Life insurance is typically a critical element of a family's estate plan -- it may enhance the amount of wealth you can bequeath to your heirs and provide a ready source of cash for post-death financial obligations. If the value of your estate exceeds the federal estate tax threshold (for 2013, this amount is $5.25 million), this source of liquidity may reduce the likelihood that your heirs will be forced to sell assets to pay estate taxes.
When you designate an individual as beneficiary, life insurance proceeds are paid directly to the beneficiary and are not subject to probate proceedings. The beneficiary has quick access to a source of funds that may be used for costs, such as lawyer's fees, associated with settling your estate. If the policy is payable to your estate instead, the proceeds are subject to probate the same as any other asset. Because the probate process for a complicated estate may take as long as a year, your heirs may have to wait longer before accessing the proceeds.
Proceeds from life insurance that are received by the beneficiaries upon the death of the insured are generally income tax free, except when:
• The insured has died within three years of transferring ownership.
• The proceeds of the policy are paid to the executor of the insured's estate.
• The insured owned or partially owned the policy.
Transferring Your Policy
Transferring ownership of a life insurance policy entails a trade-off between control and taxes. Once you transfer ownership to another person, you relinquish control of the policy. If, for example, the new owner cashes in the policy before your death, you have no recourse. Although the new owner is obligated to pay premiums that may be due following the transfer, you can periodically gift funds to be used as premium payments.
Another technique for transferring ownership is creating an irrevocable life insurance trust (ILIT) that holds the policy. A trust enables you to stipulate that the policy be kept in effect for as long as you live. You designate a trustee who, upon your death, distributes the insurance proceeds to your heirs. An ILIT excludes life insurance proceeds from the estate of the first spouse to die and from the estate of the surviving spouse. The spouse may be the life insurance beneficiary, but may not have any right to or power over trust principal except per the discretion of the trustees.
Business Value of Life Insurance
Many families also use life insurance proceeds as a tool for managing an estate that includes ownership of a business.
For example, an entrepreneur may find himself in the situation of planning an estate in which his two adult children -- one who works in his business and one who does not -- are his heirs. Many entrepreneurs in this situation will bequeath the business to the son or daughter who works there and designate the other as beneficiary of a life insurance policy whose value equals that of the business.
Many business owners rely on life insurance proceeds as part of a business continuation agreement that enables business partners to acquire the ownership interest of a deceased owner's heirs. In this instance, the surviving owners use insurance proceeds to purchase the interest of heirs who have no intention of managing the business.Estate and insurance planning are complex areas that require assistance from experienced professionals.
This communication is not intended to be legal or tax advice and should not be treated as such. Each individual's legal and tax situation is different. You should contact your legal and financial professional to discuss your personal situation
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