Life Insurance Trust Taxation: What You Need To Know

Life insurance proceeds are usually not taxable as income, but they can be taxed as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. One way to avoid this is to set up an irrevocable life insurance trust (ILIT). In this scenario, the grantor transfers ownership of the policy to the trust and cannot be the trustee, but they can determine the trust beneficiary. The trust becomes both the owner of the policy and the beneficiary of the death benefit. When the insured person dies, the trust documents dictate that the assets in the trust, including the life insurance benefit, go to the beneficiaries named in the trust document. These assets are now estate tax-free.

Estate tax exemption

Life insurance death benefits are not taxable as income. However, they may be included as part of your taxable estate for estate tax purposes. This is determined by Section 2042 of the Internal Revenue Code, which states that the value of life insurance proceeds insuring your life is included in your gross estate if the proceeds are payable:

• To your estate, either directly or indirectly
• To named beneficiaries if you possessed any incidents of ownership in the policy at the time of your death

If your beneficiary is your spouse, the life insurance payout is not taxed and will be passed on to them fully, along with the rest of your estate that was left to them. Spouses typically have an unlimited exemption with regards to estate taxes.

If your beneficiary is anyone other than your spouse, such as a child or parent, your life insurance payout will typically be added to the value of your estate. If the total value of your estate is less than the exemption level, you won't need to pay any estate taxes. However, if your estate's value exceeds the exemption level, any amount over the exemption will be subject to estate and inheritance taxes.

The exemption amount for 2022 was $12.06 million for individuals, with a top tax rate of 40%. In 2023, the exemption amount rose to $12.92 million. It's important to note that not all estates are subject to taxes. Additionally, there are state-level estate taxes in some states, which have different exemption thresholds and tax rates.

One way to avoid or reduce estate taxes on life insurance proceeds is to set up an irrevocable life insurance trust (ILIT). By transferring ownership of the policy to an ILIT, you can remove the death benefit from your taxable estate. However, it's important to be mindful of 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 pass away within three years of transferring the policy to the trust, the proceeds will be included in your estate and taxed accordingly.

Irrevocable life insurance trust (ILIT)

An Irrevocable Life Insurance Trust (ILIT) is a legal entity that can be used to preserve family wealth by providing several financial and legal advantages. It is a type of trust that holds one or more life insurance policies and is funded during the lifetime of the grantor.

ILITs are often used to mitigate estate taxes. By transferring ownership of a life insurance policy to an ILIT, the policy can be excluded from the grantor's taxable estate, thereby avoiding federal estate taxes. This is particularly beneficial for high-net-worth individuals as it allows them to remove tax liabilities from their estate. Additionally, the trust transfer can be treated as a present gift, which may not be taxed, instead of a future gift, which would be taxed.

Another advantage of ILITs is the protection of assets. The trust structure shields the insurance benefits from creditors, divorce, and legal action against the grantor and beneficiaries. It also helps preserve eligibility for beneficiaries who receive asset-dependent benefits from the government, such as Social Security Disability Income or Medicaid.

ILITs offer control over distributions, allowing the grantor to structure the distribution of assets to beneficiaries according to their specific needs and milestones. This ensures that the beneficiaries receive the funds as intended and provides peace of mind to the grantor.

Furthermore, ILITs are useful for planning generational legacies. They can provide for future generations, including those not yet born, and help them inherit wealth in a tax-efficient manner. The trust can also be used to protect an inheritance for a minor child or an adult child who may lack financial maturity, ensuring the funds are managed and controlled until the beneficiaries reach adulthood.

While ILITs offer significant benefits, it is important to consider the trade-offs. One of the main downsides is the irrevocable nature of the trust, which means the grantor gives up all rights to the property and cannot modify the trust without legal action or the consent of the beneficiaries. This loss of personal use of the policy should be carefully weighed against the advantages of the trust structure.

Additionally, there may be costs associated with setting up and maintaining an ILIT, including professional fees and gift tax returns. It is important to consult with legal and tax professionals to determine if an ILIT is the right choice for an individual's specific situation and goals.

Tax liabilities

Life insurance proceeds are generally not taxable as income, but they can be taxed as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. The federal estate tax exemption is $12.06 million per individual in 2022, increasing to $12.92 million in 2023, and $10 million in 2018. State estate tax exemption thresholds vary, ranging from $1 million to $7 million.

