Saturday, October 9, 2010

Life Insurance Tax Impact

This is a great question and answer on life insurance. For more specific guidance contact Saggio Management Group for assistance.

Life Insurance Ownership is Tax Issue

Oct 08, 2010 2:12 PM EDT

Dear Dr. Don,
My wife and I each got a term life insurance policy when we had kids. Each of us is the primary beneficiary of the other's policy, with the kids as the contingent beneficiaries. The issue, though, is that I discovered that I think our insurance agent made a mistake.

My wife is the policy owner for both policies, which I cannot imagine is the best thing to do. Either we should each own our own policies, or we should own each other's policies. But I can't see a situation in which she should own both. We are in California, if that has an impact on the question.
-Jeff Jumbled

Dear Jeff,
The ownership issue is more of an estate tax issue than anything else. If the estate at death is large enough to subject it to federal estate taxes, the proceeds of any life insurance on the deceased owned by the deceased either at death or within three years prior to death will be included in the taxable estate.

To avoid such inclusion, the life insurance policy can be owned by a trust or some party other than the insured. If there is no estate tax complication, the ownership issue is of minor importance.

If it's important to you, an individual policy typically allows you to transfer ownership. But group policies, like policies you get through work, may not let you transfer ownership.

In 2010, there is currently no federal estate tax law in place. The tax expired Dec. 31, 2009, although Congress has indicated an intent to enact a new federal estate tax law that would be retroactive to Jan. 1, 2010.

In 2009, the federal estate tax applied to estates in excess of $3.5 million. Congress is fighting over whether to reinstate the $3.5 million exemption or to raise the exemption to a higher amount, possibly as high as $5 million.

Congress also is battling over the rate of taxation, with 25 percent, 35 percent and 45 percent all being proposed. If Congress does nothing to change the federal estate tax law, older estate tax rules will be applicable in 2011 (e.g., exemption of $1 million and lowest tax rate at 41 percent).

People who die during 2010 owning multimillion-dollar estates present a dilemma for the executor or administrator of the estate. Until Congress passes a new law, it is unknown whether a federal estate tax is due.

Since California is a community property state, the ownership issue is influenced by what funds were used to pay premiums for the policies.

If community property funds were exclusively used to pay the premiums, both spouses are deemed to be owners of an undivided one-half interest. If the premiums were paid exclusively out of the separate funds of one of the spouses, the ownership would rest with the spouse whose funds were used to pay premiums.

The messiest situation would be one in which community property funds and separate funds from both spouses were used to pay premiums. In such cases, there needs to be a tracing of source funds to determine the three proportionate shares of the policy ownership. There would be one portion owned jointly as a result of community property premium payments, one portion owned separately by the husband from the husband's separate fund premium payments, and one portion owned separately by the wife from her separate fund premium payments.

If the spouses divorce, the policies' ownership can be allocated as part of the property settlement agreement. The agent may have assumed it would be beneficial to have the wife own the policies so that in the absence of a reallocation of ownership in the divorce property settlement, the wife would control the policies.

Another possible assumption on the part of the agent could have been that the husband has enough separate property to face federal estate taxes and the wife's combination of community property and separate property would not be enough to trigger a federal estate tax.

Ownership of an existing policy can be transferred to a trust (irrevocable life insurance trust), but it will not get the policy exempt from federal estate taxes until three years after the transfer date as set forth explicitly in the Internal Revenue Code. Policies are usually purchased initially by the trust rather than transferring existing policies.

Note: I'd like to thank Edward Graves, associate professor of insurance and the Charles J. Zimmerman chair in life insurance education at The American College in Bryn Mawr, Pa., for his help and insights in framing this reply.

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