Ten Serious Mistakes to Avoid in Estate Planning

9. Owning Your Own Life Insurance.

Life insurance is often sold to people with the assurance by well-meaning brokers that, upon the death of the insured, the beneficiary will receive the money tax-free. That statement, however, is only partially correct. The proceeds from a life insurance policy that you purchase will be paid to your beneficiary free of income taxes, but not from estate taxes if you own the policy (or have what are known as “incidents of ownership” over the policy) within three years of your death.

So suppose you are a widow with two children, and your estate (including your home, your retirement accounts and other assets), aside from life insurance, is worth $3 million. If you have a $1 million life insurance policy and you die when the exemption from Federal Estate Tax is $3.5 million (as it was in 2009), you will have a taxable estate because the life insurance will be included. If the marginal estate tax rate at that time is 45% (as it was in 2009), it will have cost your heirs $225,000. Of course, if the exemption from Federal estate tax is lower than $3.5 million at the time of your death or the marginal tax rates revert to 55%, the potential loss to your heirs is far greater.

There are two ways that you can avoid this problem. The first is, if the beneficiaries are adults, have no creditor or marital problems, and will not be tempted to dispose of the policy (or raid the cash value or not make premium payments), they can become the owners of the policy. If that is not the case, such as where the children are minors or you also need to provide for a surviving spouse without having the proceeds included in your spouse’s estate, then you can have the policy owned by an irrevocable inter vivos trust. You cannot be the trustee, and the trust should be drafted to permit you to pay the premiums into the trust without being treated as taxable gifts by you. There are also specific procedures that whoever acts as the trustee will have to follow. But the cost savings to your family can be substantial.

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