Life Insurance And Estate Tax Returns: What's The Connection?

Life insurance is a useful tool for estate planning, and the proceeds are usually not taxable as income. However, there are certain situations where the beneficiary may be taxed on some or all of the proceeds. For example, if the beneficiary receives the payout in installments, they may have to pay taxes on the interest generated. Additionally, if the policyholder names their estate as the beneficiary, the value of the proceeds may be included in the estate's value, potentially subjecting heirs to high estate taxes. To avoid this, one can transfer ownership of the policy to another person or entity or set up an irrevocable life insurance trust (ILIT). While life insurance can be a valuable tool for estate planning and tax benefits, it is important to carefully consider the potential tax implications to make informed decisions.

Naming your estate as the beneficiary of a life insurance policy

When you name your estate as the beneficiary, you subject the life insurance policy to the probate process. This means that instead of being immediately dispersed as outlined in your will, your estate and assets will first go through probate court, where a judge will determine what debts you owe. If you have any outstanding debts, creditors will be able to collect repayment from your estate before the remaining funds are dispersed according to your wishes.

In contrast, when the life insurance death benefit is paid directly to your beneficiaries, it bypasses probate court. This means that creditors cannot collect from your life insurance policy if they are not listed as beneficiaries, regardless of the debts you owe. By listing your loved ones as beneficiaries, you ensure that they are able to claim the death benefit directly.

Another option for connecting your life insurance policy to your estate is by setting up a trust. Assets included in a trust do not need 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 are distributed according to your wishes.

It's also worth noting that if you don't name a beneficiary for your life insurance policy, the proceeds will become part of your estate after your death. This could result in a delay in your family receiving the money and could be used to pay off any large debts you leave behind. Therefore, it is generally advisable to name specific beneficiaries to ensure that your loved ones receive the financial protection you intended for them.

Overall, while naming your estate as the beneficiary of a life insurance policy may seem like a convenient option, it's important to consider the potential drawbacks, including the impact of probate court and the potential for higher estate taxes. Seeking professional advice can help ensure that your life insurance policy aligns with your overall estate planning goals and that your beneficiaries are protected.

Estate tax exemption limits

The estate tax is a tax on your right to transfer property at your death. The fair market value of these items is used to calculate your "Gross Estate". Once you have accounted for the Gross Estate, certain deductions are allowed to arrive at your "Taxable Estate". After the net amount is computed, the value of lifetime taxable gifts is added to this number and the tax is computed. The tax is then reduced by the available unified credit.

The Tax Cuts and Jobs Act (TCJA) of 2017 determined the exemption amount at above $12.06 million for 2022 ($12.92 million for 2023), while maintaining the top rate of 40%. The TCJA also increased the gift and estate tax exemption significantly. The exemption applies to gifts and estate taxes combined—any portion of the exemption used for gifting will reduce the amount that can be used for the estate tax. The IRS refers to this as a "unified credit". Each donor has a separate lifetime exemption that can be used before any out-of-pocket gift tax is due. In addition, a couple can combine their exemptions.

The $13.61 million exemption is temporary and only applies to tax years up to 2025. Unless Congress makes these changes permanent, after 2025 the exemption will revert to the $5.49 million exemption (adjusted for inflation).

Avoiding estate taxes with an irrevocable life insurance trust (ILIT)

An irrevocable life insurance trust (ILIT) is a trust that cannot be altered, amended, or undone once it has been created. It is created during the insured's lifetime and owns and controls a term or permanent life insurance policy. It also manages and distributes the proceeds that are paid out upon the insured's death, according to their wishes.

The parties in an ILIT are the grantor, trustees, and beneficiaries. The grantor typically creates and funds the ILIT, giving up control to the trustee, who manages the trust, while the beneficiaries receive distributions. It is important for the grantor to avoid any incident of ownership in the life insurance policy, and any premium paid should come from a checking account owned by the ILIT.

ILITs are a useful tool for minimizing estate taxes. If the owner and insured, the death benefit of a life insurance policy will be included in the gross estate. However, when an ILIT owns the policy, 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.

To avoid estate taxes, it is crucial to establish the ILIT at least three years before the insured's death. This is because, if the grantor dies within three years of transferring an existing life insurance policy to the ILIT, the death benefit could be included in their estate. This is known as the three-year rule.

In addition to minimizing estate taxes, ILITs offer several other advantages, including asset protection, distribution control, and legacy planning. They can also be used to protect government benefits for beneficiaries who are receiving aid, such as Social Security disability income or Medicaid. The trustee can carefully control how distributions are used to ensure that the beneficiary's eligibility for government benefits is not affected.

While ILITs offer many benefits, there are some drawbacks to consider. Once an ILIT is finalized, no changes can be made, and the grantor loses control of the assets. Additionally, while ILIT assets are not taxed as part of the grantor's estate, they are taxed as part of the beneficiaries' estates, leaving a larger tax burden for their descendants.

