Check Your Life Insurance

Updated on February 3, 2010. 

Estate Tax Uncertainty: Since 2001, the federal estate tax has been scheduled to die in 2010. However, the tax is scheduled to come roaring back with much sharper teeth in 2011. Nobody thought our beloved Congress would allow the estate tax to expire this year, but it happened. We expect the tax to be restored sometime in 2010, but the issue of the effective date is very uncertain. If Congress tries to bring the tax back with a retroactive effective date of January 1, 2010, it might be unconstitutional. Meanwhile, the federal gift tax rules for 2010 are the same as they were in 2009. Click here for some advice on estate planning in 2010 between now and when the dust settles.  

MOST PEOPLE DON'T realize it, but unless you plan carefully, there's a chance the federal government will end up as a major beneficiary of your life insurance policy. While it is true that life insurance death benefits are paid income-tax-free to the beneficiary, the proceeds are generally counted as an asset of your estate for estate tax purposes.

The Problem
Consider this example provided by Bernard Kleinman, a CPA with Richard A. Eisner & Co. in New York. Kleinman had as a client a successful attorney who died of cancer in her mid-40s. Much of her sizable estate passed to her husband estate-tax-free, but among the assets that didn't was a $100,000 insurance policy that named her son as beneficiary. Before her son could claim the cash, Uncle Sam scooped up $45,000 of it.

The problem was that she bought the insurance herself and held the policy in her own name. When she died, according to the tax law, the payout became part of her taxable estate. What she should have done — and what Kleinman had harped on her to do, to no avail — was put the policy into an irrevocable life insurance trust. Then the $100,000 death benefit would have gone to her son tax-free and could have grown into more than enough to cover his college tuition. It's an all too common mistake. Notes Kleinman: "It happens all the time. All the time."

What to Do
If your life-insurance beneficiary is your spouse, generally there's no issue; assets pass estate tax-free between husbands and wives no matter what the amount (as long as the spouse is a U.S. citizen). But if the beneficiary is anybody else, there are two paths to follow:

1. Have a trust buy the policy in the first place so that you are never the owner. That way, the policy is never a part of your taxable estate, but you can still designate as beneficiary whomever you want.

2. If you already have policies that may generate an estate tax liability, do what Kleinman advised: Put them in an irrevocable trust. But be aware that there are some complications. First, to eliminate deathbed transfers, the government mandates that you must survive the transfer by three years or your estate will be taxed anyway. Second, if the cash value of the policy — what you would get if you cashed in now instead of when you die — is more than $13,000, the transfer may use up part of your gift and estate tax exemptions.

In the second case, you may want to set up the trust with multiple beneficiaries. That way you can transfer up to $13,000 in cash value per beneficiary without any negative tax implications. Still, you'll need a competent estate planner to help you do the deal. Says Stephan Leimberg, professor of taxation and estate planning at American College in Bryn Mawr, Pa., "Moving a life insurance policy is the easiest way to transfer wealth estate-tax-free."

For more information, visit our life insurance section.