Life Insurance: Gift Tax Implications Explained

Life insurance policies can be a great way to provide financial security for your loved ones after your death. But what happens when it comes to taxes?

In most cases, life insurance proceeds are not taxable, and beneficiaries will receive the death benefit without having to pay any taxes on it. However, if the life insurance is left to anyone other than your spouse, the proceeds may be subject to estate taxes. This is where things can get a little complicated.

The federal estate tax only affects unmarried people who leave an estate worth more than a certain amount (which was $13.61 million in 2024) and married couples leaving an estate worth more than double that amount. If your estate falls into one of these categories, you may want to consider transferring ownership of your life insurance policy to another person or entity, such as an irrevocable life insurance trust (ILIT). This way, the proceeds won't be included in your taxable estate. But be careful, because transfers made within three years of death are still subject to federal estate tax.

There are also gift taxes to consider when transferring ownership of a life insurance policy. The IRS considers the transfer of a life insurance policy as a gift, and depending on the policy's worth, it could be taxed. The gift tax exclusion for 2024 is $18,000, so if the fair market value of the policy is more than this amount, gift taxes will be assessed.

Gifting a life insurance policy to a spouse

Understanding Life Insurance Gifts

Life insurance policies can be given as gifts to spouses or other loved ones. This can be done by either designating the spouse as the beneficiary of an existing policy or by purchasing a new policy for them. When you gift a life insurance policy, you are essentially transferring ownership of the policy to the recipient. This means they will receive the death benefit and have the right to make policy changes, name beneficiaries, etc.

Tax Implications of Gifting a Life Insurance Policy to a Spouse

Additionally, it's important to be mindful of the three-year rule. According to the IRS, if you pass away within three years of transferring your life insurance policy to your spouse, the proceeds will be included in your estate, and gift taxes will apply. This rule helps prevent people from avoiding estate taxes by transferring assets shortly before their death.

Benefits of Gifting a Life Insurance Policy to a Spouse

• Financial protection: Life insurance provides financial security for your spouse in the event of your death.
• Peace of mind: Your spouse will have the reassurance of knowing that they will be taken care of financially.
• Premium rates: Locking in a premium rate early can provide long-term savings for your spouse.
• Opportunities for the future: The death benefit from a life insurance policy can be used by your spouse for various purposes, such as paying off a mortgage or covering college tuition.

Considerations Before Gifting a Life Insurance Policy to a Spouse

Before gifting a life insurance policy to your spouse, there are a few things to keep in mind:

• Loss of control: Once you transfer ownership of the policy, you will no longer have any power over it. You cannot cancel the transfer or change the beneficiary.
• Tax implications: Be sure to consult with a tax professional to understand the potential tax consequences, including gift taxes and estate taxes.
• Spousal agreement: It's important to discuss this decision with your spouse and ensure they are comfortable with the arrangement.

Transferring ownership of a life insurance policy

Reasons for Transferring Ownership

The most common reasons for transferring ownership of a life insurance policy are estate tax savings and business considerations. Transferring ownership can help reduce estate taxes by removing the policy proceeds from the insured's taxable estate. In business situations, ownership may be transferred to provide financial security for business partners or employees.

Methods of Transferring Ownership

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

• Transferring Ownership to Another Person: This involves transferring ownership of the policy to another adult, including the policy beneficiary. Once transferred, the original owner loses all power over the policy and cannot make any changes or cancel the transfer. It is important to choose a competent adult or entity as the new owner and ensure proper assignment or transfer of ownership forms are completed.
• Creating an Irrevocable Life Insurance Trust (ILIT): The insured can establish an ILIT and transfer ownership of the policy to the trust. This allows the insured to maintain some legal control over the policy and ensure prompt payment of premiums. The trust must be irrevocable, meaning the grantor cannot alter it. The insured cannot be the trustee, and certain time requirements must be met for the transfer to be effective.

Tax Implications

• Gift Taxes: Transferring a life insurance policy is considered a gift by the IRS, and if the policy has a fair market value above a certain threshold ($18,000 in 2024), gift taxes may apply. The gift tax is typically due at the time of the original policyholder's death if the estate exceeds the federal gift and estate tax exemption.
• Estate Taxes: If the insured passes away within three years of transferring the policy, the proceeds may be included in their taxable estate, and federal estate taxes may apply. This is known as the three-year rule. To avoid this, it is advisable to transfer the policy as soon as feasible. Additionally, the original owner must relinquish any "incidents of ownership," such as the right to change beneficiaries, borrow against the policy, or cancel it.
• Income Taxes: When a life insurance policy is sold or transferred for value, the proceeds may be subject to income tax. This applies to any amount exceeding the cost of transferring ownership and subsequent premium payments made by the new owner.

