Life Insurance Ownership and Beneficiary Designations
What is it?
Two important considerations when purchasing a life
insurance policy are selecting the owner and the
beneficiary(ies). Who you choose can affect your income,
gift, and estate taxes and can create solutions or cause
problems for your family. Proper planning can help your
family avoid unfortunate tax consequences, while poor
planning can leave your family facing tax liabilities with
no insurance proceeds to pay them. Too often, family members
discover that life insurance proceeds were paid to someone
else or are available for collection by creditors.
Understanding ownership and beneficiary issues will help
ensure that your life insurance proceeds will protect your
family as you intend.
Importance of coordinating ownership and beneficiary
Life insurance is often a key component of a financial plan.
If you don't coordinate your policy's ownership and
beneficiary designations, your financial plan may not
fulfill its intended purpose. For example, if you purchase
life insurance to pay estate taxes, you will likely want to
ensure that your policy's ownership is structured to keep
the proceeds out of your taxable estate. For another
example, if you want a trust to receive your life insurance
proceeds but your policy names your spouse as beneficiary,
your trust will go unfunded.
Life insurance is property with certain implied rights and
privileges. The policyowner controls these rights, which are
called incidents of ownership. A policyowner can keep or
dispose of any or all of these rights. Ownership rights
include the following:
The right to transfer, or to revoke the transfer of,
The right to change certain policy provisions
The right to surrender or cancel the policy
The right to pledge the policy for a loan or to borrow
against its cash value
The right to name and to change a beneficiary
The right to determine how beneficiaries will receive the
Owning your own policy
Owning a policy on your own life is the most common form of
ownership. With an individual policy, you pay the premiums,
you are named as the insured on the policy, and you control
all the ownership rights.
Owning a policy on another
Many people never think about life insurance in any way
other than owning a policy on themselves. However, any
person or legal entity can own life insurance on another
person as long as the owner has an insurable interest in
that person. An insurable interest exists when one person
has a financial interest in another person's life. Spouses
are assumed to have an insurable interest in each other. The
same holds true for parents and children. Certain business
relationships may also create an insurable interest, such as
when a business insures its key employees or when a bank
guarantees repayment of a loan with a life insurance policy
on the borrower.
Having a trust own a policy
Many people choose to have trusts own their life insurance
policies. This arrangement can provide two important
benefits: It allows the trust, rather than the
beneficiaries, to control how the proceeds will be used,
and, if it is set up as an irrevocable trust, it removes the
death proceeds from the estate.
Who should own your life insurance policy? The answer
depends on why you're purchasing the policy.
Owning your own policy--If the purpose of the policy is to
replace your income for your family when you die, you should
own your own policy, especially if you have a young family.
Having a spouse own your policy--Since nearly half of all
marriages today end in divorce, adverse tax consequences
could result if one spouse owns life insurance on the other.
In some cases, divorce courts have required one spouse to
transfer a life insurance policy to the other as part of the
property settlement while continuing to pay the premiums.
Generally, the IRS does not consider this a transfer for
value. If it did, this could result in adverse income tax
consequences to the beneficiary of any death benefits.
In addition, if you're divorcing, the divorce court may
require you and your spouse to maintain life insurance
policies for the benefit of your children. If you're alive
when the children are grown, you may want to change the
beneficiary(ies). If you've become uninsurable or a high
insurance risk, you may want to keep the existing policy. If
an ex-spouse owns the policy, you would lose this option.
Faced with today's high education costs, most families apply
for financial aid. When applying for financial aid, parents
and child are expected to pay a certain percentage of income
and assets for education expenses. Federal financial aid
formulas exclude the cash value of life insurance from the
Private colleges may include the cash value of life
insurance in their analyses.
Estate liquidity may be a concern, especially if you expect
the combined estates of you and your spouse to exceed your
combined applicable exclusion amounts. Amounts over the
applicable exclusion amount will be subject to estate taxes,
and if taxes are owed, they will have to be paid within nine
months of death. The applicable exclusion amount is $3.5
million for the estates of persons who die in 2009, ($7
million for combined estates) up from $2 million in 2008.
