Life Insurance Benefits: Taxable Estate Payouts?

Life insurance benefits are generally not taxable, but there are some situations in which they are. One of these situations is when the benefits are paid to the insured's estate instead of an individual or entity. In this case, the benefits are considered part of the estate's value and are subject to federal estate tax if the value exceeds the annual exemption amount. In 2024, this amount is $13.61 million, while in 2023, it was $12.92 million. Twelve states and the District of Columbia also impose an estate tax, with exemptions as low as $1 million.

Naming an estate as a beneficiary

When you name your estate as the beneficiary, you lose the benefit of naming a person who can claim the death benefit directly. Instead, the money will first go through probate court, where a judge will determine what debts you owe. If you have any outstanding debts, creditors will be able to collect repayment from your estate before the remaining funds are distributed according to your will. This process can be lengthy and complicated and may cause delays in your loved ones receiving their inheritance.

To avoid this, it is generally recommended that you name specific individuals, such as your spouse or adult children, as the primary beneficiaries of your life insurance policy. This ensures that they can access the funds directly and quickly.

Additionally, naming your estate as the beneficiary could increase the value of your estate and potentially subject your heirs to higher estate taxes. To reduce potential tax burdens on your heirs, it may be more advantageous to transfer ownership of your life insurance policy to another person or entity or to set up an irrevocable life insurance trust (ILIT).

It is important to carefully consider your beneficiary designations and keep them up to date as your life circumstances change. While it may be tempting to name your estate as the beneficiary, especially if you already have a will in place, doing so may ultimately result in a smaller payout for your loved ones and cause unnecessary delays in the distribution of your estate.

Estate taxes

According to Section 2042 of the Internal Revenue Code, the value of life insurance proceeds is included in the gross estate if the proceeds are payable either directly or indirectly to the estate, or to named beneficiaries if the deceased had any "incidents of ownership" in the policy at the time of their death. "Incidents of ownership" refer to various rights, such as the right to change beneficiaries, assign or revoke the policy, pledge the policy as loan security, borrow against the policy's cash surrender value, or surrender/cancel the policy.

The estate tax rules mean that if the decedent's estate is the beneficiary of the insurance proceeds, the value of the benefits will be included in the taxable estate. This can significantly increase the value of the estate, potentially subjecting heirs to high estate taxes. Therefore, it is generally advisable to avoid naming "payable to my estate" as the beneficiary of a life insurance policy, as this removes the tax advantages of naming a specific individual.

To reduce potential estate tax liability, one strategy is to transfer ownership of the life insurance policy to another person or entity. This can be done by choosing a competent adult or entity as the new owner and obtaining the necessary forms from the insurance company. It is important to note, however, that the original owner will give up all rights to make changes to the policy in the future. Another option is to set up an irrevocable life insurance trust (ILIT), where the policy is held in trust, and the proceeds are not included in the estate. This option allows the original owner to maintain some legal control over the policy and ensure prompt payment of premiums.

The timing of any ownership transfer is also crucial. The three-year rule states that gifts of life insurance policies made within three years of death are still subject to federal estate tax. Therefore, if the insured dies within three years of transferring ownership, the proceeds will be included in their estate and taxed accordingly.

Transfer of ownership

Transferring ownership of a life insurance policy is a key way to limit taxes upon death. This is usually done by transferring ownership to an irrevocable life insurance trust (ILIT). However, it's important to note that the three-year rule applies to ownership transfers. This means that if the original owner dies within three years of transferring ownership, the proceeds from the policy are included in their estate and taxed accordingly.

• Choose a competent adult or entity as the new owner. This can be the policy beneficiary.
• Obtain the proper assignment or transfer of ownership forms from your insurance company.
• New owners will be responsible for paying premiums. However, you can gift the new owner money to help cover these costs.
• 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 set up an ILIT. This is a trust that holds the policy, meaning you are no longer considered the owner. Therefore, the proceeds are not included in your estate. To complete an ownership transfer to an ILIT, you must not be the trustee of the trust and you cannot retain any rights to revoke the trust.

Irrevocable life insurance trust

An Irrevocable Life Insurance Trust (ILIT) is a trust created during the insured's lifetime that owns and controls a term or permanent life insurance policy or policies. The trust can also manage and distribute the proceeds that are paid out upon the insured's death, according to their wishes.

ILITs are a staple of estate planning, helping individuals, families, and business owners meet a wide range of goals. They are irrevocable, meaning the insured cannot change or undo the trust after its creation. This allows the premiums from the life insurance policy to avoid estate taxes.

There are several parties involved in an ILIT: the grantor, trustees, and beneficiaries. The grantor typically creates and funds the ILIT. Gifts or transfers made to the ILIT are permanent. The trustee manages the ILIT, and the beneficiaries receive distributions.

• Minimizing Estate Taxes: When life insurance is owned by an ILIT, 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.
• Avoiding Gift Taxes: A properly-drafted ILIT avoids gift tax consequences since contributions by the grantor are considered gifts to the beneficiaries.
• Government Benefits: Having the proceeds from a life insurance policy owned by an ILIT can help protect the benefits of a trust beneficiary who is receiving government aid, such as Social Security disability income or Medicaid.
• Protection Beyond Taxes: An ILIT can be used to protect an inheritance for a minor child, a loved one with special needs, or an adult child who lacks the maturity or financial savvy to handle a large sum of money. It can also be used to protect insurance benefits from divorce, creditors, and legal action against the insured and their beneficiaries.

The primary downside of an ILIT is that no changes can be made once the trust is finalized. This could have severe implications if, for example, the grantor unexpectedly needs assets that have been placed in the trust.

Incidents of ownership

A person has incidents of ownership if they have the right to change beneficiaries on a life insurance policy, borrow from the cash value, or change or modify the policy in any manner. This occurs even if the person chooses not to act on it and even if they don't borrow from the policy. Simply having the ability to do so gives the insured person incidents of ownership.

Other rights that constitute incidents of ownership include the right of the insured or their estate to the economic benefits of the insurance, and the power to surrender or cancel the policy.

The question of incidents of ownership is important because, if the insured has incidents of ownership in the policy, then the death benefit is included in the taxable estate of the insured. This means that the benefit will be taxed as if the insured owned it. This is why it is crucial to consult with a knowledgeable attorney before purchasing life insurance.

To avoid incidents of ownership in a life insurance policy, the insured cannot own the policy. Instead, ownership can be transferred to a trust, such as an Irrevocable Life Insurance Trust (ILIT) or an Irrevocable Dynasty Trust.

Frequently asked questions