Life insurance policies owned by you on the life of another

If you own life insurance on the life of another (the insured), and you predecease the insured, the value of the policy on the date of your death is includable in your gross estate for estate tax purposes. For example, if you buy a policy on your spouse's life and you predecease your spouse, the value of that policy is includable in your gross estate and may be subject to estate taxes. The value of a policy for purposes of inclusion in the estate of a decedent who is not the insured is generally not its face value (i.e., the death benefit) and should be determined by the insurance company. If you die owning insurance policies on the life of another individual, your executor should contact the insurer and request Form 712, which is the form the insurers use to report the value of life insurance policies for tax purposes.

Caution: Beware of the three-year rule, which causes the value of a policy originally owned by you but transferred to another owner within three years of your death to be included in your gross estate. So, if you're going to transfer ownership of a life insurance policy, do it now while you are in good health.

Insurance policies in which you hold incidents of ownership at death are includable in your gross estate for estate tax purposes. Incidents of ownership is a legal term, which refers to the right of the insured to control the economic benefits of the policy. This definition encompasses more than outright ownership in that policy and includes the power: (1) to change the beneficiaries of the policy; (2) to pledge the policy for a loan; (3) to surrender or cancel the policy; (4) to assign the policy; or (5) to borrow against the surrender value of the policy. A reversionary interest in a life insurance policy is also treated as an incident of ownership in that policy and will result in inclusion of the value of the policy in the insured's estate if the value of the reversionary interest immediately before the insured's death exceeds 5 percent of the value of the policy. A reversionary interest in a life insurance policy includes the possibility that the policy or its proceeds may return to the insured or his estate or may be subject to power of disposition (e.g., a power of appointment) by the insured.

Caution: The three-year rule applies here too, so even if you transfer away all incidents of ownership, the value of the policy will still be includable in your gross estate if you die within three years after the transfer takes place.

If you purchase a policy on your own life, pay premiums on the policy, and then transfer the policy to another owner within 3 years of your death, a portion of the proceeds may be includable in your gross estate for estate tax purposes. The includable portion is calculated by dividing the premiums you paid by the total premiums paid and multiplying the proceeds by the resulting fraction.

Example(s): You buy a $1 million policy on your own life and over 5 years, you pay $9,000 in premiums. After the fifth year, you transfer the policy to your daughter who takes over the payment of the premiums until your death 2 years later. Your daughter pays $18,000 in premiums. The amount of proceeds includable in your gross estate is roughly $333,333 ($1,000,000 x [$9,000 ÷ ($18,000 + $9,000)]).

Proceeds from policies owned by you or another and made payable directly to your estate are includable in your gross estate. Proceeds payable indirectly to your estate are also includable. Proceeds are considered paid indirectly to your estate if they are used to pay estate taxes, debts, or other expenses of your estate.

Tip: The IRS generally follows state law if state law provides that life insurance proceeds received by an estate are treated as if received by the ultimate beneficiary (and therefore are not part of the decedent's gross estate). The proceeds in this case will not be included in the decedent's gross estate only if the decedent did not own the policy upon his or her death or within three years of his or her death or if the proceeds are directed by the decedent's will to a nontaxable beneficiary such as a charity or the decedent's spouse.

Tip: If you live in a community property state, only one-half of the proceeds of policies on your life which you own but which were paid for with community funds are includable in your gross estate.

Proceeds made payable to your executor are generally deemed payable to your estate and are subject to estate taxes.

Tip: Again, the IRS generally follows state law if the law dictates that life insurance proceeds received by an executor are treated as if received by the ultimate beneficiaries of the decedent's estate.

Tip: Again, if you live in a community property state, only one-half of the proceeds of policies on your life which you own but which were paid for with community funds are includable in your gross estate.

If your named beneficiary is barred from collecting the proceeds (e.g., because he or she has intentionally killed you) and you have not named a secondary or final beneficiary, the proceeds are payable to your estate.

Tip: To avoid this result, you will want to name a secondary and/or a final beneficiary.

Tip: Once again, if you live in a community property state, only one-half of the proceeds of policies on your life which you own but which were paid for with community funds are includable in your gross estate.

