Life Insurance Proceeds: Estate Tax Exemption?

Life insurance is often seen as a reliable way to provide for your loved ones after your death. One of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses. However, there are some situations where taxes could come into play, and it's important to know when that might happen.

For example, if your beneficiary chooses to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. That extra money from interest is considered taxable income, even though the original death benefit is not. Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate's total value is large enough, it may trigger estate taxes, reducing what your loved ones ultimately receive.

Naming a person, not your estate, as the beneficiary

When it comes to life insurance, choosing the right beneficiary is crucial. While you may be tempted to list your estate as the beneficiary, this is not advisable as it can have negative consequences for your loved ones. Here are four to six paragraphs explaining why naming a person, not your estate, as the beneficiary is a better decision:

Firstly, naming your estate as the beneficiary can give creditors access to your life insurance death benefit. This means that your creditors can collect repayment from your estate before your loved ones receive their share. On the other hand, when you name a person as the beneficiary, the death benefit is paid directly to them, bypassing probate court. As a result, your loved ones receive the full amount quicker and without any delays.

Secondly, if you name your estate as the beneficiary, your assets will go through probate court, where a judge will determine how your debts should be settled. This process can be lengthy and complicated, and your loved ones may have to wait years before they receive their inheritance. In contrast, naming a person as the beneficiary ensures that the death benefit goes directly to them, avoiding the probate process altogether.

Thirdly, by naming specific individuals as beneficiaries, you can ensure that the money goes to those who need it most. For example, if you have young children, you can set up a trust and name a trustee who will manage the money on their behalf until they come of age. This way, you can be sure that the life insurance payout is used for their benefit while they are still minors.

Additionally, it's important to keep your beneficiary designations up to date and make changes as necessary. Life events such as marriage, divorce, or the birth of a child should trigger a review of your beneficiary designations. This ensures that your wishes are carried out as intended and that the right people receive the financial protection you intended for them.

Finally, it's worth noting that you have the option to name both primary and contingent beneficiaries. A primary beneficiary is the person(s) first in line to receive the death benefit, while a contingent beneficiary will receive the benefit if the primary beneficiary dies before you or at the same time. By naming both, you can ensure that the money goes to the right person and isn't left to the default order of payment, which may not align with your wishes.

In conclusion, naming a person, not your estate, as the beneficiary of your life insurance policy is a wise decision. It ensures that your loved ones receive the full benefit quickly, avoids probate court, and allows you to designate how you want your money to be used. By keeping your beneficiary designations up to date and considering the specific needs of your beneficiaries, you can make the most of your life insurance policy and provide financial security for those who depend on you.

Avoiding incidents of ownership

To avoid "incidents of ownership", the insured person cannot own their life insurance policy. This is because incidents of ownership occur when the insured has the right to change the beneficiary of the policy, transfer ownership of the policy, borrow from the policy, use the policy as collateral for a loan, or terminate the policy. If the insured has any of these rights, the proceeds from the policy can be counted as part of the estate and therefore taxed.

One way to avoid this is to transfer ownership of the life insurance policy to an irrevocable life insurance trust (ILIT). This is a trust specifically designed to hold life insurance. The insured cannot be the trustee of the trust and must not retain any rights to revoke the trust. The policy is then held in trust, and the insured is no longer considered the owner. Therefore, the proceeds are not included as part of the estate.

Another option is to use a buy-sell agreement. Life insurance obtained to fund a buy-sell agreement for a business interest under a "cross-purchase" arrangement will not be taxed in the estate unless the estate is named as the beneficiary. For example, say Alice and Barb are partners who agree that the partnership interest of the first of them to die will be bought by the surviving partner. To fund these obligations, Alice buys a life insurance policy on Barb's life. Alice pays all the premiums, retains all incidents of ownership, and names herself as the beneficiary. Barb does the same for Alice. When the first partner dies, the insurance proceeds are not taxed in the first partner's estate.

It is important to note that if the insured dies within three years of transferring ownership of their life insurance policy, the proceeds will still be taxed as part of the estate under the three-year rule.

Using an irrevocable life insurance trust (ILIT)

An irrevocable life insurance trust (ILIT) is a trust that cannot be altered or undone once it's created. It is created during the insured's lifetime and 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.

There are several advantages to using an ILIT:

• 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.
• Protecting government benefits: 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.
• Favorable tax treatment: The cash value accumulating in a life insurance policy is free from taxation, as is the death benefit.
• Asset protection: ILITs offer a level of asset protection for the beneficiaries in the event that they become embroiled in future litigation. This is because ILITs are not considered to be owned by the beneficiaries, making it difficult for courts to link the assets to them.
• Control over assets: The grantor can specify how and when beneficiaries receive distributions. The trustee can also have the discretion to provide distributions when beneficiaries attain certain milestones, such as graduating from college, buying a first home, or having a child.