If you are married and your spouse is the beneficiary of your life insurance policy, there is no estate tax on the insurance proceeds when you pass away. However, when your spouse passes away, any remaining proceeds in their name are subject to estate tax. An insurance trust can shelter the insurance proceeds from eventual estate taxes, ensuring that the proceeds are not included in your estate for tax purposes.

To avoid estate taxes, you can set up an irrevocable life insurance trust (ILIT). You transfer ownership of the policy to the ILIT and cannot be the trustee, but you can choose the trust beneficiary. While the trust owns the insurance policy, it can be excluded from your taxable estate, and therefore not subject to federal estate taxes. However, if the cash value of the life insurance policy is greater than the gift tax exemption, you may need to pay a gift tax when transferring ownership. Additionally, if you pass away within three years of transferring the policy to the trust, the policy will likely be considered part of your estate for tax purposes.

Life insurance proceeds paid to trusts are generally subject to estate tax, and may not qualify for the inheritance tax exemption provided by some states for insurance payable to a named beneficiary. In such cases, a higher tax may be owed. For this reason, it often makes more sense to name beneficiaries individually on life insurance policies, unless the beneficiaries have creditor issues, mental health problems, or other specific circumstances.

If you decide to cancel your policy and withdraw the cash value, or sell your policy in a life insurance settlement, you may be subject to income and capital gains taxes. The tax treatment of life insurance proceeds can be complex, and it is recommended to consult with a financial professional or estate planning attorney to understand the specific tax implications for your situation.

Income tax

Life insurance proceeds are usually not taxable as income, but they can be taxed as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. If you decide to get rid of your policy through a life insurance settlement or by surrendering it to your insurer, you may face income and capital gains taxes.

If you receive life insurance proceeds as a beneficiary due to the death of the insured person, this money is typically not taxable as income. However, if you receive interest on the proceeds, this interest is taxable as income.

If you have permanent life insurance, the policy has a cash value component that grows over time. The cash value is tax-deferred, and you can take a tax-free loan from the insurer using this cash value as collateral, as long as the loan does not exceed the cash value. However, if the loan amount does exceed the cash value, the policy might lapse, and you would have to pay taxes on the loan.

If you have permanent life insurance from a mutual insurance company, you may periodically receive dividends that are not taxable unless they exceed the amount you paid in premiums over the course of the year.

If you decide to surrender your life insurance policy or are unable to get a life insurance settlement, the policy's cash value will determine whether you have to pay any taxes. If the cash surrender value is greater than the amount you have already paid in premiums, the difference will be taxable as income.

One way to avoid life insurance payouts being taxed as part of your estate is to set up an irrevocable life insurance trust (ILIT). You transfer ownership of the policy to the ILIT and cannot be the trustee, but you can determine the trust beneficiary. While an ILIT is an effective way to ensure that your life insurance death benefit is not taxable as part of your estate, there are a couple of situations in which you may face a tax event:

• When setting up the trust, if the life insurance policy's cash value is greater than the gift tax exemption, you may need to pay a gift tax when transferring ownership.
• If you pass away within three years of transferring the life insurance policy to the trust, the policy will likely become part of your estate from a tax perspective.

Gift tax

When it comes to gift tax on life insurance trusts, there are a few key things to keep in mind. Firstly, all gifts to a trust are subject to gift tax. However, there is an annual gift tax exclusion, which allows each person to gift up to a certain amount to a trust without paying any gift tax. This amount varies by year, but in 2025 it is expected to be $19,000.

To qualify for the annual gift tax exclusion, the trust must provide a "Crummey withdrawal right" to the beneficiary. This means that the beneficiary has the right to withdraw the gifted funds from the trust for a certain period, usually 60 days. If the beneficiary does not exercise this right, the funds remain in the trust and can be used to pay the life insurance premiums. This process can be repeated annually, allowing the grantor to gift money to the trust to cover the premiums without incurring gift tax.

It is important to note that there are tax consequences to the Crummey right during the period when the beneficiary has the right to withdraw the funds. Additionally, if the beneficiary does not withdraw the funds and the right lapses, there may be further tax implications.

When setting up a life insurance trust, it is crucial to seek the advice of a legal professional, as the rules surrounding gift tax can be complex and depend on individual circumstances.

Frequently asked questions