George Bailey….you’re worth more dead than alive!

Remember poor George Bailey and his life insurance?  Ok that is not one of the high points of It’s a Wonderful Life….but that quote always reminds me of a common misunderstanding my clients have about counting their assets for estate tax planning purposes.  Life insurance is an often overlooked asset that greatly enhances the value of your estate.  Even if your life insurance is a term policy and has no cash value, we have to look at the potential death proceeds in determining the size of your estate and whether we need to worry about estate tax.

 That’s right…even though you’ve always heard that life insurance is not subject to tax; that is only partially correct.  Life insurance is generally not subject to income tax, but if you own a life insurance policy on your own life, the death proceeds are counted as part of your estate for estate tax purposes regardless of who gets those proceeds.  So if you add up all of your assets and then you lump the death proceeds from a big life insurance policy on top, you may find that you have an estate tax issue.  Although there is no estate tax at the moment, the tax will be automatically reinstated no later than January 1, 2011 and unless Congress gets it act together, the individual exemption will be $1,000,000 at that point (see my January 2010 Counselor’s Corner).  At that level life insurance will have a much bigger estate tax planning impact for numerous clients.

 If you have a large life insurance policy as part of your estate, what can you do?  If your adult children are the intended beneficiaries, you can transfer the policy to your children as a gift; if the policy has little or no cash value then this can be a very efficient way to reduce your future taxable estate.  On the other hand if you have minor children or if you wouldn’t trust your adult children to take care of your dog much less own and maintain a valuable insurance policy, then your planning may require the creation of a life insurance trust to own the policy.  In either case, you will have to consider a few important facts such as the current cash value and the continued premium payments for the policy.  If you plan to continue to make the premium payments to maintain the policy then those annual payments will be gifts, and your advisors will need to ensure that you properly use your gift tax exemptions to avoid any gift tax consequences.

 One more little trick the IRS has is the so-called 3 year rule.  If you read this article and decide that it sounds like a great idea and give that life insurance policy to your kids, please be sure to consult your attorney or other tax advisors first.  Second be sure to live at least three more years.  If you die within three years of gifting a life insurance policy then the gift is basically ignored and the death proceeds will be included in your estate.  As you might expect, enterprising attorneys have devised ways to avoid the three year rule, but these options can be pretty complicated and for that you’ll have to talk to you own counselor.

 Remember any day you don’t have to think about death or taxes…It truly is a Wonderful Life!

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