Life Insurance Owned by the Spouse - an Alternative to the Insurance Trust

A question has been raised about the estate tax consequences of having a spouse own and be the beneficiary of a life insurance policy. Is this a way to successfully avoid estate tax? How does this compare to an Insurnace Trust? As with all things, the results depend on the facts.

Example: Husband (H) and Wife (W) are married with 2 young children. H is purchasing a term life insurance policy for $1 million dollars. The policy is intended to (i) pay off the mortgage if H dies, (ii) provide for college education for the children, (iii) provide for income replacement, if necessary. H and W live in New Jersey, where there is only a $675,000 exemption from estate tax. Including the insurance death benefit, H and W collectively have assets in excess of $1.5 million dollars.

H owns the Insurance and names W as the beneficiary. The insurance death benefit is includible in H's taxable estate. However, since the death benefit all passes to W, and there is no tax due on assets passing to a spouse courtesy of the unlimited marital deduction, there will not be any tax due. However, the problem with this scenario is that if W dies shortly after H, without having spent any of the insurance proceeds, then the $1 million is includible in her estate, and will be subject to estate taxes as her exemption is insufficient to cover the proceeds and the other assets.

W owns the Insurance and W is the beneficiary of the policy. The estate tax result is the same as above. H dies and W receives the insurance proceeds. W's taxable estate is now increased. If W dies shortly thereafter, the insurance proceeds are subject to estate tax - not in H's estate, but in W's estate. Another wrinkle is that W owns the policy regardless of H and W's continuing relationship - if H divorces W, W owns a $1 million policy on H's life, and H can do little about it; not a comfortable thought.

H owns the Insurance and names his Estate as beneficiary; A credit shelter trust is created in the Will. Here, H avoids the divorce scenario and may generate some additional tax savings. If the Insurance policy funds his credit shelter trust, H is ensuring that his exemption from estate taxes is fully utilized at his death; thus reducing the amount of assets that W's estate needs to shelter at her death. Even if W died shortly after H, the insurance proceeds payable to the estate and allocated to the credit shelter trust would not be subject to tax in W's estate. However, there is a risk in making your insurance payable to your estate - your probate estate (i.e. assets controlled by your Will when you die) is subject to the claims of your creditors; life insurance proceeds payable to a named beneficiary generally are not. Thus, if you have debts when you die (mortgage, credit cards, margin loan, unpaid taxes....); or there are claims against your estate as a result of your death (wrongful death from a car accident), the insurance proceeds payable to the estate must be used to satisfy those claims before it can be set aside for your beneficiaries.

W owns Insurance and names children and beneficiaries. This is a scenario to be avoided at all costs. Where W owns the insurance, H is the insured, and children (or anyone other than W) are the beneficiaries, then upon H's death, W is deemed to have made a gift of the full amount of the death benefit to the children - a taxable gift in our example. Also, the children now have the insurance proceeds - W does not. W does not have a right to those funds merely by virtue of being their mother.

An Insurance Trust is created to own the Insurance. H creates an insurance trust naming W and the children as beneficiaries of the trust. Since the proceeds are owned by and payable to an irrevocable trust, they are not including in H's estate. When W dies, she is merely a beneficiary of the trust, so the insurance proceeds are not included in W's estate. Since the insurance proceeds are not passing through the Will, they are generally not subject to the claims of creditors. W can be Trustee, and distribute the funds appropriately among W and the children. There are other non-tax benefits (see 4-20-05 post - A Non-Tax Argument for Insurance Trusts). The downside to the Insurance Trust are set-up fees and annual maintenance through a separate bank account and properly issuing contribution notices.

Conclusion - There is no right answer. If your spouse survives you for a long time and spends the insurance proceeds, the estate tax consequences are negligible. Making your estate the beneficiary may give you tax savings without the costs of creating another trust. However, given that insurance is a huge cash inflow that should be protected from the possibilities, investment in an Insurance Trust may be the best way to accomplish your goals.