ELITE ADVISOR BEST PRACTICES

Make Sure Your Clients’ Life Insurance Is Not Taxed at Their Death

If clients transfer their life insurance policy to a trust or to another person, they will no longer own the policy—so they can’t change the beneficiary or exert control over it.

By Elite Advisor Report interview with Guy Baker, Hyman Darling and Randy Fox

Key Takeaways:

  • Your clients’ life insurance policy may pass to their heirs income tax-free, but it can still affect their estate tax.
  • If clients transfer their life insurance policy to a trust or to another person, they will no longer own the policy—so they can’t change the beneficiary or exert control over it.
  • If clients transfer the policy to a person, make sure it is to someone they can trust not to cash it in.
  • Transfers of life insurance policies may be subject to gift tax if the cash value of the policy is more than $14,000 in 2015 dollars—but that can be misleading, since there are no taxes due until the annual exclusion amount is gifted.

Let’s face it, many of your clients do not like talking about life insurance and estate planning because the subject of death is unpleasant and today’s tax and wealth transfer rules are so complex.

It’s tempting for clients to go to the Internet for quick and easy answers, but as with so many things on the web, sometimes the answers are misleading or incomplete. Here is a case in point. This well-intentioned article about making sure life insurance is not taxed upon death has been making the rounds. It was published originally by ElderLaw Answers, which bills itself as “The Web’s Most Trusted Long-Term Care and Planning Resource.”

Maybe your clients have seen it

The article started off on the right track by pointing out that even though your clients’ life insurance policy may pass to their heirs income tax-free, it can affect their estate tax—and if the client is the owner of the insurance policy, it will become a part of the client’s taxable estate when he or she dies. Other good advice included:

  • Make sure your life insurance policy won't have an impact on your estate's tax liability.
  • If your spouse is the beneficiary of your policy, then there is nothing to worry about. Spouses can transfer assets to each other tax-free, so long as the surviving spouse is a U.S. citizen. But if the beneficiary is anyone else (including your children), the policy will be a part of your estate for tax purposes.

Then a real-world example was provided. “Suppose you buy a $1 million life insurance policy and name your son as the beneficiary. When you die, the life insurance policy will be included in your taxable estate. If the total amount of your taxable estate exceeds the then-current state or federal estate tax exemption, then your policy will be taxed.”

The bigger problem, added Hyman Darling, an estate planning attorney with Springfield, Massachusetts-based Bacon Wilson PC, is “who is going to pay the tax if the son gets the money, but the estate has to pay the tax.”

In order to avoid having a life insurance policy taxed, ElderLaw Answers said, “you can either transfer the policy to someone else or put the policy into a trust.”

Here’s where it gets tricky

According to ElderLaw Answers, “Once you transfer a policy to a trust or to someone else, you will no longer own the policy, which means you won’t be able to change the beneficiary or exert control over it.”

Guy Baker, MBA, MSFS, CFP®, an Irvine, California-based financial advisor to business owners, said that’s correct, assuming the client transferred ownership. “The insured does not have the ability to make any changes.”

According to Randy A. Fox, co-founder, EzCharitable LLC and editor in chief of Planned Giving Design Center, many trusts now use “trust protectors” who, under some circumstances, may alter the trust or correct errors. “Certainly, an insured is better off starting out with the trust purchasing and owning the policy to begin with,” added Fox.

In addition, ElderLaw Answers said, “the transfer may be subject to gift tax if the cash value of your policy (the amount you would get for your policy if you cashed it in) is more than $14,000 (in 2015; this figure rises every few years with inflation).”

Actually, the value is the “interpolated terminal reserve,” which can be different from the cash value, said Fox, a frequent contributor to Elite Advisor Report. “However, it could be the replacement cost of the policy if the owner’s health has changed.”

Darling said the $14,000 figure can be misleading, since there are no taxes due until the annual exclusion amount is gifted. Darling, a frequent contributor to Elite Advisor Report, agreed that the $14,000 limit is subject to inflation, but he does not expect it to increase next year, since inflation is low. He also said it is important to remember that “a gift tax return is due to be filed once the gift of $14,000 is exceeded.”

Baker said you don’t want clients to forget that they can use their lifetime exemption of $5.43 million, “so there may not in fact be a gift tax. Also, you have the ‘three-year contemplation of death’ problem to contend with.”

Another option would be to transfer cash to the trust and have the trust purchase the policy from the insured. That would eliminate the three-year rule for the policy and bring back only the gift of the purchase price.

As ElderLaw Answers explained, “If you decide to transfer a life insurance policy, do it right away. If you die within three years of transferring the policy, the policy will still be included in your estate.”

So, if your client transfers a life insurance policy to a person, make sure it is to someone who can be trusted not to cash in the policy. For example, if the spouse owns the policy and the couple gets divorced, there will be no way for the client to get it back. A better option may be to transfer the policy to a life insurance trust. In that case, the trust owns the policy and is the beneficiary. The client can then dictate who the beneficiary of the trust will be. For a life insurance trust to exclude the policy from estate taxes, it must be irrevocable, and the client cannot act as trustee.

Conclusion

So there you have it. The web can be a good starting point for getting answers to complicated life planning and wealth management questions. But if your clients want to transfer a current life insurance policy to someone else or set up a trust to purchase a policy, make certain they always consult with you or an elder law attorney.


About the Authors

Guy Baker, MBA, MSFS, CFP® is a financial advisor to business owners. He works to help owners find ways to reorganize their planning to achieve tax-efficient solutions to their succession, retirement and estate planning problems. Guy is a 34-year member of Top of the Table and recognized by Worth magazine as one of the top 250 financial advisors. For more information, you can contact him at guy@bmiconsulting.com or through www.bmiconsulting.com

Attorney Hyman G. Darling is chairman of Bacon Wilson, P.C.’s Estate Planning and Elder Law departments. His areas of expertise include all areas of estate planning, probate, and elder law. He is a frequent lecturer on various estate-planning and elder-law topics at local and national levels, and he hosts a popular estate-planning blog at bwlaw.blogs.com/estate_planning_bits. He may be reached at (413) 781-0560 or HDarling@BaconWilson.com

Randy Fox is Editor in Chief of Planned Giving Design Center and Co-Founder of EzCharitable, LLC. and is the regional representative of Charitable Giving Resource Center.

Copyright © 2015 EzCharitable, LLC