Life insurance products accounted for more than 20 percent of long-term savings in the U.S. during 2013, according to an article by the Milwaukee Journal Sentinel. Furthermore, on average life insurance companies paid out more than $1.5 billion every day and the life insurance industry directly supported around 2.5 million American jobs throughout 2013, according to the article.
Yet, based on a 2013 study by the Life Insurance and Market Research Association (LIMRA), up to thirty percent of U.S. households had no life insurance at all. Furthermore, only 44 percent of homeowners had individual life insurance, according to LIMRAs study. Although the study shows there is a lack of insurance ownership within the U.S., it still suggests that a majority of consumers are aware of the importance of life insurance.
The Need for Life Insurance
Around 50 percent of U.S. households, roughly 58 million, identified as needing more life insurance, according to LIMRA’s study. On the other hand, less than 40 percent of those surveyed in the 2013 LIMRA study indicated that using life insurance coverage for premature death and funeral costs and leaving an inheritance was their top financial priority.
Over the past decade the median cost of an adult funeral in the United States has increased approximately 35%, according to the nation Funeral Directors Association. The nation median cost of a funeral was $7,045 in 2012. Obviously the life insurance industry plays a massive role in both the U.S. economy, as well as the lives of those who wish to build savings and financial protection for their loved ones.
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Benefits of Life Insurance
Fortunately for policy owners, life insurance can generate a large sum of money that is payable to the owner’s heirs in the event of their death. An even greater advantage is the proceeds for the death benefit will be income-tax-free for the beneficiary.
Nonetheless, premiums paid towards a policy by an individual for insurance on the life of his or her spouse are considered nondeductible personal expenses of the individual.
Policy owners should be weary as to who is receiving their death benefit. Death benefits that are paid into the deceased’s estate are subject to estate tax, which runs between 35 and 55 percent. When death benefits go directly to a beneficiary who is not their spouse, such as a child or sibling, the money is included in the deceased’s taxable estate.
However, most relatively simple estates do not require the filing of an estate tax return unless “the combined gross assets and prior taxable gifts exceed $5,340,000,” according to the IRS.
To determine your current net estate, add your assets then subtract your debts. Insurance policies in which you have any "incidents of ownership" are included in your taxable estate.
Methods of Avoiding Taxation of Life Insurance
One method in avoiding the taxation of a life insurance death benefit is to use a trust owned life insurance policy. Since you don't personally own the insurance or have any incidents of ownership, it will not be included in your estate.
The trust then pays the premiums, and the death benefits go to whomever you name as the trust's beneficiaries. With this arrangement, there's no federal estate tax on the death benefits, and there's no federal income tax either.
However, an irrevocable life insurance trust (ILIT) may not be the best policy depending on what the policy owner is looking to get from their policy. These types of policies do not have flexibility when it comes to changing the policy. Additionally, the beneficiaries must rely on a fiduciary to properly manage the policy.
Managing a life insurance policy may be a complex task that requires continual revision and upkeep. A fiduciary or trustee of a policy must hold themselves and their management policies to a certain standard in order to provide their client or principal with the best service.
Unfortunately, Data from a 2005 survey by The Journal of Financial Service Professionals indicated, “Approximately 74 to 79 percent of trust companies could obtain a larger death benefit for the same premium.”
Furthermore, up to almost 35 percent of trust companies “could obtain a greater death benefit while reducing the premium outlay from 55 to 82 percent,” according to the survey. An existing policy can be transferred into the irrevocable life insurance trust, but the IRS imposes a three-year waiting period before recognizing the transfer. Should the client die within the interim, the full death benefit would revert to the decedent’s taxable estate.
Nonetheless, using irrevocable trust assets to purchase permanent life insurance can provide greater amounts to heirs while minimizing both estate and income taxes.
Ultimately, a person who wants to buy a life insurance should consider all their options and seek the advise of an independent insurance professional to decide which method is right for their personal situation.