Life Insurance Proceeds: Tax-Free Transfer For Beneficiaries

Life insurance proceeds are generally not taxable, but there are exceptions. For instance, if the payout causes the estate's worth to exceed $13.61 million, heirs might be charged estate taxes. Additionally, beneficiaries might pay taxes if they receive the payout in instalments or if the policy is owned by a third party. Interest earned on proceeds is also taxable. To avoid taxation, some individuals transfer ownership of their policy or create an irrevocable life insurance trust (ILIT).

Naming your estate as beneficiary

Life insurance is a smart estate planning tool that enables you to provide for your family and loved ones financially after you pass away. When purchasing a life insurance policy, one of the most important steps is designating a beneficiary to receive the proceeds of your policy following your death. While this may seem like a relatively simple decision, naming the right beneficiaries on life insurance can be challenging and mistakes can be costly and time-consuming for the ones you leave behind.

One common mistake is naming your estate as the beneficiary of your life insurance policy. By listing your estate as the beneficiary, the proceeds become an asset of the probate estate and are subject to the claims of creditors. Probate will be required to collect and distribute the assets, which can take months. Life insurance proceeds that are paid to your estate are then subject to all of the costs associated with settling an estate, including taxes, administrative costs, attorney fees, executor fees, etc.

Additionally, by leaving the benefits of your life insurance policy to your estate, you open up the opportunity for creditors to collect from those proceeds to satisfy their claims. That means your life insurance proceeds could be used to pay off any outstanding debts you may have at the time of your death prior to distribution to the beneficiaries of your estate.

In many states, life insurance proceeds are exempt from the claims of creditors when there is a named beneficiary, but not when your estate is the named beneficiary. Therefore, instead of naming your estate as the beneficiary, a better plan may be to name a trust. Proceeds distributed to a carefully constructed trust will be shielded from the claims of creditors and will not be included in the probate estate.

Interest on proceeds

Life insurance proceeds are generally not taxable, but there are some situations in which the beneficiary may be taxed on the interest accrued on the proceeds.

If the beneficiary receives the life insurance payout in installments, the insurer typically holds the principal amount in an interest-bearing account. While the original life insurance death benefit is usually not taxable, the interest that accumulates on the death benefit is subject to income tax.

For example, if the death benefit is $500,000 but earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth. The beneficiary will not be taxed on the entire benefit, but only on the interest.

In the case of a life insurance policy with a cash value component, such as whole life insurance, the cash value is tax-deferred. This means that the policyholder will not pay taxes on the cash value as long as the policy is active. However, if the policy is surrendered or cancelled, the cash value that exceeds the amount paid in premiums will be taxable as income.

It is important to note that the rules and regulations regarding life insurance proceeds and taxation can be complex and may vary depending on the jurisdiction. It is always advisable to consult with a tax professional or financial advisor to understand the specific implications for your situation.

Estate taxes

• Naming the Estate as Beneficiary: If you name your estate as the beneficiary of your life insurance policy, the proceeds will be included in your estate, increasing its value and potentially subjecting your heirs to higher estate taxes. It is advisable to name specific individuals as beneficiaries to avoid this issue.
• Inclusion in Taxable Estate: According to Section 2042 of the Internal Revenue Code, the value of life insurance proceeds is included in your gross estate if payable to your estate or if you possessed any incidents of ownership in the policy at the time of your death. Incidents of ownership include rights to change beneficiaries, assign or revoke the policy, borrow against it, or surrender or cancel it.
• Federal Estate Tax Exemption: The federal estate tax exemption limit for 2024 is $13.61 million for an individual. If the total taxable value of your assets, including life insurance proceeds, exceeds this amount, the IRS will levy an estate tax.
• State Estate and Inheritance Taxes: In addition to federal estate taxes, some states impose their own estate or inheritance taxes with varying exemption limits. It is important to consult a tax professional to understand the specific state regulations that may apply.
• Reducing Estate Taxes: One way to reduce potential estate taxes is by transferring ownership of life insurance policies to an irrevocable life insurance trust (ILIT). This removes the proceeds from your taxable estate, but it is important to follow the rules and regulations governing such transfers, including the three-year rule, which states that transfers made within three years of death are still subject to federal estate tax.
• Spousal Exemption: Proceeds left to a spouse are typically exempt from estate tax, even if they exceed the federal limit.

