Life
Insurance a Big Part of Estate Plans
Life insurance is a unique estate planning tool,
because you pay relatively little up front
and your beneficiaries get much more when you
die.
When you name beneficiaries other than your
estate, the money passes to them directly,
without probate.
Unlike money tied up in non-liquid assets like
your company or real estate, life insurance
gets cash into your beneficiaries’ hands
without their having to resort to a fire sale
of other
assets.
Though procedures vary by company, usually
the beneficiaries receive their insurance proceeds
promptly. Generally, the beneficiary informs
the company in writing
of the death, sends a copy of the death certificate, and receives a check,
often within a few weeks.
Three Ways to Distribute Proceeds
If you own life insurance on your own life,
you can have the proceeds distributed in three
ways.
1. To beneficiaries. The company pays the
proceeds directly to one or more beneficiaries
named in
your policy. This is the quickest way to get
the money to your survivors, and the proceeds
typically
pass free of income tax. However, your estate
may be liable for federal and state estate
taxes if
the proceeds, when added to the other assets
in the estate, total more than the $1.5 million
threshold
at which the federal estate tax presently kicks
in.
2. To your probate estate. If you choose
this route, the proceeds will be distributed
along
with your
other assets according to the terms of your will.
(If you die without a will, your state’s
intestate succession laws will determine where
the proceeds go.) However, they will be tied up
in the probate process, will add to the cost of
probate by making the estate larger, and will be
subject to creditors’ claims. In addition,
they may be subject to estate tax. You should do
this only if your estate won’t otherwise
have enough money to pay debts and taxes.
3. To a trust. If you make the proceeds payable
to a trust??either one set up in your will or
created during your lifetime??they will be distributed
like the other trust assets. Paying the proceeds
to such a life insurance trust has several advantages:
- In many jurisdictions, your creditors
can’t
get at them.
- If the trust is for the benefit
of your minor children or anyone else who
needs your protection,
you can
avoid the expense and court involvement
of having a guardian manage this property.
By
having the
proceeds paid to a trust, the trustee will
have control over it.
- Generally, an estate tax
will not have to be paid on the proceeds
if certain rules are met
(see below).
Who Should
Own the Policy?
As noted above, if you own
the policy, the proceeds
payable on death will be included in your estate
for estate tax purposes. If your insurance is
payable to your spouse, it won’t matter
in the short run if it pushes the value of your
estate above $1.5 million—gifts of any
size between U.S. citizen spouses pass tax-free.
The problem comes in when your spouse dies—then
his or her estate is liable for taxes on anything
over the threshold, so in effect that estate
is paying a delayed tax on the insurance proceeds.
To escape estate taxes on the proceeds, you
must see that the policy is not owned by you
or your
estate. Life insurance trusts are a popular way
of accomplishing this. Here’s how they work.
Let’s say you set up an irrevocable life
insurance trust in which the trustee owns the policy
on your life??not you. The trustee can buy a policy
on your life, or you can transfer ownership of
an existing policy to the trustee (though in the
case of a transfer, you would have to live at least
three years for the proceeds to escape estate taxation).
Each year, you pay the premiums so the policy stays
in effect. When you die, the policy pays death
benefits to the trust, and these benefits are free
of estate taxes. Your family, including your spouse,
can live off the income from the trust and have
certain rights regarding the principal. Upon your
spouse’s death, depending on how the trust
is written, the trust can continue and benefit
your children and grandchildren for many years,
or the trust can terminate and the children take
the principal remaining. This principal passes
free of estate taxes, even if the estate were
otherwise large enough to trigger taxes.
Life insurance trusts are only one example
of using irrevocable trusts to create a tax-free
estate.
Your lawyer can explain many other options.
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