Most insureds maintain life insurance policies to replace lost earnings, maintain their family’s standard of living and perhaps provide liquidity for estate taxes in the event of their death. Typically, however, little or no consideration is given to policy ownership and beneficiary designations. If no designation is made at all, the proceeds will be paid to the insured’s estate. If the insured’s Will directs the proceeds to a surviving spouse, estate tax will not be imposed on the proceeds. But if the insured has no Will, or if there is no surviving spouse, there may be an immediate federal estate tax of up to 46% on the value of the proceeds.
Many insureds will have thought to designate their spouse as the primary beneficiary and their children as contingent beneficiaries of their policies. As stated above, proceeds paid to a surviving spouse will not be subject to estate tax. But if the spouse predeceases the insured or they die in a common accident, an unfortunate result occurs. Insurance proceeds which may be urgently needed by the insured’s children (particularly if they are minors) will be fully exposed to federal and state estate tax, meaning that the survivors may receive less than one-half of the proceeds; a disastrous result.
Insureds who are competently advised by their attorneys (or their insurance agents) upon purchasing insurance policies will likely be told to create an irrevocable life insurance trust (an “ILIT”) to serve as the owner and beneficiary of the policy. If the policy is purchased directly by the ILIT, and provided the insured retains no “incidents of ownership” with respect to the policy (which include the right to borrow from the policy or change the beneficiary), the proceeds of the policy will not be included in the insured’s estate for estate tax purposes and will therefore not be subject to estate tax, provided the trust is correctly administered.
The disadvantage of using an ILIT as a policy owner lies simply in the fact that an ILIT, by its terms, must be irrevocable. The insured will not be able to directly access the cash surrender value of the policy. Moreover, the trust terms cannot change even if family circumstances do. However, a considerable amount of flexibility can be built into an ILIT to anticipate changes.
For example, if the insured and his/her spouse later divorce, the insured would probably not want his spouse to be a beneficiary of the ILIT. Therefore, the trust terms may specify that the spouse shall only be a beneficiary after the death of the insured in the event that he or she was “married to and living with the insured as husband and wife at the time of the insured’s death.”
Or should the insured’s child have a disability or exhibit extreme bad judgment and irresponsibility regarding his or her choices in life, the Trustees may be given the power to retain trust income and principal and spend it for the child’s benefit, instead of paying out the principal and income directly to the child upon attaining a certain age.
The ownership status and beneficiary designations for all your life insurance policies (including group policies provided by McKinsey & Company) should be reviewed as soon as possible to ensure that they meet with your family’s needs and are structured in the most tax effective way possible.
If you have any questions regarding this matter, insurance planning or any other estate planning techniques, please contact a Maurice Kassimir & Associates, P.C. Trusts & Estates attorney or e-mail us: firstname.lastname@example.org.