner of the surrendered policy. Before making any decision to surrender an existing life insurance policy be sure you know what the income tax consequences will be.

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