Understanding Tax Implications Of Life Insurance Gifts

Life insurance is a valuable gift that can provide financial security for your loved ones in the event of your death. While most life insurance payouts are tax-free, there are certain circumstances where the beneficiary may have to pay taxes on the proceeds. For instance, if the death benefit is paid out in instalments and accrues interest, the interest is taxable. Similarly, if the payout is made to the insured's estate instead of a specific individual, it may be subject to estate taxes. To avoid paying taxes on life insurance proceeds, you can transfer ownership of the policy to another person or entity, or set up an irrevocable life insurance trust (ILIT). It's important to understand the tax implications when considering gifting life insurance to ensure your loved ones receive the maximum benefit.

Naming your estate as the beneficiary of your life insurance policy

When you name your estate as the beneficiary, you lose the contractual advantage of naming a real person. This means that the financial product will be subject to the probate process, which can be lengthy and complicated. It may take years before your loved ones can access your assets.

Additionally, leaving items to your estate increases its value and could subject your heirs to exceptionally high estate taxes.

To avoid this, you can transfer ownership of your policy to another person or entity, such as an irrevocable life insurance trust (ILIT). By doing so, you can remove the policy from your estate, and the proceeds will not be included as part of your estate when you die.

Another option is to create a trust and name it as the beneficiary of your life insurance policy. Any assets included in a trust do not have to go through probate court. However, it is important to work with an estate planning attorney and a financial advisor to ensure that your belongings and the life insurance payout will be distributed according to your wishes.

It is also worth noting that if you do not name a beneficiary for your life insurance policy, the money will likely be transferred to your estate when you die and will be subject to the probate process. Therefore, it is essential to carefully consider who you want to receive the benefits of your policy and keep your beneficiary designations up to date.

Transferring ownership of your life insurance policy

There are three methods to transfer a policy's ownership:

• Absolute assignment: This involves transferring all rights and ownership of a life insurance policy from yourself to someone else or a legal entity. If you want to proceed with an absolute assignment, you must notify your insurer, who will provide you with the necessary ownership forms. This type of transfer is irrevocable.
• Collateral assignment: A collateral assignment allows you to use a life insurance policy you own to obtain a loan. Rather than putting up property, you can use the life insurance policy as security. If you die before repaying the loan, the bank will receive the funds from your policy to pay off your debts, and any remaining proceeds will go to your designated beneficiaries. Collateral assignment is temporary, and the original owner will regain control of the policy once the loan is repaid.
• Irrevocable life insurance trust (ILIT): An ILIT is a type of trust that owns a life insurance policy as its primary asset. Some people use ILITs to reduce or avoid estate taxes if they anticipate leaving a sizable taxable estate to their beneficiaries. The proceeds from the life insurance policy in the trust can be used by the trustee to purchase assets from the estate of the deceased, providing the necessary funds to pay the outstanding estate tax bill.

When considering an ownership transfer, it is important to remember the following guidelines:

• Choose a competent adult/entity to be the new owner (it may be the policy beneficiary).
• Obtain the proper assignment or transfer of ownership forms from your insurance company.
• New owners must pay the premiums on the policy. However, you can gift a certain amount per person each year, which the recipient could use to pay premiums.
• You will give up all rights to make changes to this policy in the future. However, if a child, family member, or friend is named the new owner, they can make changes at your request.
• Obtain written confirmation from your insurance company as proof of the ownership change.

It is also important to keep in mind 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 transfer ownership of your policy, you should do so sooner rather than later to ensure that three years pass before your death, so the asset doesn't count toward your estate.

Creating an irrevocable life insurance trust (ILIT)

To set up an ILIT, you need to understand the three parties involved: the grantor, the trustee, and the beneficiary/beneficiaries. The grantor is the person who creates and funds the trust—that's you. The trustee is the person or organisation that manages the trust and pays the insurance premiums. The beneficiary or beneficiaries are the people who will receive the trust's assets when the grantor dies.

When setting up an ILIT, it's important to remember that it is irrevocable. This means that you cannot change or revoke the trust once it is created—the terms are set in stone. You will also need to avoid any incidents of ownership of the life insurance policy. For example, any premium paid should come from a checking account owned by the ILIT.

There are a few potential downsides to creating an ILIT. Firstly, there may be gifting problems if the policy being transferred has a large accumulated cash value. Secondly, the ILIT may be subject to 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. Finally, setting up and maintaining an ILIT may require professional fees and the filing of a gift tax return.

Despite these potential drawbacks, an ILIT can be a powerful tool for reducing your tax burden and ensuring that your beneficiaries receive the maximum benefit from your life insurance policy.

Interest earned on the death benefit

For example, if the death benefit is $500,000, but it earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth. The death benefit itself is usually tax-free, but any interest accrued is taxable.

The IRS states that if the life insurance policy was transferred for cash or other assets, the amount that can be excluded from gross income when filing taxes is limited to the sum of the consideration paid, any additional premiums paid, and certain other amounts.

To avoid paying taxes on the interest, it is important to ensure that the proper documentation and reporting requirements are met in a timely manner.

Estate taxes

Firstly, if the beneficiary of a life insurance policy is listed as the estate itself, rather than a specific individual or entity, the proceeds will be included in the estate's value and may be subject to estate taxes. This is an important distinction, as naming your estate as the beneficiary can result in higher estate taxes for your heirs. Therefore, it is advisable to name a specific beneficiary to avoid this outcome.

Secondly, the ownership of the life insurance policy at the time of the insured's death is crucial in determining estate tax liability. If the insured person retains any "incidents of ownership" in the policy, such as the right to change beneficiaries, assign the policy, or borrow against it, the proceeds will be included in their taxable estate. To avoid this, a complete transfer of ownership to another person or entity is necessary. This transfer must be done at least three years before the insured's death to avoid estate taxes, according to the IRS's three-year rule.

Additionally, the size of the estate and the type of policy can impact estate tax liability. If the value of the estate, including the life insurance proceeds, exceeds the federal estate tax threshold (which was $13.61 million in 2024), estate taxes will apply to the amount over the limit. The type of payout structure can also affect taxation. Lump-sum payouts are generally tax-free, while multiple payments or annuities that include interest may be subject to taxes.

To summarise, careful estate planning is essential to minimise estate taxes on life insurance proceeds. This includes choosing specific beneficiaries, transferring ownership, and understanding the tax implications of different policy types and payout structures. By taking these steps, individuals can ensure that their heirs receive the maximum benefit from their life insurance policies.

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