It is estimated that approximately 52% of all Americans have some form of life insurance. On the other hand, there are also estimates that only 27% percent of Americans have some form of an estate plan in place. This article provides a brief and simple overview of how the two are not mutually exclusive, and how an effective estate plan takes into consideration a person’s life insurance policy. Using certain estate planning methods in conjunction with a life insurance policy can best effectuate a person’s desires regarding how their loved ones are provided for upon their passing, minimize estate taxes, and ensure their assets are distributed according to their wishes.
Using Revocable Trusts and Life Insurance Policies in Concert
As I have written about in a previous article, a revocable trust is a simple, invaluable estate planning option.[1] That article does not provide, however, the benefits a revocable trust can provide when used in conjunction with a life insurance policy, particularly when the federal estate tax is not an issue. Consider the following two scenarios:
Scenario 1:
John Doe has one child with his ex-wife, Jane. John purchases a life insurance policy on his life, naming his child as beneficiary. John dies unexpectedly when his child was 14 years old.
In this scenario, as John’s child is a minor, the life insurance proceeds are distributed to his guardian, Jane. In this particular case, let’s assume John and Jane had as an amicable relationship as ex-spouses could possibly have. Still, Jane was particularly unversed in financial matters and had never managed such a large sum of money. She made a few bad investments, resulting in a small decrease in the proceeds before such proceeds were distributed to the child when he reached the age of 18. The child, now having unfettered access to the insurance proceeds, spent it like only an 18 year old can, and in a few years the life insurance proceeds were exhausted.
Scenario 2:
Same as Scenario 1, except prior to his death, John established a revocable trust, in which he appointed a trust and investment company to succeed him as trustee and provided that the income of the trust would support his child before the principal was distributed outright when the child turned 25. John named the trust as beneficiary under his life insurance policy.
In this scenario, the life insurance proceeds are distributed to John’s revocable trust. The corporate trustee, well versed in managing such funds, made distributions to ensure the child’s health, education, and support were provided for before the child turned 25, while also investing the proceeds, resulting in John’s child receiving an even higher sum when the trust principal was distributed to him at age 25.
Taxation of Life Insurance Proceeds – Generally
Following the death of the insured person, the life insurance proceeds received by the beneficiary are not subject to income tax.[2] If, however, the insured sells the policy prior to his or her death, the purchaser of such policy will, upon the distribution of proceeds at the insured’s death, be taxed on the difference between the proceeds received and the amount the purchaser paid for the policy along with the premiums paid by the purchaser during the insured’s life.[3] Due to this “transfer for valuable consideration” rule, if the insured wishes to transfer his or her policy to a loved one, such transfer should be treated strictly as a gift, with the recipient providing no consideration to the insured, or alternatively, ensure the transfer qualifies for one of the exceptions to the transfer for value rule. Such exceptions include a transfer in which the transferee’s basis in the policy is determined by reference to the transferor’s basis[4], such as a transfer to a grantor trust, as well as transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder.[5]
Gifting of a life insurance policy by the insured to a loved one or trust for their benefit should also be considered for estate tax purposes, as life insurance proceeds are generally included in the insured person’s estate and therefore subject to the federal estate tax if (1) the proceeds are payable to the insured person’s estate, (2) the insured person owned the policy, (3) the insured person retained incidents of ownership in the policy[6], or (4) the insured person transferred the policy in the three years immediately preceding his or her death.[7]
By gifting the policy to a loved one or to a lifetime irrevocable trust, the insured person can ensure the life insurance proceeds will pass to their intended beneficiary or beneficiaries without the 40% federal estate tax being owed, but there are a few very important caveats to consider when contemplating this. First, the value of the policy will be subject to the federal gift tax at the time of the gift of the policy, and secondly, if the insured person dies within three years after making the gift, the proceeds will nonetheless be included in insured person’s estate, subjecting it to the estate tax. To minimize both of these problems, the insured person should consider gifting the policy shortly after the policy’s inception, where the cash value of the policy is still low, and the insured person is still in good health. Alternatively, the insured can sell the policy to a lifetime irrevocable trust at fair market value, provided that the requirements of the aforementioned exception to the transfer for value rule are met. If the insured has not yet purchased a life insurance policy, the most simple option would be to first establish a lifetime irrevocable trust which then purchases the policy. This option avoids the transfer for value rule altogether but is obviously unavailable to those already owning a policy individually. When considering these options, it is important to note that due to the unlimited marital deduction, there is no tax benefit of gifting a life insurance policy to a spouse, as the proceeds will pass to the insured person’s spouse without any estate tax liability.
Using an Irrevocable Trust to Mitigate Estate Tax on Life Insurance Proceeds
An insured person wishing to minimize his or her estate tax may vary well consider gifting the policy to the beneficiary but is also concerned about doing so, as some of the same problems illustrated in Scenario 1 may arise. The insured person can accomplish the goal of removing the proceeds from his or her estate and assuage the concerns associated with gifting the policy outright to the beneficiary by instead establishing an irrevocable trust and gifting the policy to the trust, or alternatively, have the irrevocable trust purchase the policy on the insured person’s life.
As mentioned above, for the life insurance proceeds to be excluded from the insured person’s estate, (1) the proceeds should be payable to the irrevocable trust, not the insured person’s estate, (2) the irrevocable trust, not the insured person, must own the policy, (3) the insured person must not retain incidents of ownership of the policy[8] (i.e. the power to change beneficiaries), and (4) the policy must not be transferred to the irrevocable trust within three years immediately preceding the insured person’s death.
As most irrevocable life insurance trusts do not contain income producing property, the question arises as to how premiums of the policy held by the trust will be paid. To ensure that gifts made to the trust to pay for such premiums qualify for the annual gift tax exclusion, and thus not use any part of the insured’s unified credit, the trust must give the beneficiary the right to withdraw the amount of such gift for a reasonable amount of time, usually 30 days, after the gift is made.[9] After the 30 days, the beneficiary’s right to withdraw lapses, and such amount can be used to pay the premium on the policy.
Conclusion
In summary, the use of a trust is invaluable when used in concert with your life insurance plan, regardless of whether estate taxes are of concern. When the estate tax is not of concern, the use of a revocable trust is a flexible and simple way to ensure the proceeds pass according to your wishes. When estate taxes are a consideration, the use of an irrevocable trust can remove the insurance policy from your estate, thus mitigating the estate tax, while also ensuring your loved ones are provided for in a manner satisfactory to you.
[1] https://esapllc.com/rlt-for-everyone-2023/
[2] I.R.C. § 101(a)(1)
[3] I.R.C. § 101(a)(2)
[4] I.R.C. § 101(a)(2)(A)
[5] I.R.C. § 101(a)(2)(B)
[6] I.R.C. § 2042
[7] I.R.C. § 2035(b)(2)
[8] This typically means the insured should not serve as trustee.
[9] Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968).
