In most instances, the likely primary beneficiary of a life insurance policy is a spouse. But does this make sense given the special tax treatment life insurance receives in estates?
The special treatment is that life insurance proceeds are not taxable to heirs even if the heir is the estate. The tax we are talking about is the PA inheritance tax at 4.5% to lineal descendants such as children or parents, 12% to siblings, and 15% to others (excluding charities). Because of this special tax treatment, some potentially valuable strategies should be considered.
Naming children as the primary life insurance beneficiaries
The first strategy is to name the children as primary beneficiaries if the spouse is financially secure. Being financially secure is a subjective condition, so you will need the help of a financial adviser to determine if this is so.
Some clues to determining financial security are pension and fixed income streams more than satisfy expenses, potential long-term care costs being managed either through Long Term Care Insurance, or if they are a current resident at a Life Care or Continuing Care Facility.
The reason this strategy makes sense is that if the spouse is the primary beneficiary they receive the insurance death benefit tax-free. When these monies are inherited by the children they will have to pay the 4.5% PA inheritance tax. Why not have the children receive the monies as a primary beneficiary without having to pay the tax, since this is most likely the final destination of the funds?
Utilize non-lineal heirs as life insurance beneficiaries
The second strategy is to use life insurance benefits to provide for non-lineal heirs such as siblings or other non-related beneficiaries. The benefit with this strategy is that life insurance proceeds are received tax-free. Since the PA inheritance tax is much higher for siblings (12%) and others (15%), this significantly increases the net inheritance to people in this category.
Should the life insurance benefit received by the spouse serve only to inflate the estate beyond the 2016 federal estate exemption of $5,450,000, consider naming an Irrevocable Life Insurance Trust (ILIT) as the beneficiary.
Life insurance has the unique opportunity to provide tax-free liquidity to the beneficiaries who receive it. Don’t overlook this special attribute when planning for the transfer of your wealth.