Life Insurance Proceeds: Niit Exempt Status

Life insurance is often seen as a reliable way to provide for loved ones after you're gone, and 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 like paying off debts, covering funeral costs, or securing their future. However, there are some situations where taxes could come into play, and it's important to know when that might happen.

Naming your estate as your beneficiary

Firstly, it's important to understand that a beneficiary is the person or entity you name to receive the death benefits of your life insurance policy. While you can choose not to name an individual or entity, and instead, name your own estate, this can lead to some unintended consequences.

One of the main disadvantages of naming your estate as the beneficiary is that it may result in your life insurance proceeds becoming subject to the claims of creditors. This means that your life insurance benefits could be used to pay off any outstanding debts you may have at the time of your death, rather than going directly to your intended beneficiaries.

Additionally, naming your estate as the beneficiary can prolong the process of distributing the proceeds. When the estate is the beneficiary, the life insurance proceeds become an asset of the probate estate. This means that the distribution of assets, including the life insurance proceeds, will be subject to probate and will incur all the expenses and delays associated with settling an estate. This includes taxes, administrative costs, attorney fees, and executor fees.

On the other hand, if you name an individual, charity, or trust as the beneficiary, the process of releasing the proceeds is much shorter. The insurance company will distribute the proceeds to the beneficiary or beneficiaries based on your specified instructions, bypassing probate and resulting in a shorter time frame for your beneficiaries to receive the funds.

Therefore, while naming your estate as your beneficiary is an option, it is important to carefully consider the potential drawbacks and how they may affect your intended beneficiaries.

Interest on life insurance payout

Interest on a life insurance payout is taxable. This is the case even if the life insurance payout itself is not. The interest is calculated from the date of the insured person's death to the date the insurance company sends the death benefit to the beneficiary. The insurance company reports the interest to the Internal Revenue Service (IRS).

Estate taxes

According to Section 2042 of the Internal Revenue Code, the value of life insurance proceeds insuring your life will be included in your gross estate if either:

• The proceeds are payable to your estate, either directly or indirectly; or
• You possessed any incidents of ownership in the policy at the time of your death.

To avoid estate taxes, it is important to ensure that your estate is not designated as the beneficiary of the life insurance policy. Additionally, transferring ownership of the policy to another person or entity can help reduce the taxable value of your estate. It is crucial to remember 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. Therefore, if you pass away within three years of transferring ownership, the proceeds will be included in your estate and taxed accordingly.

Another effective strategy to avoid estate taxes is to set up an irrevocable life insurance trust (ILIT). By transferring the policy to the trust and relinquishing all ownership rights, the proceeds will not be included in your estate. This option allows you to maintain some legal control over the policy while ensuring that all premiums are paid promptly.

Furthermore, the structure of the payout can impact its taxability. While lump-sum payments are generally tax-free, multiple payments or annuities that include interest may be subject to taxes. Additionally, if the policyholder has withdrawn money or taken out a loan against the policy, exceeding the total amount of premiums paid may result in taxable income.

It is important to note that not all estates are subject to taxes. As of 2023, the federal estate tax threshold is $12.92 million. However, careful planning is essential to minimize the tax burden on your beneficiaries and ensure they receive the maximum benefit from your life insurance policy.

Modified endowment contracts

A Modified Endowment Contract (MEC) is a special type of life insurance under federal income tax law. Specifically, IRC § 7702A prescribes a test that is intended to distinguish policies that are purchased primarily for investment from policies that are purchased primarily for death benefit protection.

A premium limit is set to determine if a contract is a MEC. This limit, referred to as a 7-pay limit or MEC limit, is based on the annual premium that would pay the policy in full in seven level annual payments. To avoid MEC status, this limit sets the maximum premium able to be paid into the policy from the date of issue until the policy's seventh anniversary. Under what is known as the MEC test, the cumulative amount paid at any time during the first seven years cannot exceed the cumulative MEC limit for that policy year.

These rules aim to eliminate some of the favorable life insurance tax treatments for rapidly funded life insurance policies and apply to life insurance policies issued on or after June 21, 1988. A policy issued before this date can become subject to these rules, primarily if the death benefit is increased or riders are added after that date.

A MEC is still life insurance, and its death benefit proceeds are generally exempt from income tax. MECs must still meet the definition of life insurance, so cash value accumulations on a MEC are generally not subject to current tax if not withdrawn. However, if a MEC is pledged as collateral for a loan or a policy loan is taken, then any gains up to the amount of the loan or pledge will be recognized.

Generally, distributions from a MEC are taxed as earnings first, followed by a return of the policy's cost basis. Therefore, distributions are taxable to the extent of gain. For this purpose, loans, pledges, and collateral assignments of a MEC are treated as distributions. Any portion of the distribution that is taxed increases the policyowner's basis in the policy.

Dividends are taxed as a distribution of income first for a MEC policy unless they are retained by the insurer as premiums or other considerations for the policy. Dividends held to accumulate at interest, or retained to repay loan principal or interest, are considered MEC distributions.

In the case of full surrenders, the amount received (which includes outstanding debt) is included in the policyowner's gross income to the extent it exceeds the policy's cost basis.

Partial surrenders or withdrawals are treated as policy earnings first. Distributions over the amount of policy gain are a return of the policy's cost basis. For partial surrenders or withdrawals, the gain is determined by the gross cash value (without regard to debt or surrender charges) minus the cost basis.

Loans and collateral assignments are treated as a distribution and included in income, which increases the policy's cost basis. An additional 10% penalty tax applies to income distributed from a MEC before the policyowner reaches the age of 59½. Certain exceptions are provided for distributions following the disability of the policyowner, or for distributions of an IRS-approved series of substantially equal periodic payments.

Material changes to an insurance policy will cause the policy to be retested as if it was issued on the date of the change. This means starting a new 7-pay period and setting a new 7-pay premium. Material changes include certain increases in the death benefit or the addition of riders. A reduction in benefits during a 7-pay period requires the policy to be retested as if it was issued at the reduced level of benefits from the start of the 7-pay. For survivorship policies, reducing the death benefits at any time requires retesting.

Irrevocable life insurance trusts

ILITs are set up between three legal parties: the grantor, the trustee, and the beneficiary/beneficiaries. The grantor creates and funds the trust, the trustee manages it and pays the insurance premiums, and the beneficiaries receive the assets upon the grantor's death.

One of the main benefits of an ILIT is that it allows individuals to ensure that the benefits from a life insurance policy can avoid estate taxes and follow the interests of the insured. By creating an ILIT, taxable assets are removed from an individual's estate and transferred to a separate legal entity, the trust. This means that the death benefit from the life insurance policy is paid directly to the trust, which then distributes the proceeds to the beneficiaries. This can also help protect legacy assets from potential creditors.

Another advantage of an ILIT is that it gives the grantor the ability to direct, through the trust document, how and when the death benefit is used and for whom. The grantor can instruct the trustee on how to distribute the assets, such as preventing beneficiaries from wasting the benefits or spreading the assets among beneficiaries depending on their needs.

It is important to note that ILITs are irrevocable, meaning they cannot be easily modified or terminated once they are created. This is a trade-off for the benefits provided by the trust, and it requires the grantor to give up all rights to the property in the trust.

The cost of setting up and maintaining an ILIT should also be considered, as it may require professional fees and the filing of a gift tax return.

Overall, ILITs can be a powerful tool for estate planning and wealth transfer, particularly for individuals with sizable estates or loved ones with special needs who will require ongoing care.

Frequently asked questions