Life insurance proceeds are about the only source of money that is income tax free. This gives added value to the benefit that you leave your beneficiaries. 

There is one area that you need to be careful with beneficiary designations. The IRS has a three year look back rule whenever there has been a change of beneficiary, not for income tax, but for taxable estate value. What they are trying to prevent is someone changing beneficiaries when they know they don’t have long to live, to avoid estate taxes. 

Life insurance, if owned by an individual, while not income taxable, is added to the value of the estate upon death. With proper estate planning, an irrevocable life insurance trust would be in place at the time the life insurance is purchased. The trust would own and be the beneficiary of the life insurance. Since the individual doesn’t own the policy, the IRS says it is not added to the value of the estate. 

The problem comes when an individual owns a policy, his or her estate grows to the point of being taxable, and they decide to change ownership of the policy to remove it from the estate value. This triggers the 3 year look back. If the individual dies within 3 years of this change of ownership, the IRS will deem the original ownership takes precedence leaving it in the estate and added to the taxable estate value. 

I have had clients on several occasions discover that they aren’t following their estate attorney’s orders after the policy is already applied for. Changing the beneficiary after the insurance is applied for falls within the same 3 year rule. When investigating ownership for estate tax purposes they will actually look back to the original application to see what changes were made by application amendment. The original intent stands. 

Life insurance is set up incorrectly every day, usually due to the ignorance of the agent. We’ll look at a couple of viable options to deal with a poorly thought out purchase in a subsequent post. 

Bottom line. Care needs to be taken. Advice from estate planners and estate tax attorneys should be sought. Whenever you are buying substantial amounts of life insurance, quiz your life insurance agent on estate tax consequences and how to structure ownership.