By DOUGLAS GILDENMEISTER
The way that you structure the ownership of your life insurance policy can have possible estate tax consequences. Without proper planning, the beneficiaries of your life insurance policy might not receive the maximum benefit you intended. So it’s important to understand what it means to be a policyowner and the various forms of policy ownership.
What does it mean to be a policyowner?
A life insurance policyowner has the right to control the economic benefits of the policy. The owner can have outright ownership of the policy or just “incidents of ownership.” Policy ownership includes:
• The right to transfer ownership rights
• The right to change certain policy provisions
• The right to surrender or cancel the policy
• The right to pledge the policy for a loan or to borrow against its cash value
• The right to name and to change a beneficiary
• The right to determine how beneficiaries will receive the death proceeds
Ways policies can be owned
There are different ways policies can be owned. Owning a policy on your life is the most common. With this type of policy ownership, you pay the premiums, you are named as the insured on the policy, and you control all of the ownership rights.
However, any person or legal entity can own life insurance on another person as long as the policyowner has an insurable interest in the insured. An insurable interest exists when one person has a financial interest in another person’s life. Spouses are assumed to have an insurable interest in each other. The same holds true for parents and children. Certain business relationships may also create an insurable interest, such as when a business insures its key employees or when a bank guarantees repayment of a loan with a life insurance policy on the borrower.
A trust, such as an irrevocable life insurance trust (ILIT), may also own a policy. When the insured dies, the proceeds are distributed to the trust, and distribution to the beneficiaries of the trust is then made according to the trust agreement.
Should you own your life insurance policy?
Life insurance proceeds from a policy on your life are potentially includable in your taxable estate if you own the policy outright, you have any incidents of ownership in the policy at the time of your death, or you transfer ownership of the policy within three years of your death. Inclusion of life insurance proceeds in your taxable estate isn’t a problem if your taxable estate (including any includable life insurance proceeds) is less than or equal to the applicable exclusion amount (formerly known as the unified credit).
If your taxable estate (excluding any includable life insurance proceeds) exceeds the applicable exclusion amount, you (the insured) should consider alternate ownership of policies on your life.
What about your spouse as the owner?
In most states, if you name your spouse as the owner of your life insurance policy, the proceeds won’t be included in your taxable estate. However, if you live in a community property state, special rules apply. Where community property funds are used to purchase an insurance policy, and there has been no agreement otherwise affecting the ownership of the policy, the policy is generally considered owned by the community and belongs one-half to each spouse.
What about another individual as the owner?
Sometimes, it may be advantageous to name another individual as the policyowner of your life insurance policy. Proceeds of such a policy will not be includable in your taxable estate. Keep in mind, however, that if the policyowner dies before you, the cash value of the policy (not the face amount) is includable in that person’s taxable estate.
What about setting up an irrevocable life insurance trust?
An ILIT may be used to keep life insurance proceeds out of your taxable estate. However, it’s important to note that an ILIT is a complex estate planning tool and must be properly created to be effective. Before taking advantage of such a device, seek the assistance of an estate planning professional.
What happens if you transfer ownership to another individual?
If you own a policy on your life, you may want to transfer ownership to another individual (e.g., to the beneficiary) to avoid of the proceeds in your estate. Transferring ownership of a policy is easy: Simply complete a change-of-ownership form provided by your insurance company. Remember, though, that even if you transfer ownership of an existing policy to another individual, it may be included in your estate if you die within three years of the transfer. In addition, gifting a life insurance policy may subject you to gift taxes as well. Prior to making any type of transfer of your policy, consult with your tax professional.
Douglas Gildenmeister is senior vice president, investments, for Raymond James. This information was developed by Broadridge, an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Associates, Inc. member New York Stock Exchange/SIPC does not provide advice on tax, legal or mortgage issues. These matters should be discussed with an appropriate professional.
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