The main reason most people have life insurance is to replace income that would be lost if they die prematurely. Life insurance death benefit payments can generally be received by policy beneficiaries free of any federal income tax (and usually free of any state income tax too).
That's great, but what about the federal estate tax? If the tax rules treat you as the owner of a policy on your own life, the death benefit is included in your taxable estate -- unless the money goes to your surviving spouse, and he or she is a U.S. citizen. When death benefits go directly to a non-spouse policy beneficiary, such as a child or sibling (even without passing through your estate), the money is included in your taxable estate. If your estate exceeds $5 million (for 2011 or 2012), which it could if you have lots of life insurance coverage, your heirs will stand second in line behind the Internal Revenue Service (and possibly the state tax collector). Not good.
Here's the rub: The tax rules say you own a life insurance policy if you possess so-called "incidents of ownership." You have them if you retain the power to change policy beneficiaries, change coverage amounts, cancel the policy and so forth.
If having life insurance death benefits included in your taxable estate would cause an estate tax hit, the solution is to set up an irrevocable life insurance trust to own the policy. The trust then pays the premiums, and the death benefits go to whomever you name as the trust's beneficiaries. Your estate is out of the picture. With this arrangement, there's no federal estate tax on the death benefits, and there's no federal income tax either.
Naturally, there are a few complexities with this strategy. If you transfer an existing policy to the life insurance trust and die within three years, the death benefits are included in your taxable estate. To avoid this problem, the trust should purchase a new policy on your life. If that's not possible -- say because your health isn't so great -- you may have nothing to lose by transferring an existing policy and trying to outlive the three-year rule. But check with your estate planning pro first, because transferring existing policies with cash values in excess of $13,000 could trigger adverse gift tax consequences.
Finally, while setting up an irrevocable life insurance trust can be a great idea, it's not a do-it-yourself project because it's a fairly sophisticated legal procedure. Hire an experienced estate planning professional to get the job done right.
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