The unlimited marital deduction allows your spouse to receive life insurance proceeds free of estate taxes even if you own the policy on your death. However, the proceeds will be subject to estate taxes in your spouse's estate at your spouse's death unless, of course, your spouse spends them all first or remarries and uses the unlimited marital deduction. If the proceeds of life insurance policies on your life are payable to your spouse, you will not necessarily avoid estate taxes, you may only postpone them.

Tip: If you want the proceeds to eventually reach your children after benefitting your spouse during his or her remaining life if he or she survives you, you need to arrange to have the proceeds pass to a special type of trust known as a qualified terminable interest property (or QTIP) trust or, if your spouse is not a U.S. citizen, to a qualified domestic trust (or QDOT).

Caution: If you and your spouse die simultaneously, the Uniform Simultaneous Death Act (USDA) provides that the beneficiary (your spouse) will be presumed to have died first. This means that the unlimited marital deduction will not be applicable to shelter the proceeds from estate tax.

Any person who receives proceeds is liable for any estate taxes that may be owed on such proceeds. The IRS can trace the proceeds as far as they go and collect from a beneficiary's other assets if the proceeds have already been spent.

Generally, the executor pays the estate taxes from the estate's probate assets. However, the executor has the right to recover any taxes resulting from inclusion of the proceeds in the decedent's estate from the beneficiaries who receive those proceeds. The decedent may direct the executor in his or her will to pay taxes from a specific share or group of assets or may waive the estate's right to recover taxes from a beneficiary. The taxes chargeable to the share of a particular beneficiary are proportionate to the beneficiary's share of the proceeds. In other words, if a beneficiary received one-half of the proceeds, he or she is only liable for one-half of the taxes associated with inclusion of the proceeds in the decedent's estate. A surviving spouse who receives proceeds that qualify for the unlimited marital deduction would be under no obligation to contribute toward the payment of taxes resulting from inclusion of the proceeds in the decedent's estate. This is because there are no taxes associated with inclusion of the proceeds in the decedent's estate if the proceeds pass tax free to the surviving spouse.

Tip: You can direct how the tax burden will be apportioned in your will so that you can place it on the shoulders of those best able to carry it. The IRS will generally abide by these directions.

Property you give away during your life may be taxable gifts subject to the federal gift and estate tax. You or your estate could pay as much as a 40 percent tax (in 2022 and 2023) on taxable gifts. To estimate and reduce this tax, you need to understand what taxable gifts are and how the federal gift and estate tax system works.

Caution: Some states impose their own gift tax.

Tip: Generally, gifts you receive are not subject to tax (except for some states that tax inheritances). However, gifts or bequests (in the form of money or property) received from a foreign person or estate that are valued (in the aggregate per year) at more than $100,000 are reportable, as are gifts in excess of $18,567 (in 2023, $17,339 in 2022) from a foreign trust, corporation, or partnership. Recipients of such gifts must file Form 3520 with the IRS on or before the due date of the recipient's income tax return (including extensions). Failure to do so may subject the recipient to a penalty of 5 percent of the value of the gift for each month the gift goes unreported (not to exceed a total of 25 percent of the gift). Excluded from this rule are gifts made directly to a school for tuition or to a health-care provider for medical expenses.

Taxable gifts are treated in a special way.

• First, taxable gifts must be reported, and the gift tax paid, annually (you must file a gift tax return and pay the gift tax due, if any, by April 15 of the year following the year in which you make a taxable gift).
• Second, when you die, all taxable gifts made during your lifetime are added to your taxable estate (property you own at death) in order to calculate any estate tax that may be owed. This pushes your net taxable estate (what the estate tax is computed on) into a higher tax bracket. Any gift tax you paid is deducted from any estate tax owed.

Caution: Lifetime gifts to beneficiaries who are more than one generation below you may also be subject to the federal generation-skipping transfer tax.

Gifts can be made either directly (i.e., from you to another person) or indirectly (i.e., from you to another person for the benefit of a third party). To determine whether a taxable gift has occurred, the answers to the following questions must be yes.