Tax consequences of surrendering your life insurance policy

Surrendering your life insurance policy means giving up your coverage and, in some cases, owing taxes. Here are the key tax consequences to consider:

Cash Surrender Value Taxability

The cash surrender value of a life insurance policy is generally taxable. This value is the amount you receive when you surrender your policy to the insurer. If you receive more funds than the policy's cost basis (the total premiums paid), the excess amount is typically taxed as income.

Outstanding Policy Loans

If you have any outstanding policy loans that exceed the policy's cost basis when you surrender it, you may face tax consequences.

Changes to Your Cost Basis

Any changes to your cost basis during the policy term can trigger tax implications. For example, if you reduce the death benefit or add riders, and then surrender the policy, the amount received over the adjusted cost basis may be taxable.

Timing of Surrender

The timing of your policy surrender can impact the cash surrender value. Surrendering the policy earlier in the term may result in a lower cash value and potential surrender charges. On the other hand, surrendering later can lead to a larger payout and fewer fees.

Interest Accumulation

If the beneficiary of a life insurance policy receives the benefit after a period of interest accumulation rather than immediately, they must pay taxes on the interest accrued. This is an important consideration if you plan to delay the benefit payout, as it will impact the total amount received by the beneficiary.

Estate Taxes

Naming your estate as the beneficiary of a life insurance policy can have unintended tax consequences. This approach subjects the proceeds to the probate process and increases the estate's value, potentially resulting in higher estate taxes for your heirs.

Ownership Transfer

To avoid federal taxation on life insurance proceeds, you can transfer ownership of the policy to another person or entity. This strategy requires careful consideration, as it involves giving up your rights to make changes to the policy. It is also essential to obtain written confirmation of the ownership change from your insurance company.

Irrevocable Life Insurance Trusts (ILITs)

Another option to remove life insurance proceeds from your taxable estate is to set up an ILIT. This approach allows you to maintain some legal control over the policy while ensuring prompt premium payments. However, you cannot be the trustee of the trust and must give up any rights to revoke it.

Tax Reporting and Consulting

Receiving a large payout from surrendering your life insurance policy may trigger tax consequences. It is essential to consult with a tax expert to ensure proper reporting and compliance with tax regulations. Additionally, a financial advisor can guide you in investing or saving your funds appropriately.

Tax-free cash withdrawal from life insurance policies

Life insurance policies can be a valuable source of funds in certain situations, such as when you need to cover a major one-time expense or ongoing everyday expenses. However, it's important to understand the tax implications and potential downsides before making a withdrawal.

Types of Cash Withdrawals

There are four main ways to withdraw cash from a life insurance policy:

• Withdraw: Take a withdrawal from the policy, usually distributed as a lump sum or in payments.
• Borrow: Take a loan from the insurance provider, using the policy as collateral, and then pay it back.
• Surrender: Cancel the policy and receive the surrender value in cash.
• Sell: Sell the policy to a life settlement company, which will then keep the policy in force and receive the death benefit when you die.

Tax Implications of Withdrawals

The tax implications of withdrawing cash from a life insurance policy depend on various factors, including the type of policy and the specific circumstances of the withdrawal. Here are some key points to consider:

• Withdrawals from a life insurance policy are generally not taxable up to your basis in the policy. Your basis is typically the amount of premiums you have paid into the policy, minus any prior dividends or withdrawals.
• However, if you withdraw more than your basis, the excess amount may be subject to income tax. This is because the earnings in your policy grow tax-deferred, so they become taxable when you withdraw them.
• Withdrawals from certain types of policies, such as modified endowment contracts (MECs), may be subject to different tax rules. Withdrawals from MECs are generally taxed according to the rules for annuities, and early withdrawals may also incur a 10% penalty if you're under a certain age.
• If you borrow money from your life insurance policy, the borrowed amounts from non-MEC policies are typically not taxable. However, any unpaid loan balance will reduce your policy's death benefit.
• Surrendering your policy for cash may also have tax implications. The gain on the policy is generally subject to income tax, and there may be additional taxes if you have an outstanding loan balance.
• Selling your policy to a life settlement company can result in tax liabilities, and the proceeds may affect your eligibility for certain programs like Medicaid.

Factors to Consider

When considering a tax-free cash withdrawal from a life insurance policy, it's important to keep the following factors in mind:

• Type of Policy: Different types of policies, such as whole life or universal life, have different rules and restrictions on withdrawals. Some policies may not allow withdrawals at all.
• Timing: Withdrawals made during the early years of a policy may be subject to additional restrictions or fees. For example, withdrawals within the first 15 years of a policy may have tax consequences if they reduce the policy's death benefit.
• Impact on Death Benefit: Withdrawals, loans, and surrenders can reduce the death benefit that your beneficiaries will receive. It's important to consider the potential impact on your beneficiaries before making any withdrawals.
• Tax Rules: Stay informed about federal and state tax rules that may affect the taxability of withdrawals, especially if your policy is classified as an MEC.
• Alternatives: Explore alternative options for accessing funds, such as borrowing against your 401(k) or taking out a personal loan, to determine the most tax-efficient and financially prudent approach for your situation.

Frequently asked questions