Owning a policy on your spouse--No estate liquidity benefits
currently exist from owning a policy on your spouse.
Ownership by your children--A seemingly easy approach is to
have your children own the policy. You can pay the premiums
and have an unwritten agreement with them that they'll use
the funds to pay the estate's obligations, although you
can't require that or you'll retain an incident of
ownership, thereby bringing the proceeds back into your
estate. However, with human relationships being what they
are and with your children possibly facing competing needs
for the proceeds, children are rarely named as owners of
their parents' insurance. Use of the insurance proceeds by
your children, however, may subject them to gift tax for
amounts paid to your estate.
Ownership by an irrevocable life insurance trust (ILIT)--One
commonly used trust arrangement is called an irrevocable
life insurance trust (ILIT). If a life insurance policy is
transferred to a properly structured and funded ILIT, it
guarantees that the death proceeds will not be included in
your taxable estate. In establishing an ILIT, you set up or
transfer the incidents of ownership to the trust, thereby
allowing you to create a source of cash to provide estate
liquidity without adding to your estate. Joint life
(second-to-die) policies are frequently used in ILITs. These
policies cover two lives and pay off at the death of the
survivor. They are usually bought to provide cash to pay
estate taxes. If the insured individuals owned the policies
rather than the trust, the proceeds would be included in
their taxable estates.
If you transfer a policy to a trust, the three-year rule
applies. This requires that if you die within three years of
transferring the policy to the trust, the IRS will include
the value of the transferred policy in your taxable estate.
insurance beneficiary designation
Just as a life insurance policy always has an owner, it also
always has a beneficiary. The beneficiary is the person or
entity named to receive the death proceeds when you die. You
can name a beneficiary, or your policy may determine a
beneficiary by default. If you don't name a beneficiary,
your estate often becomes the beneficiary. When a policy is
issued on your life, your beneficiary must have an insurable
interest in you to avoid adverse income tax consequences.
The primary beneficiary is the person or entity you name to
have first rights to receive your life insurance proceeds
when they become payable at your death.
The contingent beneficiary is the person or entity you name
to receive your life insurance proceeds if the primary
beneficiary dies before you.
As a policyholder, you generally reserve the right to change
a beneficiary at any time. A revocable beneficiary is one
that you can cancel anytime before you die. This means a
revocable beneficiary's rights do not vest during your
An irrevocable beneficiary is one you cannot cancel unless
he or she consents. In other words, once you name an
irrevocable beneficiary, you can't change it. An irrevocable
beneficiary's rights to your death proceeds vest during your
lifetime. This means that you may not exercise your
ownership rights without written permission of the
irrevocable beneficiary. You cannot borrow against the
policy, pledge it as collateral, receive dividends, or
surrender the policy.
You may name multiple beneficiaries if you choose. There are
no legal restrictions--and few company restrictions--on the
number of beneficiaries you can designate. You can later
change your beneficiaries provided you have retained that
If you name multiple beneficiaries, you must also specify
how much each beneficiary will receive (you may not want to
give each beneficiary an equal share). Because of the
numerous interest and dividend adjustments the insurance
company must make, the death benefit check often does not
equal the policy's face value. Thus, it's wise to distribute
percentage shares to your beneficiaries or to designate one
beneficiary to receive any balance.
gift, and estate tax considerations
The death proceeds of a life insurance policy are generally
not subject to income tax. However, interest paid to your
beneficiary from the date of your death to the date of
payment of the death proceeds is income taxable to your
beneficiary, although it's not included in your gross
Owning your own policy with spouse and children as
Owning your own policy is the most common form of ownership
and the most predictable as far as your beneficiaries are
concerned. In most cases, when you own your own policy and
the beneficiaries are your spouse or children, the death
proceeds that they receive will not be subject to income
However, the death proceeds are included in your gross
estate. If the beneficiary is your spouse, you enjoy a
special tax break called the unlimited marital deduction.
This allows you to transfer as much as you want to a
surviving spouse free from federal estate taxes. This
transfer generally only delays the estate tax liability,
however. When your surviving spouse dies, the estate he or
she passes to your children or other beneficiaries may be
subject to estate tax because the proceeds will not be
eligible for the unlimited marital deduction.
