Life Insurance, Estate Tax, And Basis: What's The Link?

Life insurance is a big step for anyone, and it's crucial to understand how it will be taxed. The proceeds of a life insurance policy can be included in your estate and may be subject to estate tax, depending on the ownership of the policy and the size of the estate. The easiest way to avoid this is to transfer ownership of the policy to someone else or to a trust. However, if you transfer ownership within three years of your death, the proceeds will still be taxed as part of your estate. Additionally, if you retain any incidents of ownership, such as the power to change beneficiaries or cancel the policy, the IRS may still consider you the owner for tax purposes. It's important to note that the proceeds are generally not subject to income tax and that placing your policy into a trust can help mitigate inheritance tax.

Life insurance proceeds can be subject to estate tax

If you fall into either of these categories, you may want to consider the following methods to avoid your life insurance proceeds being taxed.

Transferring Ownership to Another Person

One way to avoid federal estate tax on your life insurance proceeds is to transfer ownership of the policy to another person or entity. This method involves a trade-off: once the transfer is complete, you lose all power over the policy. You cannot cancel the transfer or change the beneficiary.

Life Insurance Trusts

Another way to avoid federal estate tax is to create an irrevocable life insurance trust (ILIT) and transfer ownership of the policy to the trust. The trust must be irrevocable, meaning that its terms cannot be changed after it is signed. The grantor cannot be the trustee, and the trust must be created at least three years before the grantor's death.

Leaving the Insurance Proceeds to Your Spouse

If you leave all your property, including insurance proceeds, to your spouse, it is not subject to estate taxes when you die. Your life insurance proceeds would only be taxed as part of your estate if your estate is over the tax threshold, the beneficiaries are people other than your spouse, or you haven't successfully transferred the policy.

The taxable estate includes proceeds from policies owned by the deceased

To avoid having life insurance proceeds included in the taxable estate, individuals can consider transferring ownership of the policy to another person or entity. This can be done by transferring ownership to another adult, including the policy beneficiary, or by creating an irrevocable life insurance trust (ILIT). It is important to be aware of the tax implications of such transfers, including potential gift taxes. Additionally, transfers made within three years of death may be disallowed for federal estate tax purposes, and the proceeds may still be included in the taxable estate.

By planning ahead and understanding the applicable tax laws, individuals can make informed decisions about their life insurance policies and potentially reduce the tax burden on their estate.

Transferring ownership of a policy can reduce estate tax liability

Transferring ownership of a life insurance policy can be a smart move to reduce your estate tax liability. Here's how it works:

How Transferring Ownership Reduces Estate Tax Liability

Only the assets you own or control at the time of your death are considered part of your taxable estate. Therefore, transferring ownership of your life insurance policy to someone else means that it won't be counted towards your estate after your death, potentially reducing the estate tax liability. This is especially beneficial if your estate is already subject to estate tax, as the full amount of your life insurance policy will be included and taxed when you die. However, if you transfer the policy before your death, only the amount the policy was worth will be taxed at the applicable rate.

Two Methods to Transfer Ownership of a Life Insurance Policy

There are two common methods to transfer ownership of a life insurance policy:

• Transferring Ownership to Another Adult: This involves transferring ownership of the policy directly to another adult, including the policy's named beneficiary. This method is generally simpler than setting up a trust, but it is irreversible. Once the transfer is complete, you lose all power over the policy and cannot cancel the transfer or change the beneficiary.
• Creating an Irrevocable Life Insurance Trust (ILIT): With this method, you transfer ownership of the policy to an irrevocable trust. You must not be the trustee of this trust, and the trust must be created at least three years before your death. This method allows you to maintain some control over the policy and ensure that premiums are paid promptly.

Important Considerations

When considering transferring ownership of a life insurance policy, keep the following in mind:

• The Three-Year Rule: The IRS has a three-year rule that applies to transferring ownership of life insurance policies. The transfer must take place at at least three years before the original owner's death and be made without any consideration. If the owner dies within three years of the transfer, the proceeds from the policy will be included in the decedent's estate for tax purposes.
• Retaining 'Incidents of Ownership': After transferring ownership, the original owner must not retain any "incidents of ownership," which refers to significant power over the policy. This includes the right to cancel, surrender, or convert the policy, change beneficiaries, borrow against the policy, or select the method of payment. Retaining any of these rights may result in the IRS counting the policy as part of the estate for tax purposes.
• Gift Tax Considerations: Transferring a permanent life insurance policy may trigger a gift tax, depending on the policy's worth. The gift tax will be assessed if the fair market value of the policy exceeds the annual exemption amount ($18,000 in 2024). However, the gift tax will only be payable if the owner's estate exceeds the federal gift and estate tax exemption when they die.

The three-year rule applies to ownership transfers before death

The three-year rule is a provision of the U.S. Internal Revenue Code that determines the assets included in a decedent's gross estate. It applies to transfers of ownership of life insurance policies before death. If the original owner of the policy dies within three years of transferring ownership, the proceeds from the policy are included in the decedent's estate for tax purposes. This is true regardless of whether the policy was transferred to another individual or to an irrevocable life insurance trust (ILIT).

The three-year rule was enacted by Congress to discourage attempts to avoid estate taxes by transferring property when death is imminent. It applies to transfers of property, including gifts of life insurance proceeds, where the decedent retained certain powers or ownership interests. The rule requires that the transfer must take place within three years of the original owner's death and be made without any consideration.

The IRS will consider the proceeds from the policy as part of the decedent's estate if the person covered by the policy retains any "incidents of ownership" after the transfer. Incidents of ownership include the power to cancel, surrender, or convert the policy, use the policy as collateral, change the beneficiary, or select the method of payment.

To avoid the three-year rule, individuals can sell their life insurance policy to the ILIT for its full fair market value rather than gifting it. This is because the rule applies to gifts of life insurance policies but not to outright sales.

An irrevocable life insurance trust can remove proceeds from the taxable estate

An irrevocable life insurance trust (ILIT) is a powerful tool for reducing or eliminating estate taxes on life insurance proceeds. Estate taxes can consume up to 55% of life insurance proceeds, so it is essential to consider strategies to minimise this tax burden.

An ILIT is specifically designed to hold and own life insurance policies. The trust owns the life insurance policy, ensuring the proceeds are outside of the individual's taxable estate. The settlor (owner of the life insurance policy) transfers their life insurance policies to the trustee, who manages the trust and its distributions. The settlor must be prepared to relinquish control as they cannot be the trustee or a beneficiary, though their children can be beneficiaries.

The key benefit of an ILIT is that it removes the proceeds from the taxable estate. When the trust receives death benefits, it can transfer the funds to the beneficiaries without the proceeds being taxed as part of the estate. This allows the settlor to keep assets intact for their beneficiaries and can be particularly useful for real estate holdings.

Additionally, an ILIT can be used to manage and distribute proceeds according to the insured's wishes. It can also protect government benefits for beneficiaries, such as Social Security disability income or Medicaid, by carefully controlling distributions.

It is important to note that if the settlor dies within three years of transferring their life insurance policy to the ILIT, the IRS will pull the proceeds back into the estate, and they will be taxed if they increase the value. This "three-year rule" aims to prevent deathbed transfers solely for tax avoidance.

While an ILIT offers significant benefits, it is essential to consult an attorney or financial advisor to determine if it is suitable for an individual's specific circumstances.

Frequently asked questions