Death Insurance Benefits: Income For Estates?

Death benefits from life insurance policies are typically not considered income to estates and are therefore not subject to ordinary income tax. However, there are certain circumstances where the beneficiary may be taxed on some or all of the proceeds. For example, if the beneficiary receives interest on the payout, they will be required to pay taxes on that interest. Additionally, if the death benefit is paid to the insured's estate rather than a specific beneficiary, it may be subject to estate taxes. To avoid paying taxes on life insurance proceeds, individuals can transfer ownership of the policy to another person or entity or create an irrevocable life insurance trust (ILIT).

Naming an estate as beneficiary

Naming an estate as a beneficiary is a common practice, but it is important to understand the implications of doing so. Here are some key points to consider when naming an estate as a beneficiary:

Understanding Beneficiary Designations

Firstly, it is crucial to understand the concept of beneficiary designations. This refers to the act of naming a person or entity that will inherit your assets upon your death. Common examples include life insurance policies, retirement accounts, and bank accounts. By designating beneficiaries, you can ensure that your assets are transferred according to your wishes.

Advantages of Naming an Estate as Beneficiary

One advantage of naming your estate as a beneficiary is that it can be more straightforward than naming specific individuals. It allows you to consolidate your assets and distribute them according to the instructions in your will or trust. This can be especially useful if you have multiple heirs and want to split your assets as you see fit.

Disadvantages of Naming an Estate as Beneficiary

However, naming your estate as a beneficiary also has several downsides. One significant disadvantage is the probate process. If you designate your estate as a beneficiary, your assets will likely have to go through probate, which can be time-consuming and expensive. The probate process increases the possibility that your assets will not be distributed according to your specific wishes.

Additionally, naming your estate as a beneficiary can have tax implications. In some cases, it may trigger estate taxes, which could result in high tax bills for your heirs. It is important to consider the potential tax consequences before making your decision.

Importance of Regular Review

Whether you choose to name your estate or specific individuals as beneficiaries, it is crucial to regularly review and update your beneficiary designations. Life changes, such as marriage, divorce, or the birth of children, may require you to adjust your designations. By staying on top of these updates, you can help ensure that your assets are distributed according to your current wishes.

Seeking Professional Advice

Designating beneficiaries and estate planning can be complex, and it is important to understand the legal and tax implications of your decisions. Consider consulting a financial professional, attorney, or estate planner to guide you through the process and help you make informed choices that align with your specific situation and goals.

Taxation on interest accrued

For example, if the death benefit is $500,000 but it earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth. The original death benefit amount is usually not taxed.

The interest that accrues from a life insurance policy payout is typically subject to federal income tax, whether the beneficiary receives the proceeds as a lump sum or in periodic payments. Interest accrues from the day of the insured's death until the day the beneficiary receives the payout. This interest is taxable to the beneficiary, while the unearned premium is not because the insured paid using after-tax dollars.

If the beneficiary elects to receive periodic payments over a number of years rather than in one lump sum, the insurance company typically pays interest on the remaining balance. The tax code treats these installment payments similarly to annuities because the payout and tax-exempt amounts are known upfront.

For example, a $250,000 policy may pay out $2,200 per month for 10 years for a total of $264,000. Each payment consists of the death benefit and interest, according to the proportion of the death benefit to the total payout. Because $250,000 divided by $264,000 equals 95%, $110 of the $2,200 monthly payment is taxable interest.

The beneficiary must report the interest as income in the year that they earn it, even if they leave it on deposit with the company. The insurance company will report how much interest the beneficiary earned on a Form 1099 each year.

Estate tax thresholds

Estate tax is a federal or state levy on inherited assets whose value exceeds a certain dollar amount. The federal government has levied an estate tax since 1916. In 2024, the Internal Revenue Service exempts estates of less than $13.61 million from the tax, so few people will pay it. The tax is calculated based on the current fair market value of the assets.

Thirteen states levy an estate tax, and the thresholds vary. In 2024, the threshold in Washington is $2,193,000, in Oregon and Massachusetts it is $1 million, in Connecticut it is $9.1 million, in New York it is $6.94 million, and in Maine it is $6.8 million.

