Life Insurance Proceeds: Trust Payments And 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 on to your heirs exceeds federal and state exemptions. If you're the beneficiary, you generally don't have to report life insurance proceeds as gross income. However, if you receive the payout in installments, any interest you receive is taxable. If the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds may be limited, and you may need to report the taxable amount. Life insurance proceeds paid to trusts are generally subject to estate tax, and the proceeds may not qualify for the inheritance tax exemption provided by some states for insurance payable to a named beneficiary. To avoid taxation, you can transfer ownership of the policy to an irrevocable life insurance trust (ILIT) or another person/entity.

Naming a spouse as the beneficiary

Naming a beneficiary is an important part of owning life insurance. The beneficiary is the person or entity that you legally designate to receive the benefits from your financial products. In the case of life insurance, this is the death benefit your policy will pay if you die.

A primary beneficiary is the person (or persons) first in line to receive the death benefit from your life insurance policy. Typically, this is a spouse, child, or other family member. If your primary beneficiary dies before or simultaneously as you, you can name a secondary or contingent beneficiary to receive the benefit.

However, if your estate is larger than your state's estate tax exemption threshold, you may want to consider putting the ownership of your life insurance policy in an irrevocable life insurance trust (ILIT). By doing so, the proceeds of the death benefit payout will not be included as part of your taxable estate, which can be taxed as high as 40%. While federal estate tax exemptions are high ($12.06 million for 2022 and $12.92 million for 2023), some states have much lower exemptions. For example, Oregon's estate tax exemption is only $1 million.

Therefore, while naming a spouse as the beneficiary of your life insurance policy is a straightforward and beneficial choice, it is worth considering the potential tax implications, especially if you have a high net worth.

Estate tax exemption thresholds

Life insurance proceeds are generally not taxable if you are the beneficiary receiving them due to the death of the insured person. However, if you are the policyholder and you surrender the life insurance policy for cash, the amount you receive may be taxable if it is more than the cost of the policy. Any interest received on life insurance proceeds is also taxable.

Now, regarding estate tax exemption thresholds, this can vary depending on the state and federal level. At the federal level, the estate tax exemption for 2024 is $13.61 million. This means that only estates valued at more than this amount are subject to the federal estate tax. The exemption amount is adjusted annually to account for inflation and is set to decrease to $5 million in 2026.

It's important to note that each state has different estate exemption laws and tax rates. For example, Oregon has one of the lowest estate tax exemptions at $1 million. On the other hand, some states do not have an estate tax at all.

To determine if an estate is subject to taxation, the fair market value of all assets, including cash, securities, real estate, insurance, trusts, annuities, business interests, and other assets, is considered. Deductions and reductions are then applied to arrive at the "Taxable Estate." These deductions may include mortgages, debts, estate administration expenses, property passing to a surviving spouse, and donations to qualified charities.

Irrevocable life insurance trust (ILIT)

An Irrevocable Life Insurance Trust (ILIT) is a legal arrangement that allows individuals to ensure the benefits from a life insurance policy can avoid estate taxes and follow the interests of the insured. It is a type of trust that holds one or more life insurance policies and provides certain advantages.

ILITs 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. The proceeds of a death benefit payout will not be included as part of the taxable estate if a trust, not an individual, owns the policy. This can be taxed as high as 40% if not placed under an ILIT.

ILITs also allow the insured to choose a manager of assets and how the beneficiaries receive them. The insured can instruct the trustee to do things like prevent the beneficiaries from wasting the benefits or spread the assets among beneficiaries depending on their needs.

Funding a trust with life insurance can help cover estate taxes and other expenses after death, preventing the need to sell high-value assets. It also enables the insured to fully leverage the annual gift tax exclusion by using gifts to pay premiums on the life insurance in the trust.

The main downside of an ILIT is that the grantor must completely give up all rights to the property in the trust, including who the trust beneficiaries are and under what circumstances they receive the assets. The cost of setting up and maintaining an ILIT may also be high, requiring professional fees and the filing of a gift tax return.

Interest on death benefit

The death benefit is the payout your beneficiaries receive at your death if your policy is still in force. It is what the policy is "worth" and is usually paid as a lump sum. The death benefit can be a level benefit or an increasing benefit. A level death benefit remains the same regardless of how long the policy has been in force, while an increasing death benefit can grow over time, but this may result in higher insurance plan costs.

Generally, life insurance proceeds are not taxable and do not need to be reported. However, any interest received on the death benefit is taxable and must be reported as interest received. If the policy was transferred for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts.

The proceeds of a death benefit payout will not be included as part of the taxable estate if a trust, not an individual, owns the policy. This is because trusts are not considered individuals, and life insurance proceeds paid to trusts are generally subject to estate tax. Therefore, if your estate exceeds your state's estate tax exemption threshold, it may be wise to place your ownership of any life insurance in an irrevocable life insurance trust.

Life insurance dividends

Whole life insurance policies can be eligible for dividends. If you buy a whole life insurance policy, find out whether it’s "participating" or "non-participating". Only participating policies can get dividends. A participating policy charges a higher premium and, in return, pays regular dividends to the policy owner. Non-participating policies pay no dividends, and premiums are usually lower than participating policies.

If you’re buying a participating policy, you can typically choose a dividend option. Here are some common dividend options:

• Dividend payment in cash: You can choose to receive any dividends as a cash payment. With this option, the insurance company will send you a check after every policy anniversary.
• Reduce your future premium payments: With this option, the insurance company automatically applies any dividends to reduce your future premiums. As dividends increase, your required premium payments decrease.
• Leave the dividends with the insurance company and collect interest: With this option, the dividend is retained by the insurance company and earns interest in a dividend accumulation account. There is a minimum guaranteed interest rate, but you might get an even higher interest rate.
• Buy paid-up additional life insurance: You could use your dividends to purchase small amounts of completely paid-up additional life insurance. This additional life insurance will be the same type of life insurance as your original policy.
• Buy one-year term life insurance: You could use your dividend money to purchase as much one-year term life insurance coverage as possible. The amount of coverage you can get will be based on your age and how much dividend money you have.

Frequently asked questions