Life Insurance Review

End of Life Management Toolkit #4 | by Team Passare, Robert L. Shepard and Jeff A. Perry

3. Taxes and Transfer of Ownership

The Internal Revenue Code allows special income tax and estate tax treatment for life insurance. In most cases, the death benefit proceeds from a life insurance policy are not taxed as income for income tax purposes. For estate tax purposes, there are different rules. You may be able to avoid estate taxes on the insurance proceeds by transferring ownership to another party.

Life insurance policies that are owned by the decedent are part of the decedent’s gross estate for federal estate tax purposes.

  • Life insurance proceeds on the life of a deceased person ar e included in a deceased person’s estate if that deceased person had “incidents of ownership” over the policy during the last three years of the decedent’s life.
  • An incident of ownership is an instance of legal interest or right in any type of property. Owning the life insurance policy is a clear incident of ownership.
  • If somebody else owns the life insurance policy but the deceden t pays the premiums and controls the policy. The payment and control may be considered an incident of ownership and cause the life insurance policy proceeds to be included in the decedent’s gross estate.
  • Other incidents of ownership include the:
    Right to change the beneficiary designation on the policy
    Right to borrow against the life insurance policy
  • The presence of any of these rights in the policy is enough to include the life insurance proceeds in the decedent’s taxable estate.

Helpful Hint: To avoid including life insurance proceeds as part of your estate, do not have incidents of ownership in the policy.

Transfer Ownership of Life Insurance Policies

An existing insurance policy can be transferred or gifted to remove the policy from a person’s estate. Sometimes it makes more sense to transfer ownership of your life insurance policy if you leave an estate greater than $5.25 million. For a couple, they should transfer ownership if their combined taxable estate is more than $10 million.

  • This transfer is treated as a taxable gift.
  • The “three-year contemplation of death rule” means the transfer must occur at least three years prior to the insured person’s death or the value of the life insurance policy will be brought back into the estate for estate tax purposes.
  • You must live for three years after the gift of the insurance policy to get the policy value out of your estate for estate tax purposes.

Here is an example of the three-year contemplation of death rule. Norma gives her $500,000 term life insurance policy to her friend, Carry. Norma dies two years later. For federal estate tax purposes, the gift is rejected, and all of the proceeds, $500,000, are included in Norma’s taxable estate. If Norma had transferred the life insurance policy three or more years before her death, none of the proceeds would have been included in her taxable estate. If you want your life insurance proceeds to avoid federal estate tax, transfer ownership of your life insurance policy to another person or entity.

The life insurance proceeds are paid to the person who owns the policy, also known as the beneficiary, when the insured dies. Another option is to create an irrevocable life insurance trust and transfer ownership to the trust. When the insured dies, the proceeds go into the trust.

Helpful Hint: If you own a life insurance policy on your life and you are concerned that your estate may have a future federal estate tax liability, contact a trusted insurance and financial professional or estate planning attorney that can help answer questions and advise you correctly.

Now, take a few minutes to answer these helpful questions about life insurance review.
  1. What are the advantages of transferring ownership of your insurance policy?
  2. What are the disadvantages of transferring ownership of your insurance policy?
  3. If you decide to transfer ownership, who would you transfer ownership to?
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