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Is Uncle Sam a Beneficiary of Your Life Insurance?

It's Your Money

Posted: February 21, 2008 7:25 p.m.
Updated: April 23, 2008 5:04 a.m.
Life insurance is an excellent way of providing financial support for a surviving spouse or children upon the death of the family breadwinner or if both parents die. In certain cases, however, the IRS may take as much as 45 percent of the insurance death benefit.

Although life insurance death benefits are not taxed as income to the beneficiaries, the insurance death benefits of policies owned by the insured are included in the insured's estate for purposes of calculating federal estate taxes.

Without considering life insurance, most people will not have to worry about the federal estate tax since an estate must now exceed $2 million to be subject to this tax. A large life insurance policy, however, may push your estate over the $2 million threshold and subject the amount over $2 million to a 45 percent federal tax. Note: Under the current federal law, beginning in 2011, estates over $1 million will be subject to the federal estate tax with a maximum tax rate of 55 percent.

There are ways to prevent life insurance proceeds from being included in the insured's estate. The best way is for the insured never to own the policy in the first place. If the beneficiary (such as a spouse or children) purchases the policy and pays the premiums, the death benefit will not be included in the insured's estate if certain steps are taken. The money to pay the premiums can be gifted from the insured to the beneficiary who owns the policy.

Irrevocable life insurance trusts are commonly utilized to remove life insurance from your taxable estate as well as the estate of your spouse. Life insurance trusts may also provide additional advantages such as management of the proceeds for the beneficiaries. This is especially important if any of the beneficiaries may be minors or financially irresponsible.

If you already own life insurance, the policy can be gifted to the beneficiaries or to a life insurance trust. However, if the transfer occurs within three years of your death, the proceeds will be included in your estate.

The rules relating to the various methods of removing life insurance benefits from your estate for federal estate tax purposes are very technical. Do not attempt any of the methods mentioned in this article without obtaining the advice of a qualified professional. If the total value of your estate, including life insurance, approaches the $2 million limit, please contact your agent and your attorney to determine the best way to arrange your estate and your life insurance.

Randall D. Armour is an estate planning attorney and licensed real estate broker. "It's Your Money" appears Thursdays and rotates between a handful of the valley's financial professionals. His column represents his own views, and not necessarily those of The Signal.


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