How does your life insurance stack up?

May 2010 Western DairyBusiness

It’s your money

by Verlyn de Wit

Pop Quiz: Is the life insurance payout your family receives at the time of your death, tax-free?

As a student I believed that pop quizzes were the moral equivalent of a surprise attack in a not-yet-declared war.  As a former teacher I must confess that the pain of taking a pop quiz is in perfect inverse correlation to the sinister pleasure of giving one.

No easy answer

The answer to this quiz is two-fold and complex:

1) For income-tax purposes – the life insurance death benefit is almost always tax-free, but beware of the unusual exception described below.

2) For estate-tax purposes – the basic rule is that if you owned, or had limited control over your life insurance policy,  the death benefit is included in your taxable estate. Inclusion in your estate could mean that up to 45% of the death benefit will be lost to taxes!

You may want to talk to an attorney about “corrective surgery” if:

1) You own or have any control over your life insurance, or,

2) You and your spouse own policies on each other.

Income tax rule

Life insurance death benefits are generally income-tax-free. One primary exception exists, the “transfer for value” rule. This rule states that if an existing life insurance policy was sold to another, the buyer of the policy will pay income tax on his or her gain.

Example: Your neighbor needs cash very badly and offers to sell his $100,000 life insurance policy to you for $40,000.  Judging from his overall appearance, you determine that’s a pretty good deal and run for your checkbook. After paying the $40,000 purchase price, you make no further premium payments and collect a death benefit check of $100,000.  You have just incurred a taxable gain of $60,000.

Extate tax rules

We’ve already summarized the “incidents of ownership” rule in answer #2 above. But the problem reaches further than one might suspect. Let’s assume you own a $1 million policy on your life. Your estate is large enough that you expect it will be taxed, so you decide to give the policy to an irrevocable life insurance trust (ILIT). Death benefits are not estate taxed when received by a properly drafted ILIT.  But a new hurdle appears. IRC Section 2035, commonly called the “three-year rule,” states than any policy given to another entity will be taxed in the donor/insured’s estate if death occurs within three years of the date of the gift.

The easy solution

If you are in good health, your ILIT could purchase a new life insurance policy on your life. If properly drafted, your life insurance death benefit should be tax-free on both levels.

But what if you aren’t in good health?  What if the purchase of a new policy is cost-prohibitive or even impossible?

Put on your scrubs

It is time for corrective surgery on your existing policy. Don’t try this at home; you need a qualified attorney.

• Issue #1 – Avoiding the three-year rule: If you give the policy to your ILIT you come under the jurisdiction of Section 2035. So, let’s sell the policy to your ILIT. It should be sold to your ILIT for the appropriate value, but since the ILIT purchases the policy (probably with dollars you gave to the ILIT), estate taxation under the three-year rule can be avoided

• Issue #2, If the ILIT purchases the policy, won’t the death benefit be taxed under the “transfer for value” (TFV) rule? Normally, yes. But the TFV rule has a number of exceptions. If you fall under one of these exceptions, the death benefit is not income taxed.

One exception to the TFV is a transfer of the policy to the insured. Here comes the magic: your ILIT should be drafted so that it is a grantor trust for income tax purposes.

Steps can be taken

There are at least three “triggers” that can be written into the ILIT to make it so. On an income tax level your ILIT is now viewed as being the same entity as you!  Your attorney has successfully completed emergency corrective surgery; your existing insurance policy is in a tax-free ILIT, the death benefits will be income and estate-tax free, and you don’t have to live three years to make it so.

Yes, I know, this is a crazy business.


Verlyn De Wit helps successful dairy producers make smart decisions about their money.  He can be reached toll-free at 1-888-468-1728 by e-mail at or snail-mail at 1270 Eastside Dr., Sioux Center, IA  51250. Securities offered through Sammons Securities Co., LLC. 4261 Park Road, Ann Arbor, MI  48103. Member FINRA and SIPC.

Neither Western DairyBusiness nor Verlyn De Wit is qualified to offer legal or tax advice. Consult your attorney and/or tax professional for a qualified opinion regarding your personal situation.