Most people are aware that life insurance policies are immune to creditors. What trips most people is the confusion that arises from ownership of the policy and designations to various beneficiaries due to tax treatment. This on its own, is quite a complicated issue regarding life insurance due to two tax issues: U.S. Ordinary income taxes and federal estate taxes.
If your spouse is the beneficiary of your life insurance, there is no sweat. This is because there is no estate tax when assets are passed between husbands and wives regardless of the amount so long as the spouse is a citizen. On the other hand, if your estate is more that $2 million, it might be wise placing ownership of the life insurance policy under an irrevocable life insurance trust to help deal with the taxes that come with the passing of the surviving spouse. When an irrevocable trust is established, the death benefit proceeds will not be part of the taxable estate, which on other cases may be as high as 40%. However, revocable trusts do not experience the same benefit.
Additionally, if the policy is a new one, you should name the trust as the policy’s owner. If it is existing, you can change ownership to the trust. However, the government is aware of deathbed transfers and to eliminate them; it requires that the policyholder survives the transfer with three years. Otherwise, the estate will be taxed. Furthermore, if the policy’s cash value that one would get when cashed in instead of when you pass exceeds $15,000, the transfer might eat into the gift and the estate tax exemptions.
In most cases, it’s best to name the beneficiaries of the life insurance individually as opposed to making a trust as the beneficiary. On the other hand, if the beneficiaries are minors, have drug issues, creditor issues, can’t be relied on with large amounts of cash, suffer from mental health problems or other special cases, then naming a trust is the better option.
Listing a spouse as a beneficiary to life insurance proceeds upon the death of the policyholder will make the proceeds estate and income tax-free. Since trusts are not considered individuals, the proceeds paid to trusts are subject to estate tax. Also, the proceeds made to a trust may not be eligible for the exemption of inheritance tax that is provided in some states.