• Was the gift voluntary? — Did you freely give property to another individual or organization? Transfers of property that you are legally obligated to make are not gifts. For example, payments you make to support your minor children, or payments you make as a result of a court judgment are not gifts.
• Was the gift complete? — You must relinquish control over the property. A taxable gift has not occurred if you retain the power to change or revoke the gift. A gift is complete only upon delivery. Completion of delivery varies according to the nature of the gift. For example, a gift of cash is complete when given, a gift of a personal check is complete when paid, a gift of stock is complete on the date the endorsed certificate is delivered, and a gift of real estate is complete when the deed is recorded.
• Was the gift made in exchange for nothing or property of lesser value? — Ordinarily, you may think of a gift as something you give expecting nothing in return. But gifts also include uneven exchanges of property. The value of the gift is the difference between the exchange.

Example(s): Alec gives his old Harley-Davidson motorcycle, valued at $3,000, to his younger brother, William, in exchange for $500. Alec has made a $2,500 gift.

Caution: An uneven exchange is not a gift, however, if it is a legitimate business sale or just a bad bargain.

Some types of gifts are exempt from the gift tax. These include:

• Tuition paid to an educational institution — You can pay for tuition at a private school, college, or other qualified educational institution without incurring gift tax as long as payment is made directly to the institution. This exclusion is limited to tuition costs and does not include payments for books, supplies, or dormitory fees. You don't need to file a gift tax return with respect to this type of gift.
• Medical expenses paid to the medical care provider — You can pay for someone else's medical bills without incurring gift tax as long as payment is made directly to the medical care provider. This exclusion is not allowed for amounts reimbursed by insurance. You don't need to file a gift tax return with respect to this type of gift.
• Annual gift tax exclusion — You are allowed to exclude $17,000 (in 2023, $16,000 in 2022) of gifts given to each and every person or organization each year from the amount subject to tax, provided that the gift is of a present interest in property.

Tip: For gifts made after August 5, 1997, you don't need to file an annual gift tax return with respect to gifts that are within the annual gift tax exclusion unless you have split gifts with your spouse or have made a partial interest gift to charity (a partial interest gift is split between charitable and noncharitable beneficiaries).

Tip: The annual gift tax exclusion may also reduce the federal generation-skipping transfer tax.

• Gifts to spouses — Qualified gifts to spouses are fully deductible under the unlimited marital deduction if your spouse is a U.S. citizen. Gifts you give to your non-U.S. citizen spouse qualify for a $175,000 (in 2023, $164,000 in 2022) annual gift tax exclusion, but no unlimited marital deduction is allowed.

Tip: For gifts made after August 5, 1997, interspousal gifts that fully qualify for the unlimited marital deduction need not be reported on a gift tax return for the year unless other taxable gifts or partial interest gifts to charity have also been made (partial interest gifts are split between charitable and noncharitable beneficiaries).

• Gifts to charity — Qualified gifts to charity are fully deductible under the charitable deduction.

Tip: Gifts to charity made after August 5, 1997, need not be reported if all gifts for that year are fully deductible under the charitable deduction.

• Applicable exclusion amount — The applicable exclusion amount effectively exempts the first $12,920,000 (in 2023, $12,060,000 in 2022) plus any deceased spousal unused exclusion amount of taxable gift you make. You must use your applicable exclusion amount before you become liable for any gift tax. Any applicable exclusion amount you use for lifetime gifts effectively reduces the amount that will be available at your death.

An outright gift of a life insurance policy to another individual is a taxable event, subject to gift taxes, as long as you do not retain any incidents of ownership. The gift is valued on the date of the transfer. The value of the gift is generally the interpolated terminal reserve or the cash value of the policy. The insurance company is the only reliable source of a policy's value and can provide on request Form 712, which states the value of the policy as of a particular date and can be used to verify the value for estate or gift tax purposes. The $17,000 (in 2023) annual gift tax exclusion is applicable to gifts of life insurance. Gifts from one spouse to another qualify for the unlimited marital deduction. A gift to a qualified charity qualifies for the charitable deduction.

