Since we all know the main purpose of life insurance is to provide for those when you aren’t around the conversation often focuses on the beneficiary and almost no time is spent discussing the owner. I think this is a huge shortcoming of both the legal world and the financial world because usually one side thinks the other is having this part of the conversation.
Since the Death Benefit of Life Insurance May be Included in your Taxable Estate Ownership Matters
It is often repeated almost like dogma that life insurance is tax free. Well as with most absolutes there are notable and important gray areas. One important gray area that is often not discussed has to do with IRC Section 2042 which states that if a decedent has incidents of ownership (i.e. owns and controls that policy) then the death benefit will be included in his estate for estate tax purposes.
While 99% of those reading this blog won’t get hit by the federal estate tax since a decedent need assets of more than $5,250,000 (2013 and growing) it is more plausible that you may get hit with State estate taxes if your State is one that is decoupled.
Lets take the example that inspired the post
- Divorced individual from New York
- New York has an estate tax starting at $1,000,000 of assets
- $1,000,000 life insurance policy split evenly between his children, but owned by the Decedent
- $2,000,000 policy owned by the individual naming his girlfriend as beneficiary
- Other assets of about $2,000,000 all going to his Children.
With $5,000,000 or so of estate taxable assets we are looking at $0 to the federal government and approximately $400,000 to New York State. The glaring problem that no one talked to his individual about until the other day when someone from my office had the opportunity to meet him is two fold:
- Currently, the Children will be paying for the increase in the estate bill born from the girlfriend’s newly enlarged bank account. The Estate is going to come after the $400,000 from the Children not the girlfriend. This was not his intent.
- Second with a different ownership structure we could erase $300,000 of the possible estate tax bill
First, we have the girlfriend own the policy on client. Now that she owns the policy it is out of his estate for estate tax purposes. Second, we move the children’s policy into an irrevocable life insurance trust. Depending how we move the policies (gift or sale) the policies would be out of his estate for estate tax purposes after a time certain. Thus leaving his heirs with a $97,000 tax bill instead of a $400,000 one.
This particular situation may not fit your family dynamics but it is just one example of how ownership of a policy is important and options should be considered.