Alyssa Lane
Life insurance is a valuable asset that can provide financial security for loved ones after one's death. However, it is important to understand how life insurance proceeds are taxed and when they may be included in one's gross estate for tax purposes. In the United States, the Internal Revenue Code, specifically Section 2042, outlines the conditions under which life insurance proceeds are considered part of the insured's gross estate. This typically occurs when the insured has certain ownership rights, known as incidents of ownership, over the policy or when the proceeds are payable directly or indirectly to the insured's estate. Understanding these rules is crucial for effective estate planning to minimize tax liabilities and maximize the benefits for heirs.
| Characteristics | Values |
|---|---|
| If the proceeds of the policy are payable to a beneficiary in the form of an annuity | Included in the gross estate |
| If the proceeds of the policy are payable to the insured's estate | Included in the gross estate |
| If the insured possesses certain economic ownership rights | Included in the gross estate |
| If the insured possesses "incidents of ownership" | Included in the gross estate |
| If the insured has the power to change the beneficial ownership in the policy or its proceeds | Included in the gross estate |
| If the insured has the power to change the time or manner of enjoyment of the policy or its proceeds | Included in the gross estate |
| If the insured has any rights over the policy, including the right to change the beneficiary | Included in the gross estate |
| If the insured has transferred ownership of the policy within three years of death | Included in the gross estate |
| If the insured has set up an irrevocable life insurance trust (ILIT) with the trust as the owner and beneficiary of the policy | Not included in the gross estate |
| If the insured has gifted up to the annual exclusion amount ($15,000 in 2020) | Not included in the gross estate |
| If the insured has a group-term life insurance policy | Not included in the gross estate |
| If the insured has a combination annuity contract and life insurance policy with no insurance element at the time of death | Not included in the gross estate |
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What You'll Learn
Incidents of ownership
The term "incidents of ownership" refers to the rights of a person or trustee to change the beneficiaries on a life insurance policy, borrow from the cash component, or alter the policy in some way. This becomes important when determining tax responsibility when a person gifts a life insurance policy to another person or entity. When such a transference is made, the person making the gift must give up all legal rights to the policy and not pay any premiums.
The Internal Revenue Service (IRS) will often look for any incidents of ownership by a person who gifts a life insurance policy to another person or entity. When transferring a policy, the original owner must forfeit all legal rights and must not pay the premiums to keep the policy in force. This is because, if an individual possesses an incident of ownership in life insurance at the time of their death, the full death benefit will be included in the individual's taxable estate for federal estate taxation.
Incident of ownership is more than just owning the life insurance on one's life. Death benefits owned by the insured on the insured's life are included in the insured's taxable estate. However, even if the policy is not owned by the insured, if there is an incident of ownership in the policy, the death benefit will be included in the insured's taxable estate. An incident of ownership includes the right to: change the policy beneficiary; surrender or cancel the policy; assign the policy or revoke an assignment of the policy; or borrow against the policy or pledge the policy.
The three-year rule states that if the insured or transferor dies within three years of the date the policy was transferred, the life insurance proceeds will be included in the gross value of the original owner's estate. This is an important consideration for those looking to avoid taxation on life insurance proceeds. One way to do this is to create an irrevocable life insurance trust (ILIT), where the policy is held in trust, and the owner no longer has any rights to the policy.
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Estate tax rules
In the United States, the Internal Revenue Code, specifically Section 2042, states that the value of life insurance proceeds insuring an individual's life is included in their gross estate if the proceeds are payable either directly or indirectly to their estate, or to named beneficiaries if the individual possessed any "incidents of ownership" in the policy at the time of their death. Incidents of ownership refer to certain rights over a policy, such as the ability to change the beneficiary, borrow against the policy, or surrender or cancel the policy. It is important to note that simply paying the premiums is not considered an incident of ownership.
To avoid having life insurance proceeds included in one's taxable estate, one option is to transfer ownership of the policy to another person or entity. This requires choosing a competent adult or entity, completing the proper assignment or transfer of ownership forms, and understanding that the new owner will have control over the policy. Another option is to set up an irrevocable life insurance trust (ILIT), where the trust owns the policy, and the individual is the insured. This allows the individual to maintain some legal control over the policy while ensuring the proceeds are not included in their taxable estate.
It is worth noting that certain types of life insurance policies and ownership structures may have specific implications for estate tax purposes. For example, second-to-die policies, which insure two lives and are typically used for estate planning purposes, may have different tax considerations. Additionally, the timing of any ownership transfers or changes can be crucial, as some states have rules regarding the timeframe between a transfer and the insured's death.