Transfers of life insurance policies to an irrevocable trust and subsequent payments of premiums are both taxable gifts. The date of the taxable event is the date of transfer or payment. The value of the gift is either the replacement value of the policy or the sum of a proportionate part of the most recent premium paid prior to the gift and covering a period that extends beyond the gift, plus the policy's interpolated terminal reserve value (approximately the cash surrender value). Gifts made to an irrevocable trust qualify for the unlimited marital deduction if it is a QTIP trust. A charitable deduction may be allowed for the value of the charity's interest in an irrevocable split-interest trust. The annual gift tax exclusion is generally not applicable to gifts to a trust unless the trust includes a Crummey withdrawal provision. This is because in many cases, trusts create future interest in their beneficiaries and the annual gift tax exclusion can be applied only to gifts of present interest.

If the trust is revocable, the date of the taxable event is the date on which distributions are made to the beneficiaries because prior to this date, the gift is revocable and therefore not complete. The annual gift tax exclusion, the unlimited marital deduction, and the charitable deduction are generally not applicable to gifts to a revocable trust since the gift is incomplete for gift tax purposes and therefore not taxable. When the gift becomes complete (i.e., when a payment is made from the trust to a beneficiary), then various exclusions and deductions from the gift tax may be applicable.

If you own a policy on the life of someone other than yourself (the second party), the proceeds of which are payable to a beneficiary who is not yourself or the insured (the third party), you will have made a gift to the third party: (1) upon the death of the second party, or (2) upon making the beneficiary designation, if it is irrevocable. The value of the gift is determined as of the date that the gift is complete.

If you pay a premium on a policy owned by another, you have made a taxable gift to the owner. The amount of the gift is the amount of the premium paid.

If the owner of the policy is an ILIT, transfers you make to the ILIT to cover premiums on the policy are taxable gifts to the beneficiaries of the trust. If the ILIT is properly drafted, the annual exclusion will be applicable to transfers to an ILIT. If a beneficiary of an ILIT makes premium payments, he or she has made a taxable gift to the other beneficiaries of the ILIT. Again, if the ILIT is properly drafted, the annual exclusion will be applicable to such transfers.

If a primary beneficiary is entitled to receive proceeds under a settlement option but allows his or her power to withdraw the proceeds to lapse such that the secondary beneficiary becomes entitled to the proceeds, then the primary beneficiary has made a taxable gift to the secondary beneficiary.

Example(s): Rob dies. Rob's life insurance policy names Lisa as primary beneficiary under a settlement option that gives Lisa the right to receive all the interest each year and to withdraw a stated amount of principal once a year. The settlement option also names secondary beneficiaries who will receive the remaining principal upon Lisa's death. The first year, Lisa receives the interest but does not exercise her right to withdraw principal. Her power to withdraw this stated amount of principal lapses and the lapse is a taxable gift to the secondary beneficiaries.

The donor (person making the gift) is responsible for payment of gift taxes on that gift. However, the donee (person receiving the gift) is liable for any taxes not paid by the donor. With a gift of life insurance, the donee's liability extends beyond the cash value of the policy (i.e., the IRS can go after any of the donee's assets). Where the donee pays taxes on a gift by the donor, it is called a net gift — the calculation of gift tax due on a net gift is very complicated but the net effect is to reduce the overall gift taxes due since the donee's actual gift is reduced by the gift taxes he or she paid on the gift (i.e., the donee is treated as having "bought" the gift for the price of the taxes) — no taxes are assessed against the portion of the gift paid for by the donee since this portion wasn't really a gift.

The GSTT is an excise tax levied when you transfer property either during life or at death to a skip person. A skip person is someone two or more generations below you (e.g., a grandchild or great-nephew). GSTT can be imposed on gifts to persons outside your family as well. Generations for non-family members are determined based on the number of years younger than the transferor the transferee is. The GSTT is imposed on transfers to skip persons at the highest federal gift and estate tax rate then in effect (40 percent for transfers made in 2013 and later years), in addition to any gift taxes or estate taxes assessed on the transfer.

Life insurance is generally treated the same as any other type of property for GSTT purposes. Thus, an outright gift of a life insurance policy to a skip person is a taxable event, subject to gift tax and GSTT, as long as you do not retain any incidents of ownership in the policy. The gift is valued on the date of the transfer and the value of the gift should be obtained from the insurer and can vary depending on the type of policy. In most cases, the annual gift tax exclusion can be applied to gifts to a skip person.

