Life Insurance Proceeds: Gift Tax Exemption?

Life insurance proceeds are generally not taxable as income, but they can be taxed as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. In the US, federal estate tax affects unmarried people who die leaving a taxable estate of more than $13.61 million, and married couples leaving a taxable estate of over $27.22 million. If you want to avoid federal estate tax, you can transfer ownership of your life insurance policy to another person or entity, or create an irrevocable life insurance trust (ILIT). However, if you transfer ownership of a life insurance policy within three years of your death, the proceeds will be taxed as part of your estate.

Ownership Transfer

Life insurance proceeds are generally not subject to income tax, but they may be included as part of your taxable estate for estate tax purposes. One way to avoid this is by transferring ownership of the policy to another person or entity. Here are the key points to consider regarding ownership transfer:

Timing of the Transfer

The sooner you make the transfer, the better. If you wait too long, your intentions may be defeated. If ownership of the policy is transferred within three years of your death, the proceeds will revert to your taxable estate. This is known as the three-year rule.

Choosing the New Owner

You need to determine who the new owner will be. This could be a competent adult or entity, such as an irrevocable life insurance trust (ILIT). An ILIT can be one of the best ownership alternatives as it allows you to maintain some control over the policy while keeping the proceeds out of your taxable estate.

Rights and Responsibilities

As the original owner, you will give up all rights to make changes to the policy in the future. The new owner will have the right to control the economic benefits of the policy, including the right to transfer ownership, change policy provisions, surrender or cancel the policy, borrow against its cash value, name and change beneficiaries, and determine how beneficiaries will receive the death proceeds.

Premium Payments

The new owner must pay the premiums on the policy. However, you can gift a certain amount per person per year (e.g., $16,000 in 2022) to help cover the cost of premiums.

Gift Taxes

If the policy's current cash value exceeds the gift tax exclusion, gift taxes will be assessed and will be due at the time of the original policyholder's death. The gift tax exclusion for 2024 is $18,000 per recipient, and both spouses can gift separately, resulting in a total of $36,000 per recipient.

Obtaining Confirmation

Make sure to obtain written confirmation from your life insurance company as proof of the ownership change.

Life Insurance Trusts

Life insurance proceeds are generally not taxable, but they may be included in your taxable estate for estate tax purposes. One way to avoid this is by setting up a life insurance trust.

A life insurance trust is a trust that owns the eventual proceeds of your life insurance policy. Once you create a life insurance trust, you are no longer the legal owner of the insurance policy—instead, the trust is. As a result, the proceeds are not counted in your estate when you die.

• The trust must be irrevocable. This means that it generally cannot be modified or canceled, and you cannot be the trustee.
• The trust must exist for at least three years before your death. This is the IRS's way of prohibiting "last-minute" transfers to avoid estate taxes.
• You can still pay the premiums for the life insurance policy, but you need to be careful about gift taxes. You can also give money to someone else to pay them or consider buying a single-premium policy so that no further payments are due.
• The trust should make all life insurance policy premium payments rather than having the grantor pay the insurer directly. The grantor can make cash gifts to the trust to cover the premiums.
• Life insurance trusts can help with asset protection and government benefit protection. For example, if you have a family member with special needs, a life insurance trust can help set aside assets for their care without interfering with their eligibility for government benefits.
• Life insurance trusts give you more control over the distribution of the proceeds. You can dictate how, when, and for what purposes distributions are to be made.
• If you die within three years of transferring your policy to a life insurance trust, the IRS considers the trust invalid, and the value of the policy will be included in your estate.
• Life insurance trusts are not necessary for everyone. Only the wealthiest Americans will benefit from setting up this kind of trust under the current estate tax laws. However, this may change in the coming years as exemption limits are expected to decrease.

Estate and Gift Taxes

Life insurance proceeds are typically not taxable as income, but they can be taxed as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. In 2024, the federal estate tax affects unmarried people who die leaving a taxable estate of more than $13.61 million, and married couples leaving a taxable estate of over $27.22 million. If your beneficiary is anyone other than your spouse, your life insurance payout will be added to the value of your estate. If your total estate is worth more than the exemption, any amount over the exemption is subject to estate and inheritance taxes. Federal estate taxes are levied at a rate of up to 40% on the value of an estate that exceeds $12.06 million per individual. State estate and inheritance taxes vary, with 17 states and Washington, D.C., having an inheritance or estate tax, and the exemption amount ranging from $1 million to $7 million.