If you are divorced and own a policy with your children as
beneficiaries, the proceeds may be subject to estate tax
because they will not be eligible for the unlimited marital
Owning a policy on another
Some people still believe that it's beneficial for spouses
to own life insurance on each other. However, since tax law
changes created the unlimited marital deduction, there are
no estate tax benefits and few income tax benefits from this
If Barry owns life insurance and dies leaving his wife,
Blossom, as the sole beneficiary, the life insurance
proceeds are included in his estate. However, due to the
unlimited marital deduction, any assets Barry leaves Blossom
are exempt from federal estate taxes.
If Blossom owned the policy on Barry's life, the death
proceeds would generally not be subject to income tax and
would be included in Barry's estate and thus not subject to
estate tax. In other words, the tax effect would be the same
as if Barry had owned the policy. However, if Blossom owned
the policy and cashed it in during Barry's lifetime, she
might see a small income tax saving if she and Barry file
their income tax returns separately and she is in a lower
income tax bracket.
A serious potential gift tax problem can arise if there is a
three-way split in ownership, insured, and beneficiary. If
one spouse owns a policy on the other with the children
named as beneficiaries, the IRS treats the spouse owning the
policy as having given a gift to the children. Any gifts
over the annual gift tax exclusion ($13,000 per donee in
2009, up from $12,000 in 2008) may be subject to federal
A problem can also arise if a divorce court requires one
spouse to transfer a life insurance policy to the other as
part of a property settlement, yet requires the transferring
spouse to continue to pay the premiums. It's possible that
the IRS could consider this a transfer for value, resulting
in adverse income tax consequences for the beneficiaries of
any death benefits.
If you transfer ownership to anyone who doesn't have an
insurable interest in your life, the transfer will generally
lead to income taxation of a portion of the death proceeds.
Giving life insurance as a gift
Life insurance is subject to estate and gift tax rules not
applicable to other types of property. If you transfer your
life insurance policy as a gift (regardless of its value)
during the three years before your death, the death proceeds
will be included in your estate. However, you may give any
other property free of gift and estate tax as long as it
doesn't exceed the annual gift tax exclusion amount per
person in a given year.
If you give a $5,000 life insurance policy to your son today
and you die in two years, the death proceeds are included in
your estate. However, if you give your son any other
property as long as it doesn't exceed the annual gift tax
exclusion, it won't be included in your estate or subject to
Effect of beneficiary on your estate
It was stated that if you retain any incidents of ownership
in a policy at your death, the proceeds will be included in
your taxable estate. However, even if ownership is held
outside your estate, you must also be sure that you don't
require your beneficiary to benefit your estate in any way
if you want to keep the proceeds out of your estate.
Whenever proceeds are paid to or for the benefit of an
estate, they are included in the estate and subject to
estate tax. For example, if you name your estate's executor
as the beneficiary, and he or she is legally obligated to
use the proceeds to pay expenses for the benefit of the
estate, then the proceeds will be included in your estate
and subject to estate tax.
You can avoid this problem by establishing an ILIT to own
the policy. As long as the terms allow it, the ILIT can lend
money to the estate for the executor to pay the expenses,
thereby allowing the proceeds to remain outside your estate.
Minor as beneficiary
One of the greatest mistakes you can make is to name minor
children as beneficiaries, yet the most common combination
of beneficiaries is a spouse followed by minor children. The
courts generally will not allow minor children to directly
receive the proceeds of a life insurance policy. If you have
not established a trust or named a guardian for your
children in your will, the courts may require a trust to be
set up or a guardian to be appointed to manage the proceeds.
Trustees will make all spending decisions and may not
approve the use of funds as you would have preferred. There
is a cost associated with establishing a trust that will
vary depending on the trust's complexity and other factors.
If you have a large estate, you should consider establishing
a trust to receive the proceeds for minor children. The
trust can hold the proceeds until the children are 25 to 35
years old. This may encourage your children to begin making
their own way in life before inheriting substantial wealth.
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