Avoiding Tax Pitfalls

To avoid potential tax pitfalls when transferring ownership of a life insurance policy:

• Consult an Attorney: Before initiating a transfer, it is advisable to consult an attorney to understand the implications and options fully.
• Choose the Right New Owner: Select a competent adult or entity as the new owner. Consider choosing someone with whom you have a close and trusting relationship, such as a spouse or adult child.
• Obtain Written Confirmation: Obtain written confirmation from the insurance company to ensure the ownership change is properly documented.
• Comply with IRS Rules: Be mindful of IRS rules regarding "incidents of ownership." Relinquish any rights to make changes to the policy, and refrain from paying premiums to avoid the IRS considering the proceeds as part of your taxable estate.
• Consider an ILIT: If there is no suitable individual to transfer ownership to, consider establishing an ILIT to maintain legal control over the policy and ensure prompt payment of premiums.

In conclusion, transferring ownership of a life insurance policy can be a complex process with significant tax implications. It is important to seek professional advice, understand the applicable tax rules, and carefully consider the new owner or entity to ensure a smooth transfer and minimize potential tax burdens.

Life insurance trusts

There are several benefits to setting up a life insurance trust. Firstly, it gives you control over who benefits from your pay-out and who manages it. Secondly, it speeds up the payout process as your loved ones don't have to wait for probate, which can take months to complete. Finally, it can help reduce the chance of an inheritance tax bill as the policy is no longer considered part of your estate.

To set up a life insurance trust, you need to transfer ownership of your life insurance policy to a trustee or trustees, who will then manage the policy and ensure the money goes to your chosen beneficiaries. It's important to note that you'll need at least two trustees who are over 18 and have a sound financial history. You also can't be the trustee yourself. The trust must also be irrevocable, meaning you can't change your mind or cancel it once it's set up.

There are a few different types of life insurance trusts, including absolute or 'bare' trusts, discretionary trusts, flexible trusts, split trusts, and survivor's discretionary trusts. Each type offers different levels of flexibility in terms of changing beneficiaries and their shares of the trust.

While setting up a life insurance trust can be advantageous, there are also some potential downsides to consider. One of the main disadvantages is that it can be difficult and risky to make changes to the trust once it's established. Additionally, there may be tax implications if you move a life insurance policy into a trust and change the beneficiary.

Gift taxes

The donor is generally responsible for paying the gift tax. However, under special arrangements, the donee may agree to pay the tax instead. The gift tax applies to any transfer to an individual, direct or indirect, where full consideration (in money or money's worth) is not received in return.

There are some exceptions to the rule that any gift is a taxable gift. These include:

• Gifts that are not more than the annual exclusion for the calendar year.
• Tuition or medical expenses you pay for someone (the educational and medical exclusions).
• Gifts to your spouse.
• Gifts to a political organization for its use.
• Gifts to qualifying charities are deductible from the value of the gift(s).

The annual exclusion amount for 2024 is $18,000 per donee. This means that if you give each of your children $18,000 in 2024, the annual exclusion applies to each gift.

If you gift a life insurance policy, it could be considered a gift and therefore subject to gift tax. The IRS regards the transaction as a gift, and depending on the policy's worth, the transfer could be taxed.

If you transfer a policy with a fair market value of more than $18,000 to another person, gift taxes will be assessed. However, the gift tax won't have to be paid until your death and will only need to be paid if your estate exceeds the federal gift and estate tax exemption.

For example, if you transfer a policy with a fair market value of $28,000 to your son, under IRS rules, $10,000 (the amount over $18,000) is subject to gift tax. If you die four years later, and the insurance policy pays out $300,000, none of this amount is included in your federal taxable estate.

To avoid gift taxes on a life insurance policy, you can transfer ownership of the policy to another person or entity. Alternatively, you can create an irrevocable life insurance trust (ILIT) and transfer ownership to it.

Estate taxes

Life insurance proceeds are generally not subject to estate taxes if they are paid directly to a named beneficiary. In this case, the life insurance benefit is not considered part of the deceased's estate. However, if there is no named beneficiary, the proceeds may be paid to the estate, and estate taxes may apply if the total value exceeds the exemption threshold.

To avoid estate taxes on life insurance proceeds, it is important to name a beneficiary when setting up a life insurance policy. Additionally, transferring ownership of a life insurance policy to another person or entity, or creating an irrevocable life insurance trust, can also help reduce potential estate taxes.

It is worth noting that while life insurance proceeds are generally not subject to income taxes, there are certain scenarios where taxes may apply. For example, if the beneficiary chooses to receive the payout as an annuity, the interest accrued may be taxable. Similarly, if the policyowner withdraws or takes out a loan against the cash value of a whole life insurance policy, and the amount withdrawn exceeds the total premiums paid, the excess may be subject to income taxes.

Frequently asked questions