Tax Tips for Tax-Free Life Insurance
With tax-saving planning, you can enjoy tax free life insurance policy benefits. However, wrong moves can make your benefit 100 percent taxable. This article will give you smart tax saving tips.
How Life Insurance Works for Estate Taxes
There are a variety of reasons to buy life insurance such as, taking care of family, continuation of business, providing funds for paying estate taxes, etc. Generally, death-benefit payments are free of federal income taxes.
In the case of estate tax, the death benefit is included in taxable money in your estate for federal estate tax purposes. If the life insurance is paid to your surviving spouse, who has a U. S. citizenship, tax law offers you the unrestricted marital deduction. This allows the benefits to bypass your estate and go to your spouse. In such situation, tax law simply waits for a while for collecting estate taxes from your spouse.
In case if death benefits go to someone other than your citizen-spouse, the life insurance benefits become a taxable asset.
To Own or Not to Own Your Life Insurance Policy
Any incidents of ownership, for instance the power to change policy beneficiaries or coverage amounts, or cancelling the policy makes you considered as the owner of a life insurance policy. This means, the incident of ownership is much likely to occur. The death benefit including all other assets may easily surpass federal estate tax exemption of $5.12 million.
The existing estate tax is scheduled to expire on December 31, 2012. This triggers two big changes:
1. Exemption from estate tax drops to $1 million from the $5.12 million.
2. Estate tax rate increased to 55 percent from 35 percent.
You can’t count on lawmakers as the track record shows many drastic changes in tax policies every year. What you can do is taking control of your death benefit by not owning the policy.
Do This
Found an irrevocable life insurance trust, which will own the policy on your life. This will eliminate your incidents of ownership, and hence, bypass the estate tax hit.
With cash infusions from you, the trust pays premiums of life insurance policy. When you die, the death benefits of life insurance directly go to the trust’s beneficiaries you named. This way, you will be able to eliminate income and estate tax as the legal owner of policies is trust, and furthermore, the money transfers are tax-free.
Caution
Avoid using the irrevocable life insurance trust for directly paying estate taxes. Using the death benefit to pay the estate taxes directly raises the taxable estate and results in avoidable estate taxes. Make the trust purchase assets from the estate. You can also make a loan to address the need of liquidity with the estate.
Irrevocable life insurance trust gives you two great benefits that are exemption from income and estate taxes on the death benefit.
Generally, life insurance premiums are nondeductible, irrespective of the reason behind buying the coverage.
Mind the Details with Your Irrevocable Life Insurance Trust
Pay attention to these four details of your irrevocable life insurance trust:
• Transferring an existing policy to trust and dying within three years includes the insurance benefit in your taxable estate.
• The trust needs money to pay premium. You can plan yearly cash gifts to the insurance trust and exempt gift taxes. You can enjoy the gift and estate tax exemption by making yearly cash gifts to the insurance trust of maximum $13, 000, 9 and establishing the insurance trust. This will give the trust’s beneficiaries an authority to withdraw your cash gifts within a reasonable time you make them. Make sure you include the Crummey clause, which allows the withdrawal of gift. Without the clause, the gifts will not be qualified for the annual exclusions.
• The existing cash value of an existing policy can cut into your exclusions for estate and gift tax purposes and cause higher taxes. Making the trust buy a new policy can address this concern.
• Seek guidance of an estate planning professional to help you found your irrevocable life insurance trust. The money spent for this is money well spent.
Final Thoughts
With good planning, you can ensure that your death benefits are free of federal income and federal estate taxes. People generally buy life insurance with a thought of helping their children in the future. However, without planning, taxes can take away a major chunk of the death benefit, destroying policy’s primary objective of helping survivors. However, a proper planning and guidance of estate planning professional will give you tension-free life and a better sleep.
For further information, Please contact Dwayne K Dowell, CPA/PFS at dkdowell@dkdcpa.com or call (502) 271-8452.