Question:  If I have a $1 million life insurance policy, are the proceeds of that policy considered as part of my gross taxable estate for determining federal estate taxes at my death?

Answer:  As is the answer for most legal questions, it depends.  This is an issue that many people are unaware of and that may have significant estate planning implications.  In light of that, a detailed discussion is necessary.

Photo via Dallas Dowell, Tucumcari, NM

Why Should We Care?

The reason that the answer to this question is so important is that people often overlook life insurance proceeds when considering the applicability of the federal estate tax.

Currently, the federal estate tax exemption is set at $5.34 million, meaning that if an individual has a gross taxable estate valued over $5.34 million ($10.68 million per couple) and dies in 2014, his or her estate will be responsible for paying a 40% tax on any amount over the $5.34 million that is not passed to a spouse.  Oftentimes, people hold life insurance policies worth upwards of $1 million, which could impact whether estate taxes are owed.  Thus, it is important that when working on an estate plan an individual consider whether the inclusion of life insurance proceeds may make estate taxes an issue that needs to be dealt with.

The Law

The general rule is that life insurance proceeds are counted as part of the gross taxable estate if the beneficiary of the policy is that person’s estate or if the insured retains “incidence of ownership” in the policy.   See 26 U.S. Code Section 2042.  Incidence of ownership includes the right to modify beneficiaries, the power to cancel the policy,  the right to borrow against the policy, and the right to use the policy as collateral for a loan.  See Treas. Reg. Section 20.2042-1.

What Can Be Done?

So what can be done to avoid inclusion of life insurance proceeds in the decedent’s taxable estate?  There are a couple of options.

First, an insured could simply give up incidence of control, making another person the owner of the policy.  This transfer would, however, be subject to federal gift tax laws (applicable if the value of the policy is over $14,000).  In order  to avoid inclusion of the policy value in the taxable estate, the listed beneficiary must be someone other than the insured’s estate, the policy must be given to a new owner (may be the beneficiary or not), and the owner must be given control over the policy.  It is also advisable for the new owner to make premium payments on the policy.  The insured, however, may gift money to the new owner for the purpose of making these payments, subject to federal gift tax rules.  The obvious downside, however, is that the insured would lose control over the policy and the right to modify the beneficiaries.

Second, an insured could work with an attorney to create an irrevocable life insurance trust.  Under this instrument, title to the policy is transferred into the irrevocable trust and the trust itself is listed as the beneficiary of the life insurance policy.  Upon the death of the insured, the appointed trustee will be in charge of the proceeds and will distribute income or proceeds to the beneficiary identified in the trust instrument, oftentimes to the surviving family members.  Importantly, this trust must be irrevocable and the insured may not be listed as trustee of the policy, thus the same downside of lack of control exists for this option as for the first option discussed above.

It is important to note, however, that the IRS regulations include a three year look back period, meaning that any transfer of ownership of a life insurance policy–whether to another person or to an irrevocable life insurance trust–that occurred within three years of the insured’s death will be disregarded and the proceeds are considered as part of the taxable estate.  See 26 U.S. Code Section 2035.

More Information

Given the complex nature of this issue, I highly recommend that you seek advice from a licensed attorney on this topic.

Here are additional helpful sources of information:

Protecting Life Insurance from Estate Taxes

Shielding Your Insurance from Estate Taxes