Keeping Life Insurance Out of Your Taxable Estate

How can you use life insurance trusts to minimize estate taxes on the proceeds of life insurance policies?

Life insurance can be an effective way to leave a large sum of money to a loved one free of  income tax. But mistakes may prevent beneficiaries from reaping the full advantages as well as create adverse estate tax consequences.

For example, if the life insurance is payable to your estate, rather than to a specific person, it may be subject to probate which can be a lengthy process. The beneficiaries of your estate may  have to wait up to one year to receive their share of the death benefits from your life insurance policy. Even if you name a beneficiary, the proceeds from your life insurance policy are included in your taxable estate. When combined with your financial assets, the value of your home, and other assets, the proceeds from your life insurance policy could increase the value of your estate substantially, thus resulting in an estate tax.

Create a Life Insurance Trust

If a life insurance policy is owned and payable to an irrevocable trust, the proceeds of the life insurance policy will not be considered part of your taxable estate and the proceeds are not considered taxable income. A transfer to a trust has other advantages. You can name the persons you want to serve as trustees who will manage the investment of the proceeds. You can also set forth the distribution terms for the beneficiaries which is particularly important for minor and disabled beneficiaries. You can also provide for the trust to pay the insurance premiums.

The transfer of a life insurance policy to an irrevocable trust is subject to the “three-year” rule, which requires that the transfer to the trust occurs at least three years prior to your death.

If you wish to keep life insurance proceeds out of your taxable estate, a qualified estate planning attorney can help you design and implement an irrevocable trust.

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