If you are like most life insurance policyholders, the primary reason that you applied for a policy is that—in the event of your death—your loved ones will be able to take care of themselves financially. But, as the old cliché goes, the only two certainties in life are death and taxes.
Taxes can diminish the overall value of your life insurance policy but, fortunately, there are many things you can do to minimize the amount of money that is taken from your policy following your death. We take a look at how taxation and life insurance work, and what you can do in order to maximize the benefits of your policy.
Do Not Make Your Life Insurance Policy Payable to Your Estate
When some people sign up for a life insurance policy—especially those who do not have any beneficiaries at the time they apply—they make their policy payable to their estate. Though many of these people make this decision with the plans to change their beneficiary later, they may end up forgetting to do so or experience an unexpected early death.
Since the American Taxpayer Relief Act was passed in 2013, some US citizens face an estate tax rate as high as 40%. Because your estate tax rate is likely much higher than the income tax rate being paid by your beneficiaries, choosing to make your life insurance policy payable to your estate is effectively the same as willingly giving more money to the government. Life insurance benefits can often be delivered tax-free, but only in the instances where they are not delivered through an individual’s estate.
Consider Transferring the Ownership of Your Policy
One thing that many life insurance policyholders forget is that their policy, by definition, is a financial asset. Just like stocks, bonds, gold, and money, it is something that you may have the option to transfer to another individual.
Transferring a policy to another person is different than having your policy paid out to them in full. The person that the policy is transferred to will still be expected to pay future monthly premiums. Instances where doing this might make sense include universal policies that are enjoying a large rate of monthly growth, families that are capable of sustaining themselves with the surviving spouse’s income, or instances where it seems likely that estate taxes will be reformed soon.
Consider Setting up an Irrevocable Life Insurance Trust (ILIT)
With an Irrevocable Life Insurance Trust (ILIT), you are no longer considered the legal owner of your life insurance policy. Though you will lose some of the rights you have as an owner in the status quo (such as changing your policy, the beneficiaries, etc.), because the policy has been transferred to a trust, it will no longer be subject to ordinary estate taxes.
These trust can often offer an advantage when compared to simply transferring ownership. Instances, where this makes sense, including times where it seems the transferee is unlikely to make future monthly payments, marriages that are in the middle of the divorce process, or instances where there is not an adult capable of managing the trust. If you are considering setting up an irrevocable life insurance trust, it is generally a good idea to speak with a life insurance agent or an estate lawyer (or both).
Though it can be difficult to think about a world where you and your family members are no longer together, planning for the future is very important. Depending on your financial situation, your estate may be subject to a significant amount of taxes. By finding ways to deliver or transfer your life insurance policy without the use of your estate, you can be comforted by the fact that your loved ones will be better provided for.
Thank you for reading our article, “How can Life Insurance Avoid Taxes?”
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