The federal estate tax is paid from the estate itself, not by the people who inherit it. However, an inheritance tax is a state tax on inheritances paid by the heir. Only six states charge this tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Transferring ownership of a policy

Yes, it is possible to transfer ownership of a life insurance policy. There are several ways to do this, depending on the specific circumstances and the type of policy involved. Here are some common methods:

• Absolute assignment: This involves transferring the ownership rights of the policy to another person or entity. The transfer is usually permanent and irreversible.
• Change of beneficiary: Instead of transferring ownership, the policyholder can change the beneficiary designation on the policy.
• Sale or gift: The policyholder may choose to sell or gift the policy to another person or entity.
• Trust: A life insurance policy can be transferred to a trust, which becomes the new policy owner. This can provide various estate planning benefits.
• Corporation or business: A life insurance policy may be owned by a corporation or business entity for purposes like key person insurance or executive benefits.

If you want your life insurance proceeds to avoid federal taxation, you may need to transfer ownership of your policy to another person or entity. Here are some key considerations:

• Choose a competent adult or entity as the new owner. It may be the policy beneficiary.
• Obtain the proper assignment or transfer forms from your insurance company.
• The new owner must pay the premiums on the policy. You can gift them money to cover this cost.
• You will give up all rights to make changes to the policy in the future.
• Obtain written confirmation from your insurance company as proof of the ownership change.

Another way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT). The policy is held in trust, and you will no longer be considered the owner. Therefore, the proceeds are not included as part of your estate. With an ILIT, you can maintain some legal control over the policy and ensure that all premiums are paid promptly.

Death benefits from life insurance policies are generally not considered taxable income. However, there are some situations where the beneficiary may have to pay taxes on the proceeds.

If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a period of time, the beneficiary may have to pay taxes on any interest generated. Additionally, if the death benefit is paid to an estate rather than an individual, the person inheriting the estate may have to pay estate taxes.

In most cases, however, inherited money from a life insurance policy beneficiary is not taxed as income.

Irrevocable life insurance trusts

An Irrevocable Life Insurance Trust (ILIT) is a legal arrangement that helps to minimise an individual's current tax burden and the impact of taxes on their estate when they pass away. It is created and funded by the grantor during their lifetime and typically cannot be altered or undone after it is created. The trustee manages the trust and oversees trust administration, including paying insurance premiums. The beneficiaries are the individuals who will receive the trust assets upon the grantor's death.

Benefits of ILITs

• Tax advantages: ILITs can help lower an individual's current tax burden by removing taxable assets from their portfolio. The proceeds from the death benefit are not part of the insured's gross estate and are thus not subject to state and federal estate taxation.
• Estate planning: ILITs can help cover estate tax costs and other debts. The trustee can purchase the estate's assets, allowing beneficiaries to maintain control of those assets while still paying off taxes and other expenses.
• Asset protection: ILITs can protect assets from creditors, as any excess value above state limits is generally protected from the creditors of both the grantor and the beneficiary.
• Government benefit protection: ILITs can help ensure that inherited assets don't interfere with a beneficiary's eligibility for government benefits such as Social Security Disability Income or Medicaid.
• Legacy benefits: ILITs can make it easier for beneficiaries to qualify for Medicaid and other government assistance programs by transferring ownership of the life insurance policy to the trust.
• Control and distribution: ILITs allow the grantor to have control over how and when the death benefit is used and distributed to beneficiaries.

Downsides of ILITs

• Irrevocability: ILITs cannot be easily modified or terminated once established. The grantor gives up control over the assets and the trust can only be modified with legal action or the consent of the beneficiaries.
• Tax implications for beneficiaries: While the ILIT can reduce the grantor's tax burden, it may shift the tax burden onto the beneficiaries when they receive the estate.
• Cost: Setting up and maintaining an ILIT may require professional fees and the filing of a gift tax return.
• Loss of personal use: As the owner of the policy, the grantor loses the flexibility to take money out of the policy tax-free or use it for personal and retirement expenses.

In summary, an Irrevocable Life Insurance Trust is a powerful tool for estate planning, particularly for individuals with sizable estates or specific legacy planning goals. It offers tax advantages and control over the distribution of assets but comes with the trade-off of reduced flexibility and potential costs.

Frequently asked questions