However, there are also some drawbacks to using an ILIT. Changes to an ILIT can only be made by the beneficiaries, so the benefactor loses control of the assets before death. Additionally, while ILIT assets are not taxed as part of the estate, they are taxed as part of the beneficiaries' estates, leaving a bigger tax burden to their descendants. The paperwork surrounding the creation of ILITs is also unusually complex, with strict drafting and procedural guidelines that must be met to conform to IRS guidelines.

Understanding the three-year rule

The three-year rule is an estate tax provision of the US Internal Revenue Code. It applies when determining the assets included in a decedent's gross estate. The rule states that if an individual transfers assets—whether by trust or otherwise—within three years of their date of death, the value of the transferred assets may be included in their gross estate for tax purposes. This rule was enacted by Congress to discourage attempts to avoid estate taxes by transferring property when death is imminent.

The three-year rule applies to property transferred within three years of the date of death for less-than-full-fair-market-value consideration. This includes revocable transfers, transfers with a retained life interest, transfers upon death, transfers of life insurance proceeds, and transfers where the decedent retains any powers or interests in the assets.

For example, if you transfer ownership of your life insurance policy to another person or entity, you must do so at least three years before your death. Otherwise, the proceeds from the policy will be counted in your estate for tax purposes. This is true even if the new owner makes all premium payments after the transfer.

The three-year rule does not apply to outright sales of assets for their full fair market value, even if the sale occurred during the three-year period. Most gifts are also excluded from the three-year rule, except for gifts exceeding the annual gift tax exclusion plus the taxes paid on them, and certain gifts of life insurance proceeds.

It's important to note that the three-year rule applies to gifts of life insurance proceeds if the deceased owner retained any "incidents of ownership". This includes the right to change beneficiaries, assign or revoke the policy, pledge the policy as security for a loan, borrow against the policy's cash surrender value, or surrender or cancel the policy.

To avoid the three-year rule and minimize estate tax liability, individuals can consider transferring their life insurance policy to a trust or another person or entity. It's recommended to seek the advice of a qualified estate planning attorney to understand the best options for your specific situation.

Transferring ownership of the policy

Transferring ownership of a life insurance policy is a way to reduce your estate tax liability. Only assets you own or control when you die count as part of your taxable estate. So, if you transfer title and control of your life insurance policy to someone else, it will not count toward your estate after you die.

The Three-Year Rule

When transferring ownership of life insurance policies, the three-year rule applies. Under this IRS rule, the transfer must:

• Take place within three years before the original owner's death.
• Be made without any consideration.

If both are the case, then the proceeds from the policy are counted in the decedent's estate for tax purposes.

Retaining 'Incidents of Ownership'

The person covered by a life insurance policy cannot keep any "incidents of ownership" over the policy after a transfer. If they do, the IRS will count the policy as part of their estate for tax purposes. Incidents of ownership exist if, after a transfer, the covered person retains the power to do any of the following:

• Cancel, surrender, or convert the policy.
• Use the policy as collateral to borrow money.
• Change the named beneficiary on the policy.
• Select the method of payment for the policy (e.g. installments or a lump sum).

Two Methods to Transfer Life Insurance Policies

There are two ways to transfer policy ownership. First, you can transfer ownership of the policy directly to another adult. This includes the policy's named beneficiary. Second, you can create an irrevocable life insurance trust (ILIT). With an ILIT, you can transfer ownership of the policy to the trust.

Transferring Rights

Transferring ownership using your insurance company's forms is best to ensure everything is clear. You can request a transfer form directly from your life insurance company. However, you may also have to change the policy to indicate that the insured is no longer the owner. After the transfer, the new owner is responsible for making all premium payments. If you continue to make the payments on the policy yourself, the IRS may view this as evidence that you are still the true owner.

Life Insurance Trusts

Transferring your policy to a trust for estate tax purposes can be a wise move to reduce your estate tax liability. You must move the policy to an irrevocable life insurance trust. After you transfer the policy to the ILIT, you are no longer the policy owner, meaning the policy benefits will not be included in your estate.

There are three requirements that must be satisfied to create a valid life insurance trust:

• It must be an irrevocable trust, meaning that you must not have the power to revoke the trust or alter its terms.
• The grantor (i.e. the creator) cannot be the trustee.
• The grantor must create the trust at least three years before the grantor's death.

Frequently asked questions