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Buy life insurance, but don’t retain ‘incidents of ownership’

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in Small Business Tax,Small Business Tax Deduction Strategies

Typically, you can protect your family by securing adequate life insurance coverage. But how much will they receive after Uncle Sam siphons off a portion for the federal estate tax?

Strategy: Avoid potential estate tax problems. As long as you haven’t retained any “incidents of ownership” in the policy, the proceeds won’t be included in your taxable estate.

Here’s the whole story: Your gross estate in­­cludes proceeds from a life insurance policy on your life even if the proceeds are payable to your estate (or are received by someone else for the estate’s benefit). Of course, you can designate beneficiaries other than the estate, like your spouse and children, and give them full control over the proceeds. But that’s only part of the equation.

The proceeds are still included in your taxable estate if you possessed an incident of ownership in the policy upon death (unless they go to your spouse who is a U.S. citizen).

This also applies to any ownership rights transferred within three years of death.

The term encompasses more than technical legal ownership. It refers to the right to the ­economic benefits of a policy, including the powers to:

  • Change beneficiaries
  • Revoke an assignment
  • Obtain a loan against the cash value
  • Pledge the policy for a loan
  • Surrender or cancel the policy.

If you transfer all incidents of ownership in your policy more than three years before your death, all the proceeds are removed from your taxable estate for federal estate tax purposes.

Tip: Although the transfer is subject to gift tax, it may be sheltered by the annual gift tax exclusion (currently $13,000) and the lifetime gift tax exemption ($5.12 million for 2012).

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