Rich or poor you will accumulate assets over your life. How do you want your assets distributed, all to your spouse, children, or a charity? How you want your assets distributed is your goal. But, accomplishing your goal might not be as straightforward as you might think. And without a will your state by statute will determine the division of your assets. So failing to plan causes you to lose the ability to decide who gets your assets. The statute might distribute your assets exactly how what you would, but I would bet that it would not.
There are many other factors to consider besides simply “A” gets 50%, and “B” gets the other 50%. A crucial factor to consider when you are creating an estate plan is the possible tax liability whether on your estate or heirs. Your estate and heirs may be taxed, and a portion large or small is gone. Now, I am a patriot, but I do not want to overpay my taxes for failing to plan for the inevitable. And I assume that you do not wish to pay more than required, too.
An estate plan can help accomplish another goal one that you might not have even thought you needed. An estate plan will memorialize your desires, reducing the likelihood of infighting between your heirs. I know you are saying right now my family will not fight over money or property, and I hope that you are right. But, so many families do fight over the smallest things at this tragic time. With emotions running high, it would be nice to remove a possible trigger. Infighting is less likely to occur if they know this is what you wanted.
But, returning to the issue of minimizing your estate’s tax liability. In 2016, Tennessee’s estate tax will be abolished, but there are still six months left of 2015 for your estate to be subjected to estate taxes if the unthinkable happens. I am not going to go into detail about the Tennessee estate tax since it will not be useful in six-month time, but it is still a possible tax and can be minimized with strategic planning
Federal estate taxes, however, are not going away anytime soon. An estate will be exempt if the value does not exceed $ 5,430,000 in 2015. Most estates will not exceed the exempt amount, but the law can change, just a few years ago it was set to go back to $ 1,000,000, but luckily Congress did not let it expire. So, when you think of all of your assets and say my estate would be below that and will not owe any taxes do not forget to include the value of your life insurance policies.
I know right now you are saying life insurance is not taxable, this is a myth, but it is true in part. You are right that life insurance proceeds are not subject to federal income tax, it is, however, subject to estate taxes. The Internal Revenue Code Section 2042 states that the value of life insurance proceeds is included in your gross estate if the proceeds payable fall into one of two categories. (1) If the proceeds are payable to your estate, either directly or indirectly; or (2) to named beneficiaries, if you possessed any incidents of ownership (we will discuss this more below) in the policy at the time of your death. There are ways to avoid life insurance proceeds from being part of your taxable estate.
For estates that will owe taxes, whether life insurance proceeds are part of the taxable estate depends on the ownership of the policy. You will need to transfer the ownership of your policy to another person or entity for life insurance proceeds to avoid federal estate taxes.
The cheaper (but not always better) route is just to transfer ownership of your policy. The new owner can be a competent adult or entity. Contact your insurance company for the proper assignment, or transfer of ownership, forms complete the forms and send them to the insurance company. The new owners must pay the premiums on the policy. You can gift up to $14,000 per person in 2015, so the recipient could use this gift to pay premiums. But, you will give up all rights to make changes to this policy in the future. The new owner can make changes at your request. Transferring ownership is an irrevocable event, so beware of divorce situations when planning to name the new owner. Be sure you get written confirmation from the insurance company as proof of the ownership change.
A second method to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT (we will discuss ILITs in greater detail in a later post)). When transferring ownership, you cannot be the trustee or retain any right to revoke the trust. The policy is held in trust, so you are no longer be considered the owner. Therefore, the proceeds are not included as part of your estate.
What is an incident of ownership? A natural determination is it has you as the named owner of the policy. The IRS has made rules to help determine who the owner of the life insurance policy when the insured person dies.
The primary regulation overseeing ownership is the three-year rule. The three-year rule states that any gifts of life insurance policies made within three years of death are still subject to federal estate tax. This rule applies to both a transfer of ownership to another individual and the establishment of an ILIT. So, if you die within three years of the transfer, the full amount of the proceeds are included in your estate as though you still owned the policy.
Another regulation looks for any incidents of ownership by the person who transferred the policy. When transferring the policy, the original owner must forfeit any legal rights the owner would have as the owner. Additionally, the original owner cannot make the payments to keep the policy in force. These actions are considered to be a part of the ownership of the assets, and if any is carried out, it can negate the tax advantage of transferring them. Even if a policy transfer meets all of the requirements, some of the transferred assets may still be subject to taxation. If the current cash value of the policy exceeds the $13,000 gift tax exclusion, gift taxes will be assessed and will be due at the time of the original policyholder's death.
Today, it's not uncommon for individuals to have a life insurance policy for $500,000, $1 million, or more. Taking into account all of your assets, such as your home, retirement accounts, saving accounts, and your other belongings, you may be surprised by the size of your estate. Factor in several more years of growth and the fact that the estate tax exemption could be reduced, it is clear that many of us are facing an estate tax issue. A viable solution to this is to maximize your gifting potential and to transfer policy ownership whenever possible at little or no gift tax cost. As long as you live another three years after the transfer, your estate could save a significant amount of tax.
Benjamin F. King
My goal is to bring issues that are often over looked. But, this blog is not legal advice it is only for general information. Each situation is fact specific.