One of the most important features of any type of life insurance policy is that the death benefit is typically paid to the beneficiary tax-exempt. However, speculators soon realized that transferring life insurance policies could result in a tax-free windfall. To prevent this, the IRS designed the Indexed Universal Life Transfer for Value Rule.
This article will cover everything you need to know about how this rule affects your life insurance, with key exceptions, examples, and recommendations.
What is the Transfer-for-Value Rule?
When a life insurance policy is sold, the new owner may be taxed on the amount received as a death benefit. The transfer-for-value rule applies if the policy is transferred from the original policyholder to another party for money or valuable consideration.
After the transfer, only the sum of the consideration and any additional premiums paid into the policy is excluded from taxation. The remaining death benefit is taxed as ordinary income.
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Exceptions to the Rule
There are important exceptions to the transfer-for-value rule. Life insurance proceeds remain tax-free, even with consideration, in the following situations:
- The named insured or their grantor trust receives the policy.
- A corporation in which the insured is a shareholder, officer, or stakeholder acquires the policy.
- A partnership where the named insured is a partner receives the transfer.
- A partner of the named insured takes ownership.
- Corporations in a tax-free reorganization exchange the policy under certain conditions.
- The transfer qualifies as a gift from the named insured, with no consideration given.
To understand the implications of these exceptions on your specific policy, it’s important to consult a professional.
Related Topic: Learn more about other types of Indexed Universal Life Insurance and how they are used in estate planning.
When Does the Transfer-for-Value Rule Apply?
The rule is typically triggered when a life insurance policy is transferred for money or services, especially in business settings. For example, business co-owners may transfer policies as part of a buy-sell agreement.
Even though “gifts” do not trigger the rule, it’s hard to argue that transfers between business co-owners would qualify as a gift, especially when there is a formal agreement in place.
If you’re planning to transfer a policy, advisors from Insurancequotes2day can guide you through the process and ensure compliance with IRS rules.
A Simple Example of the Transfer-for-Value Rule
John Smith owns a real estate insurance brokerage. He holds a $100,000 term life insurance policy on one of his key employees. The company pays the premiums until they transfer the policy to another agent for $5,000. The agent becomes the policyowner and is responsible for premium payments.
When the original employee passes away, the new policyowner will be taxed on the $100,000 death benefit, minus the $5,000 consideration and the total premiums paid after the transfer.
While this creates a tax liability, it also allows the new policyowner to potentially profit from the policy’s death benefit.
FAQs About the Transfer-for-Value Rule
What triggers the transfer-for-value rule?
The rule is triggered when a life insurance policy is transferred to another party in exchange for money or valuable consideration.
Are there exceptions to the transfer-for-value rule?
Yes. There are exceptions when the policy is transferred to the insured, their business partner, or within certain corporate or partnership structures.
How is the death benefit taxed after a policy transfer?
The portion of the death benefit that exceeds the sum of consideration and post-transfer premiums is subject to income tax.
Does the transfer-for-value rule apply to all types of life insurance policies?
Yes, it applies to all life insurance policies, including indexed universal life, term life, and whole life policies.
How can I avoid triggering the transfer-for-value rule?
Consulting with an insurance professional can help structure the transfer to avoid tax liabilities. For example, certain transfers between businesses and their owners may qualify for exemptions.
Conclusion
If you or your business are considering transferring a life insurance policy, it’s essential to be aware of the transfer-for-value rule and its tax implications. If you’re uncertain whether the transfer will trigger a tax liability, contact us at Ogletree Financial. We can help determine if the transfer will be taxable or exempt and guide you through the process to avoid unnecessary tax burdens.
