Life Insurance Proceeds: Tax-Free Or Not?

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. If the beneficiary is anyone other than your spouse, the life insurance payout will typically be added to the value of your estate. If the total value of your estate exceeds the exemption, any amount over this will be subject to estate and inheritance taxes.

Naming your estate as your beneficiary

Disadvantages of naming your estate as your beneficiary

There are several disadvantages to naming your estate as your beneficiary. Firstly, it increases the value of your estate, which may result in your heirs having to pay exceptionally high estate taxes. Secondly, it subjects the financial product to the probate process, which can delay the distribution of assets by several months. Thirdly, it opens up the opportunity for creditors to collect from the proceeds of your life insurance policy to satisfy their claims, meaning your life insurance proceeds could be used to pay off any outstanding debts you may have at the time of your death.

How to avoid these disadvantages

To avoid these disadvantages, you can name an individual, charity, or trust as the beneficiary of your life insurance policy. This will shorten the process of releasing the proceeds significantly. Additionally, in many states, life insurance proceeds are exempt from creditor claims when there is a named beneficiary, but not when your estate is the named beneficiary. Another option is to create an irrevocable life insurance trust (ILIT) and transfer ownership of your life insurance policy to the trust. This will allow you to maintain some legal control over the policy and ensure that all premiums are paid promptly.

Estate tax exemption

The federal estate tax exemption for 2023 is $12.92 million. Estates below this threshold are not taxed when the owner dies. If your estate exceeds this limit, a life insurance transfer may be a helpful estate planning move.

The estate tax exemption is the value of an estate that is exempt from the estate tax. In the United States, the federal estate tax exemption for 2023 is $12.92 million. This means that estates valued below this threshold are not subject to the estate tax when the owner dies. However, if your estate exceeds this limit, you may want to consider strategies such as a life insurance transfer to reduce your estate tax liability.

It is important to note that the estate tax exemption amount can change over time. For example, the exemption amount for 2022 was $12.06 million, and it is expected to increase to $12.92 million in 2023. Additionally, it is worth considering that some states have their own estate or inheritance taxes, with exemption amounts ranging from $1 million to $7 million.

To reduce potential estate tax liability, individuals can transfer ownership of their life insurance policies to another person or entity, or create an irrevocable life insurance trust (ILIT). By doing so, the proceeds from the life insurance policy may be excluded from the taxable estate. However, it is crucial to be mindful of the three-year rule, which states that gifts of life insurance policies made within three years of death are still subject to federal estate tax.

Furthermore, when considering estate planning, it is essential to consult with a qualified professional, such as an estate planning attorney or a certified public accountant (CPA), to ensure that you understand the tax implications of your specific situation and make informed decisions.

Avoiding estate tax with an irrevocable life insurance trust

Life insurance proceeds are not usually subject to income tax, but they can be included in the value of the deceased's estate and become subject to federal estate tax. This is where an irrevocable life insurance trust (ILIT) can be used to avoid estate tax.

An ILIT is a trust created during the insured's lifetime that owns and controls a term or permanent life insurance policy. The trust can also manage and distribute the proceeds that are paid out upon the insured's death, according to the insured's wishes. The parties in an ILIT are the grantor, trustees, and beneficiaries. The grantor typically creates and funds the ILIT, and the trustee manages the trust and distributes the proceeds to the beneficiaries.

To avoid estate tax, it is crucial that the ILIT, not the individual, owns the life insurance policy. This means that 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. The death benefit will then go directly to the trust beneficiaries, not to the estate that goes through probate.

There are a few requirements to funding an ILIT:

• The grantor cannot be the trustee, as this could lead to the trust being included in their estate.
• The trust must own the life insurance policy.
• Funds need to be transferred to the trust to pay the policy premiums, which creates an issue with gift taxes.
• The beneficiary of the life insurance policy is usually the trust.

An ILIT can be used to minimize estate taxes, avoid gift taxes, protect government benefits, and more. It is a powerful tool for reducing estate taxes and protecting assets, but it is also complex and has some potential drawbacks, such as the loss of control over the policy and the complexity of setting up and managing the trust.

Whole life insurance policies

Whole-of-life insurance, or whole life insurance, is a type of life insurance that pays out whenever you die. It is different from term life insurance, which only pays out if you die during a specified period.

In the UK, if the total value of your estate is more than £325,000, inheritance tax (IHT) will be deducted from your insurance payout at a rate of 40%. This includes the proceeds of any life insurance policies. However, you can legally avoid IHT by writing your life policy in trust. A trust is a legal arrangement that allows you to give your policy to trustees, who become the legal owners and look after it on behalf of the beneficiaries.

In the US, the federal estate tax limit is $13.61 million for 2024. The death benefit from a life insurance policy is generally not taxable and is not counted as taxable gross income. However, if the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated. Additionally, if the policyholder names their estate as the beneficiary, the death benefit will be included in the estate and may be subject to estate taxes.

Group term life insurance policies

Group term life insurance is a common employee benefit, often provided by employers at no cost. It covers not just the policyholder but also their co-workers. This type of insurance is linked to ongoing employment, so the coverage automatically ends when an individual's employment terminates.

The first $50,000 of group term life insurance coverage is tax-free to the employee. According to Internal Revenue Service (IRS) Code Section 79, if an employer provides coverage over $50,000, the cost of the additional coverage must be recognised as a taxable benefit and reported on the employee's W-2 form as income. This taxable amount is calculated using an IRS premium table, based on the employee's age, and is subject to Social Security and Medicare taxes.

If an employer differentiates—which is allowed—by offering different amounts of coverage to select groups of employees, then the first $50,000 of coverage may become a taxable benefit to them. This includes corporate officers, highly compensated individuals, or owners with a 5% or greater stake in the business.

The coverage offered through a group plan varies among employers. The amount of coverage available to an employee may also differ depending on where they are in the organisational hierarchy. Benefits for highly paid executives and managers may be more robust than those offered to lower-level or hourly employees.

Some upper-level employees may be eligible for both a group policy and an individual one through a group carve-out plan. Many group plans only cover an individual's base salary or some multiple of it, excluding other forms of compensation such as bonuses, sales commissions, or incentives.

Group term coverage is generally inexpensive, especially for younger workers, but rates increase with age. Most plans have rate bands where the cost of insurance automatically increases in increments—for example, at ages 30, 35, 40, etc. The premiums for each rate band are outlined in the plan document.

It is important to note that, while death benefits paid to a beneficiary are generally not considered taxable income, there are situations where the beneficiary may be taxed on some or all of a policy's proceeds. If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated.

Frequently asked questions