When it comes to setting up an estate plan, one should consider the important advantages that life insurance provides. However, it is also important to know about the limitations on life insurance, and some possible planning ideas to utilize life insurance in an overall estate plan.
First, one must keep in mind the difference between the tax consequences of life insurance from the federal estate tax perspective and from the federal income tax perspective.
If you own a life insurance policy on your life, upon your death the life insurance benefit will be includible in your estate and subject to federal estate tax. The good news (at least, for now) is that that the amount that one can have in his or her estate and still avoid the imposition of the federal estate tax is pretty sizable. At present, the federal estate tax exclusion amount is $5 million, or $10 million for a married couple. For most people, therefore, the federal estate tax is not a serious concern. That may very well change, of course, if the exclusion amount goes back to the lower levels it has traditionally been at–say $1 million. So, bottom line, it will be important to keep an eye on what Congress does with the federal estate tax exclusion amount over time as you plan your estate and work with your estate planning attorney.
From an income tax perspective, life insurance is a great asset to have in one’s estate planning toolbox. The benefits payable to a person’s beneficiaries are not subject to federal income tax–they are income tax free to the beneficiaries. And, if you think you may have some debts or taxes (including estate taxes) that you are going to owe at your death, insurance proceeds provide a nice pool of money to use for those financial needs.
So, what can you do if you think you’re going to want to shelter your life insurance proceeds from the federal estate tax? Say, you’ve got a really large insurance policy or you have substantial wealth otherwise or you simply believe the federal exclusion amount is going to return to a lower level by the time of your death?
Well, in order to keep the life insurance proceeds from being includible in your estate for federal estate tax purposes, you’re going need to part with ownership of your policy. There are many ways of doing this, including giving the policy to a beneficiary or setting up an irrevocable life insurance trust. One of the key planning points if a person decides to part with ownership of a life insurance policy for estate planning purposes is that he or she must then live 3 years or the policy will still be brought back into his/her estate for tax purposes.
All in all, life insurance can play a key role in a person’s estate plan, but care must be taken to review the overall size of the person’s estate and to consider whether it makes more sense to keep ownership of the policy until death (maximizing the ability to make changes, etc.) or parting with ownership (taking the proceeds out of the person’s estate, assuming he/she survives for 3 additional years).