While life insurance proceeds are generally income-tax-free for the beneficiary, careful planning is necessary to ensure that they are not inadvertently included in one's taxable estate, which could reduce the amount received by heirs.
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Irrevocable life insurance trust
Life insurance proceeds are considered a financial asset by the government, and they may be included in your gross estate for tax purposes. One way to avoid this is to set up an irrevocable life insurance trust (ILIT).
An ILIT is a type of trust that holds one or more life insurance policies and is funded during the insured's lifetime. It is a legal arrangement that seeks to minimise your current tax burden and the impact of taxes on your estate. The trust is irrevocable, which means that once it is created, it generally cannot be changed or revoked without legal action or the consent of the beneficiaries. The primary downside of an irrevocable trust is that no changes can be made once the trust is finalised, and the grantor gives up all rights to the property in the trust.
To set up an ILIT, you must transfer ownership of your policy to the trust, and the trust becomes the owner and beneficiary of the policy. This means that the proceeds are not included as part of your estate, and the trust can distribute the proceeds to your chosen beneficiaries. The trustee can be a friend, relative, or independent professional, and they will be responsible for managing and distributing the proceeds according to your wishes.
ILITs can also help to leverage the annual gift tax exclusion by using gifts to pay premiums on the life insurance in the trust. This can be especially beneficial if you are gifting to grandchildren instead of children, as it helps leverage the grantor's generation-skipping transfer (GST) tax exemption. Additionally, when the policy is held in an ILIT, any excess value above the state-determined limits is generally protected from the creditors of both the grantor and the beneficiary.
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Beneficiaries
The proceeds of life insurance are usually included in the estate of the owner of the policy, regardless of who the beneficiary is. However, if you want to ensure your beneficiaries receive the maximum benefit, there are ways to avoid federal taxation on life insurance proceeds.
Firstly, you could set up an irrevocable life insurance trust (ILIT). The trust owns the policy, and you are the insured, so the death benefit is not included in your estate value. However, if the payment is made to a trust and then later to a beneficiary, that second payment may be a taxable event if there has been growth or income. It is important to act early if you are considering this option, as the three-year rule states that unless you live for at least three years after transferring ownership, the proceeds will be taxed in your estate.
Another option is to transfer ownership of your policy to another person or entity. This could be an adult or entity, or it could be the policy beneficiary. The new owner must pay the premiums on the policy, but you can gift up to a certain amount per person per year to help cover the cost. You will need to give up all rights to make changes to the policy in the future, although if the new owner is a child, family member, or friend, they can make changes at your request.
A third option is to buy life insurance to fund a buy-sell agreement for a business interest under a "cross-purchase" arrangement. This will not be taxed in your estate unless the estate is named as the beneficiary.
It is important to carefully consider any changes to the ownership of a life insurance policy, as it is a complex matter. It is recommended that you review ownership provisions with an expert estate planner or insurance agent.
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Death benefits
If you want to avoid federal taxation on your life insurance proceeds, you can transfer ownership of the policy to another person or entity. To do this, you must choose a competent adult or entity as the new owner, which may be the policy beneficiary, and then contact your insurance company for the proper assignment or transfer of ownership forms. New owners must pay the premiums on the policy. However, you can gift up to a certain amount per person each year, which can be used to pay premiums. By transferring ownership, you give up all rights to make changes to the policy in the future.
Another way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT). In this case, you cannot be the trustee of the trust and you may not retain any rights to revoke the trust. The trust owns the policy, but the trust agreement must ensure that you have none of the ownership rights described above, in which case the proceeds will not be included in your estate. The trust can then be used to pay future premiums, or the trust can buy the insurance itself with funds contributed by the insured.
In the US, Section 2042 of the Internal Revenue Code 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 or to named beneficiaries if you possessed any incidents of ownership in the policy at the time of your death. The term "insurance" refers to life insurance of every description, including death benefits paid by fraternal beneficial societies operating under the lodge system.
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Frequently asked questions
A gross estate is the total value of the property owned by a person at their time of death, including the proceeds of insurance on their life.
Life insurance is included in a person's gross estate if:
- The person's estate is the beneficiary of the insurance proceeds.
- The deceased possessed certain economic ownership rights, known as "incidents of ownership", in the policy at their time of death or within three years of their death.
"Incidents of ownership" refer to certain rights over a life insurance policy, such as the power to change the beneficial ownership in the policy, the time or manner of enjoyment, or the right to surrender the insurance.