When all trust beneficiaries are skip persons, transfers to the trust will be subject to the GSTT. The trust must meet certain requirements to qualify for the annual GSTT exclusion. Every individual has a limited lifetime exemption that can be applied to generation-skipping transfers. This exemption is $12,920,000 in 2023. If some or all of an individual's lifetime exemption is applied to a transfer to a trust (whether or not that trust currently has beneficiaries who are skip persons), a portion or all of the subsequent distributions from the trust to skip persons will not be subject to the GSTT. The exemption is automatically applied to direct skips (transfers by an individual directly to a skip person or to a trust who is a skip person).

If you die without a will, it is called dying "intestate."In these situations, the probate court will order your debts paid and your assets distributed. Unfortunately, your assets will be distributed according to state law. Since the state doesn't know your preferences, the probate court may not distribute your assets according to your wishes.

Because intestacy is settled in the probate court, your heirs may have to endure a long, costly, and public probate process that could take six months to a year or more. They will have to wait until the probate process is over to receive the bulk of their inheritance.

And depending on the state, probate fees could consume more than 5% of your gross estate.

A will is your written set of instructions on how you want your estate to be distributed.

While using a will guarantees probate, it is a more desirable alternative than intestacy.

In a will, you can name a "personal representative" of your estate. This person or institution (e.g., a bank or trust company) will act as the executor and will be appointed to carry out your wishes according to your testament. You can also nominate a guardian for your minor children and their estates. Without such a nomination, the court can appoint a guardian based on other information, often depending upon who volunteers.

A will can also set forth the trust terms, including who you have named as trustee to manage the assets for the benefit of your beneficiaries. This is often referred to as a "testamentary" trust because it is created as part of the last will and testament and takes effect at the probate of the will.

A trust is a legal arrangement under which one person, the trustee, manages property given by another party, the grantor, for the benefit of a third person, the beneficiary. Trusts can be very effective estate planning tools.

Trusts can be established during your life or at death. They give you maximum control over the distribution of your estate. Trust property will be distributed according to the terms of the trust, without the time, cost, and publicity of probate.

Trusts have other advantages, too. You can benefit from the services of professional asset managers, and you can protect your assets in the event of your incapacity. With certain types of trusts, you may also be able to reduce estate taxes.

If you use a revocable living trust in your estate plan, you may be the grantor, trustee, and beneficiary of your own trust. This allows you to maintain complete control of your estate.

While trusts offer numerous advantages, they incur up-front costs and ongoing administrative fees. These costs reduce the value of future probate savings. The use of trusts involves a complex web of tax rules and regulations. You might consider enlisting the counsel of an experienced estate planning professional before implementing such sophisticated strategies.

Another way to distribute your estate is through jointly held property — specifically, joint tenancy with rights of survivorship.

When you hold property this way, it will pass to the surviving co-owners automatically, "by operation of law." Because title passes automatically, there is no need for probate.

Joint tenancy can involve any number of people, and it does not have to be between spouses. "Qualified joint tenancy," however, can only exist between spouses. In common law states, this arrangement is generally known as "tenancy by the entirety." Qualified joint tenancy has certain income and estate tax advantages over joint tenancy involving nonspouses.

How you hold title to your property may have substantial implications for your income and estate taxes. You should consider how you hold title to all of your property, including your real estate, investments, and savings accounts. If you'd like to know more about how the way you hold title may affect your financial situation, consult a professional.

The fifth and final way to pass your property interests is through beneficiary designations.If you have an employer-sponsored retirement plan, an IRA, life insurance, or an annuity contract, you probably designated a beneficiary for the proceeds of the contract. The rights to the proceeds will pass automatically to the person you selected. Just like joint tenancy, this happens automatically, without the need for probate.

It is important to review your employer-sponsored retirement plan, IRA, life insurance, and other contracts to make sure your beneficiary designations reflect your current wishes. Don't wait until it's too late.

A variety of considerations will determine the distribution methods that are appropriate for you. For example, you must consider your distribution goals. By examining your situation and understanding how your assets will pass after your death, you may be able to identify the methods that will help you achieve your goals most effectively.

Likewise, the larger your estate, the more you may want to use a trust to help guide your estate distribution. In addition, you will have to review any special situations you may have — such as a divorce.