Find out how, and estate tax pitfalls to avoid 

By Edward E. Graves, ChFC^®, CLU^®, holder of the Charles J. Zimmerman Chair in Life Insurance Education and Associate Professor of Insurance at The American College. 

In essence, life insurance ensures against forced change. Even if a household income is cut following a death, benefits can cover the mortgage to keep a family in the only home they know. It can help a living parent continue to save for her kids’ educations. It can help a father who loses his stay-at-home spouse to pay for day care and continue working at a job he loves.

In all these instances, the life insurance policy fills a financial void. But don’t discredit life insurance as a potential vehicle for clients who have enough assets to cover these expenses, regardless of an income loss. Tax advantages make life insurance a desirable planning contract for the wealthy. It can be used to provide funds to children or grandchildren, as well to non-family members.

Charitable Giving
Use of life insurance contracts can replace amounts given to charity by parents during their lifetime. In these situations the children are named beneficiaries of the life insurance covering amounts to offset the earlier charitable contributions. Policies can also be given to charities or purchased by charities with specific contributions to pay the premiums.

Family Business
Life insurance pays cash to the beneficiary after the death of the insured, making it very effective in equalizing the treatment of children who will not receive ownership interest in an ongoing family business. It can also be used to pay tax on a parent’s estate (due within nine months of death), preventing the liquidation of the family business.

Fund Transfer
Death benefits are not subject to federal income tax (IRC section 101), making life insurance an effective means of transferring funds to children, even when family businesses or estate taxes are not a concern.

Furthermore, there is no income tax applicable to the increases in cash value of a life insurance policy with annual or monthly premiums as long as it is kept in force.

Lifetime distributions from a life insurance policy may be subject to income tax if the policy was paid by a single premium or with periodic premiums, that exceed the seven-pay test.(IRC sections 7702 and 7702A(a)(1)).

These single premium policies or policies fully paid up in seven years or less are called modified endowment contracts. They provide the same tax advantage as continuous premium life insurance contracts as long as no money is taken out of the contract during the lifetime of the insured.

Preparing LI Proceeds for Estate Tax
Because any life insurance policy owned by an insured will be included in his estate for federal estate tax purposes, estate planners almost universally suggest that a life insurance policy should not be owned by the insured. When the policy is owned by someone else or a trust, and when the death benefits are not payable to the estate of the insured, the death benefit proceeds can be kept out of the insured’s estate if it is subject to the federal estate tax.(IRC section 2042).

But with this rule-of-thumb come caveats: For one, the death benefits can still be payable to the estate of the insured if the primary beneficiary predeceases the insured and there is no contingent beneficiary. To prevent unintentionally including the life insurance policy in the estate, it is important to name at least one contingent beneficiary. Furthermore, it is strongly suggested that the last contingent beneficiary be a charity so that all beneficiaries cannot possibly predecease the insured.

Another concern is transferring the ownership of an existing life insurance policy from the insured to some other party. Section 2042 of the tax code provides that the insurance policy will be treated as if it is still owned by the insured for three years after the transfer. That’s why estate planners generally suggest the purchase of a new policy by the intended owner – a person, business or trust – so that the life insurance will never be included in the estate of the insured.

Before a transfer occurs, how do you decide whom or what is an appropriate party to acquire and own the policy? First, it is important to be sure that there is an insurable interest between the intended owner and the person to be insured. This is especially true if the policy will be owned by a trust in the state of Maryland. When applying Maryland law, a recent case in a federal District Court (Chawla vs. Transamerica Occidental Life) held that a trust owning a life insurance policy did not have an insurable interest in the life of the insured.

The laws of all states require that there be an insurable interest between the insured and the policy owner at the time the life insurance contract is created. Grantor trusts owning life insurance policies insuring the life of the grantor are generally deemed to have an insurable interest in the life of the grantor.

The above concerns are not as important if the insured does not have a large enough estate to be subject to the federal estate tax. And while these concerns will supposedly go away for large estates after the year 2010 if Congress repeals the federal estate tax completely, they are a factor for multi-million dollar estates up through 2009. Currently it seems likely that the estate tax will be extended beyond 2009 in some as yet to be determined form.