One way to avoid life insurance payouts being taxed as part of your estate is to set up an irrevocable life insurance trust (ILIT). You transfer ownership of the policy to the ILIT and cannot be the trustee, but you can determine the trust beneficiary. However, there are some situations in which you may still face a tax event. Firstly, if the life insurance policy's cash value is greater than the gift tax exemption when setting up the trust, you may need to pay a gift tax when transferring ownership. The gift tax exemption for 2022 is $16,000. Secondly, if you pass away within three years of transferring the policy to the trust, the policy will likely become part of your estate for tax purposes. This rule is intended to prevent individuals from avoiding taxes by giving away assets as deathbed gifts.

Another way to avoid estate taxes on life insurance proceeds is to transfer ownership of the policy to another person or entity. This method also involves a trade-off: once the policy is transferred, you lose all power over it, including the right to cancel the transfer or change the beneficiary. Additionally, the new owner must pay the premiums on the policy.

Taxable Income

Life insurance proceeds are typically not taxable as income. However, there are certain situations in which life insurance proceeds may be taxed.

Estate and Inheritance Taxes

If the total value of your estate exceeds federal and state exemptions, your life insurance payout will be added to the value of your estate and may be subject to estate and inheritance taxes. The federal estate tax exemption is $12.06 million per individual, with a tax rate of up to 40% on amounts exceeding this threshold. State estate and inheritance tax exemption amounts vary, ranging from $1 million to $7 million, with tax rates of up to 20%.

Gift Tax

If you transfer ownership of your life insurance policy to another person, it may be considered a gift by the IRS and subject to gift tax. The gift tax exemption for 2022 is $16,000, and for 2024, it is $18,000.

Income Tax on Interest

If your beneficiary receives the life insurance payment as a series of installments, the insurer will typically pay interest on the outstanding death benefit. This interest is considered taxable income and must be reported.

Taxes on Whole Life Insurance

Whole life insurance policies have a cash value component that grows over time and is treated differently from a tax perspective. If you decide to cancel your policy and withdraw the cash value, or sell your policy in a life insurance settlement, you may be subject to income and capital gains taxes.

Taxes on Life Insurance Dividends

If you have permanent life insurance from a mutual insurance company, you may receive periodic dividends. These dividends are generally not taxable unless they exceed the amount you have paid in premiums over the course of the year.

Taxes on Surrendered Policies

If you surrender your life insurance policy or are unable to get a life insurance settlement, the policy's cash surrender value will determine whether you owe any taxes. If the cash surrender value is greater than the amount you have paid in premiums, the difference will be taxable as income.

Taxes on Group Life Insurance

Group term life insurance policies provided by an employer or association are treated differently for tax purposes. While the employer can deduct life insurance premium payments for up to $50,000 of coverage per employee, the cost of group or supplemental life insurance is added to the taxable income of the employee or association member. If the coverage exceeds $50,000, the IRS assigns a fair market value, and the difference between this value and the amount paid in premiums is considered taxable income.

Federal and State Exemptions

Life insurance proceeds are generally not taxable as income, but they can be taxed as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. The federal estate tax affects unmarried people who die leaving a taxable estate of more than $13.61 million, and married couples leaving a taxable estate of more than $27.22 million. In such cases, the value of the estate that exceeds $12.06 million per individual is subject to a tax rate of up to 40%.

Additionally, there are 17 states, plus Washington, D.C., that have an inheritance or estate tax. The estate tax exemption amount varies by state, ranging from $1 million to $7 million, and tax rates can be as high as 20%.

It is important to note that your life insurance policy would only be considered part of your estate for tax purposes. It would not be included in your estate for other purposes, such as paying creditors, unless you named the estate as a beneficiary or all your beneficiaries passed away.

To avoid estate taxes, you can set up an irrevocable life insurance trust (ILIT). By transferring ownership of the policy to the ILIT, you are no longer considered the owner, and the proceeds are not included as part of your estate. However, if the cash value of the life insurance policy is greater than the gift tax exemption, you may need to pay a gift tax when transferring ownership. The gift tax exemption for 2022 is $16,000, and it is expected to increase to $17,000 in 2023.

Another important consideration is the three-year rule, which applies to both the transfer of ownership to another individual and the establishment of an ILIT. If you pass away within three years of the transfer, the full amount of the proceeds is included in your estate, and it is taxed accordingly. This rule is in place to prevent individuals from avoiding taxes by giving away assets as deathbed gifts.

Frequently asked questions