Return of estate tax creates a danger for life insurance policies

With the federal estate tax now back in effect – and the possibility that it will apply to estates as small as $1 million at some point in the next few years – many people need to take a second look at their life insurance policies.

Life insurance proceeds are not subject to income tax. But what many people don’t realize is that if you own your life insurance policy, then the proceeds will be considered part of your estate when you die. If those proceeds – combined with your other assets – amount to more than the estate tax exemption, then your estate may be subject to estate taxes.

If the beneficiary of your policy is your spouse (and your spouse is a U.S. citizen), then no estate tax will be due at the time of your death. However, the proceeds will now be part of your spouse’s estate when he or she dies, and will be subject to estate taxes then.

What many people don’t realize is that if you own your life insurance policy, then the proceeds will be considered part of your taxable estate when you die.

A good solution is to transfer ownership of the policy. You could transfer ownership to your children, but it’s usually better to put the policy into a trust. The advantage of a trust is that, when you die, the proceeds in the trust can be used to benefit your spouse during his or her lifetime if necessary, and when your spouse dies, the remaining proceeds can pass tax-free to your children or other heirs. In this way the bulk of the proceeds can go to your heirs without being taxed either as part of your estate or as part of your spouse’s estate.

There are some complexities to life insurance trusts. For instance, if you transfer a policy to a trust and you die within three years, the tax benefits will be lost. (You can avoid this problem if you set up the trust first and have the trust buy the policy.)

Also, there are some notice and paperwork requirements each year in order to properly pay the premiums without jeopardizing the tax advantages. But for many people, the huge tax savings and added control provided by a trust are worth it – especially with the uncertainty over the estate tax rules.

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