Any financial expert will tell you that if you have a family who depends on your income, a life insurance policy is a must-have. Without life insurance, your family may find themselves in a financial crisis if something happened to you. An effective life insurance plan will ensure that all of your family’s financial needs will be covered in the event of your death—from the monthly mortgage to final expenses to your child’s college education.
Plus, life insurance can offer your family a tax-free death benefit that far surpasses the premiums you pay for the policy each month. However, there’s a catch: if you don’t properly set up your life insurance ownership and beneficiary designations, much of the proceeds from your policy may be severely taxed, leaving your loved ones with very little.
Here are three important tax facts to keep in mind as you structure your life insurance policy:
Don’t name yourself or your estate as the beneficiary:
Everything that you own may be subject to federal estate tax when you die, and this must be paid from your estate. However, this tax generally will not be imposed if your property is valued at less than your estate tax exemption amount upon your death. (The federal estate tax exemption amount is $2 million in 2008 and will increase to $3.5 million in 2009.)
However, if you own a life insurance policy with you or your estate named as the beneficiary, this will increase the value of your estate. If this pushes the value of your estate in excess of the exemption amount, the entire death benefit of your life insurance policy could be taxed. Consequently, your heirs could be left with very little or nothing at all.
Therefore, if you think you could be affected by estate taxes, you’re probably better off making someone else the owner and beneficiary of your life insurance policy. For example, you could establish an irrevocable trust as the owner and beneficiary of the policy. On the other hand, you could set it up so that your grown children are the owners and beneficiaries of the policy. Either option will ensure that the proceeds from your insurance policy will not be included in the value of your estate.
Name a contingent beneficiary:
If the beneficiary you named on your life insurance policy dies before you, and you die shortly thereafter, the proceeds from your policy may be paid to your estate. Once again, this will raise the value of your estate, increasing the odds of estate taxes and the risk of your life insurance death benefit being fully taxed.
This is why you should name at least two contingent beneficiaries on your insurance policy. That way, if the first beneficiary dies before you, the death benefit from your policy will be paid to directly to the next beneficiary in line, which will avoid the risk of probate and estate taxes.
Understand gift taxes:
Any life insurance that you give to a third party other than your spouse may be subject to gift taxes. If you don’t survive this gift by three years, the policy will be brought back to your estate—which once again, increases the value of your estate and with it the risk of estate taxes. Therefore, if you are considering transferring a life insurance policy to a third party, you should consult with a tax or legal professional first to avoid these tax snares.
There’s no question that life insurance and estate taxes can be extremely complex and difficult to understand. That’s why you should work closely with a financial professional to ensure you make the right choices when it comes to setting up your life insurance policy. Otherwise, your heirs may not receive the death benefit they rightly deserve.