Policy ownership transfer

Life insurance proceeds are generally not subject to income or estate taxes. However, there are certain situations where the proceeds may be taxable. For example, if the payout causes the estate's worth to exceed the federal estate tax exemption limit, heirs might be charged estate taxes.

One way to avoid this is by transferring ownership of the life insurance policy to another person or entity. Here are the steps to do so:

Choose a Competent Adult/Entity as the New Owner

The new owner can be the policy beneficiary. It is important to choose someone competent who will be responsible for making premium payments.

Obtain the Proper Forms from the Insurance Company

Contact your insurance company to request the appropriate assignment or transfer of ownership forms.

Understand the Rights You Will Give Up

Once the transfer is complete, you will give up all rights to make changes to the policy in the future. However, if the new owner is a child, family member, or friend, they can make changes at your request. It is important to note that transferring ownership is an irreversible event, so caution is advised in certain situations, such as divorce.

Ensure the New Owner Pays the Premiums

While you can gift the new owner an amount up to the annual gift tax exclusion to help cover premium payments, it is important that they make the payments themselves. If you continue to make the payments, the IRS may view this as evidence that you are still the true owner, and the proceeds could be included in your estate for tax purposes.

Obtain Written Confirmation from the Insurance Company

Once the transfer is complete, obtain written confirmation from your insurance company as proof of the ownership change.

In addition to transferring ownership to another person, you can also create an irrevocable life insurance trust (ILIT) to remove life insurance proceeds from your taxable estate. With an ILIT, you cannot be the trustee, and you must give up any rights to revoke the trust. The policy will be held in trust, and you will no longer be considered the owner.

Irrevocable life insurance trust (ILIT)

An Irrevocable Life Insurance Trust (ILIT) is a legal arrangement that helps individuals minimise their current tax burden and the impact of taxes on their estate. It does this by transferring assets from the individual to the trust, which then uses a life insurance policy to distribute the proceeds to beneficiaries when the individual passes away.

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. If the policy were not created under an ILIT, any insurance benefits plus other assets of the insured above the applicable exclusion amount could trigger both state and federal estate taxes.

The three legal parties involved in an ILIT are:

• The grantor: the person who creates and funds the trust
• The trustee: the individual or organisation that manages the trust and is responsible for paying annual insurance premiums and overseeing trust administration
• The beneficiary(ies): the individual(s) who will receive the trust assets upon the grantor's death

There are several benefits to setting up an ILIT, including:

• Tax benefits: ILITs can help lower an individual's current tax burden by removing taxable assets from their current portfolio.
• Estate planning: ILITs provide a tax-efficient way to transfer wealth to beneficiaries outside of the taxable estate. They can also help cover estate taxes and other expenses after death, preventing the need to sell high-value assets.
• Asset protection: When the policy is held in an ILIT, any excess value above the state-defined limits is generally protected from the creditors of both the grantor and the beneficiary.
• Government benefit protection: For those seeking to provide lifetime care for a family member with special needs, an ILIT can help ensure that inherited assets don't interfere with the beneficiary's eligibility for government benefits.
• Legacy benefits: Transferring ownership of a life insurance policy to a trust can make it easier for beneficiaries to qualify for Medicaid and other government assistance programs.

The main downside of an ILIT is that it is irrevocable. This means that the trust cannot be modified without legal action or the consent of the beneficiaries. Additionally, establishing this type of trust requires the grantor to give up all rights to the property in the trust, including who the trust beneficiaries are and the circumstances under which they receive the assets.

Frequently asked questions