Life insurance can be a useful tool in estate planning. Through proper planning , it is possible to keep your life insurance policy proceeds out of your estate, thereby reducing the size of the estate subject to taxation and providing immediate funding for short-term financial needs. You cannot do so, however, if you have held any incidents of ownership in that insurance policy on your own life during the three year period preceding your death. In general, an incident of ownership is a right to exercise control over the policy or to receive an economic benefit from the policy. Unless any incident of ownership that you have ever held was transferred more than three years prior to your death, the entire policy benefit will be included in your estate.

In practice, application of this simple rule is not always clear and, in some circumstances, life insurance policy proceeds may be included in an insured's estate for tax purposes even though the insured was never named in the policy as the owner.

Steps You Can Take

Your new life insurance policies, proceeds are not included in the estate of the insured when another person (often an adult child of the insured or an irrevocable trust created by the insured) is the initial applicant and owner of the policy and the insured never possesses an incident of ownership in the policy.

For existing policies, if you want to keep life insurance proceeds out of the estate, you need to transfer any incidents of ownership in the insurance to another person at least three years before your death. You must also make sure that your estate is not the beneficiary of the policy and that the policy beneficiary is not required to use policy proceeds to pay estate claims and expenses.

Incidents of ownership in life insurance would include: any powers to surrender the policy, to pledge the policy as collateral, or to assign the policy, any reversionary interest equal to 5% or more of the value of the policy before death; or any power to act as a fiduciary of a trust that holds insurance on your life if: you establish the trust; if you transferred the policy or consideration of the policy to the trust; or if you can exercise any fiduciary power over the trust for your own benefit.

However, your estate will not include your life insurance proceeds merely because you initiated its purchase or paid its premiums within three years prior to your death.

A Plan of Action

The above guidelines can help you develop a plan of action for keeping your life insurance proceeds out of your estate. However, before you take any action that might affect your policies, consider all of the alternatives and seek professional counsel about how best to achieve your specific objectives.