Life insurance has long been a staple in basic estate planning. Life insurance may provide an income tax-free death benefit1 far in excess of the premiums paid. However, much of the life insurance proceeds may be wasted if the ownership and beneficiary designations are not properly structured.
Because of federal and/or state estate taxes, a tax may be imposed on all the property that you own at your death.2 This tax must be paid from your estate. This tax does not attach if, as a general rule, your property is valued at less than your estate tax exemption amount. If you own a life insurance policy, or name either yourself or your estate as beneficiary, the policy death benefit will increase your estate. If, after including your life insurance death benefit proceeds, your estate is still valued at less than your estate tax exemption amount, no federal estate tax will be assessed. Therefore, your policy's death benefit proceeds can be directed to any of your heirs, and need not be used to pay your estate tax liability.
If you own property in excess of your estate tax exemption amount, you may have a taxable estate. If you own a life insurance policy or name either yourself or your estate as beneficiary, you may have exposed the policy's death benefit proceeds to estate taxes.
For this reason, when estate tax is a concern, an insurance policy on your life is usually best owned by someone else. You can establish an irrevocable trust to be the owner and beneficiary of your life insurance policy. Alternatively, you might have your adult children own, and be the beneficiaries of the policy. Either scenario should avoid inclusion of the policy proceeds in your estate. Meanwhile, third-party owners may be able to lend these proceeds to, or purchase assets from, your estate to provide cash to satisfy your estate tax liability. (If you make your spouse the owner of a policy on your life, you should ensure that, if your spouse dies before you, you will not end up owning the policy either through a provision in your spouse's will or a living trust.)
Even where the owner is a third party, if the beneficiary dies before you (the insured), the proceeds may be paid to your estate. Naming a contingent beneficiary to the policy will ensure that the proceeds will go directly to that person, thus avoiding probate and estate taxes. The "Rule of Two" holds that a policy should always have at least two contingent beneficiaries in order to avoid such problems.
You should remember that any gift of life insurance to a third party (except to your spouse) may carry with it gift tax consequences. Additionally, if you fail to survive your gift by three years, the policy will be brought back into your estate. Because of these pitfalls, you should always seek tax and legal advice prior to any transfer. But keep in mind, an improperly structured life insurance contract effectively takes money out of your heirs' pockets.
1 For federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC Sec. 101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2) (i.e. the “transfer- for- value rule”); arrangements that lack an insurable interest based on state law; and an “employer-owned” policy unless the policy qualifies for an exception under IRC Sec. 101(j).
2 The federal estate tax exemption amount is $3,500,000 in 2009. The highest federal estate tax rate is 45% in 2009. The federal estate tax will be repealed on 1/1/10 until 12/31/10. Beginning 2011, the federal estate tax will be reinstated with a federal estate tax exemption amount of $1,000,000 and a maximum estate tax rate of 55%. Congress continues to discuss and consider legislation that, if passed, would permanently repeal or otherwise lessen the impact of the federal estate tax.
This material may only be used in New York.
For more information on this subject, and professional guidance in selecting the right kind and amount of insurance coverage, contact your insurance professional.
This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) or matter(s) addressed by this material. Pacific Life & Annuity Company, its distributors and their respective representatives do not provide tax, accounting or legal advice. Any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
Pacific Life refers to Pacific Life Insurance Company and its affiliates, including Pacific Life & Annuity Company. Insurance products are issued by Pacific Life Insurance Company in all states except New York, and in New York by Pacific Life & Annuity Company. Product availability and features may vary by state. Each company is solely responsible for the financial obligations accruing under the products it issues, and its product and rider guarantees are backed by that company’s financial strength and claims-paying ability. Variable insurance products are distributed by Pacific Select Distributors, Inc. (member FINRA & SIPC), a subsidiary of Pacific Life Insurance Company, and are available through licensed third party broker-dealers.
CWEB-L-NY-42