Usually, a life insurance policy will not be part of your estate for purposes of paying estate taxes. The IRS excludes certain assets from a deceased person’s taxable estate, including life insurance, 401(k) retirement plans, IRAs, and payable on death banks accounts. There are always exceptions to the rule, and life insurance can become part of the taxable estate if (1) the deceased person had “incidents of ownership” over the policy, (2) the estate is the named beneficiary, or (3) the policy was transferred to a different owner within three years of death.
- Incidents of Ownership
“Incidents of ownership” refers to some demonstration that the deceased person owned the policy. A variety of items could be incidents of ownership:
- Name on the policy, in combination with other incidents
- Who paid the premiums
- What was the source of the money used to pay the premiums
- Who has the right to change the beneficiary
- If someone can borrow against the policy’s cash value
- If someone can make changes to the policy
One of these items alone is usually not enough to require inclusion of the policy in the taxable estate. It depends on the circumstances. Essentially, the IRS is looking for a reversionary interest to the person whose life is insured. This means that there is a possibility (however small) that part of the policy proceeds could benefit the insured, rather than the beneficiary.
- Estate Is Named Beneficiary
Sometimes, people simply do not name a beneficiary of their life insurance policy. Sometimes, the named beneficiary dies before the person who is insured. More rarely, someone names their estate as the beneficiary of the policy. In all three cases, the life insurance would become part of the person’s taxable estate.
- Transfer to Another Owner
The IRS has a special rule stating that all assets transferred to another owner within three years before the original owner’s death will be included in the original owner’s estate. (26 U.S.C. § 2035.) This is supposed to keep people from transferring all of their property out of their taxable estate in anticipation of their death. If you transfer ownership of a life insurance policy to someone else – such as by placing it in an irrevocable life insurance trust (ILIT) without consideration – it will become part of the taxable estate. Of course, there are special exceptions to this rule too, including an ILIT exception to be discussed in a later blog.
The IRS applies these exceptions to make life insurance part of the taxable estate because it is supposed to include all property the deceased person owned at death. Incidents of ownership and transfer both involve the owner exercising some degree of control over and ownership of the policy.
Planning your estate? Look to Janet Brewer, Esq. for thorough and thoughtful estate planning advice. Janet’s more than 20 years of legal experience will give you confidence and peace of mind. To schedule a “Get Acquainted” meeting, visit Janet's website or call her office at (650) 469-8206.