Life insurance in an estate plan remains one of the most cost effective ways to increase the size of an inheritance. It is most commonly used to pay income tax, estate tax or other transfer costs.
Life insurance is income tax free to the recipient.
There may be estate taxes assessed against the policy. How the insurance is owned and who is designated as beneficiary determines if the insurance is subject to estate taxes.
There are four ways that ownership and beneficiary designations occur in life insurance.
Insured Owner/ Spouse Beneficiary: The entire value of the insurance is subject to tax.
Insured Owner/Estate Beneficiary: this method is used to more fully fund the client’s applicable exemption amount from taxes. The amount that causes the insured’s share of the estate to exceed the exemption amount is subject to tax.
Cross Purchase: The full death benefit of the surviving spouse is subject to tax. If a cross purchase is to have estate tax benefits, the surviving spouse cannot have any incidents of ownership of control over the cross-owned policy.
ILIT (Irrevocable Life Insurance Trust): None of the death benefit is taxed as long as the trust is properly created. Existing insurance is not protected from estate taxes if the insured dies within three years of the transfer of the policy to the trust.