Jeffrey Wade
Life insurance can be a great way to support your family and business after your death. However, the proceeds of a life insurance policy are generally considered part of the estate of the deceased and are therefore taxable. There are ways to avoid this, such as placing the policy in an irrevocable life insurance trust (ILIT) or changing the number of beneficiaries.
| Characteristics | Values |
|---|---|
| Life insurance proceeds taxable in the estate | Yes, if the proceeds are payable in a lump sum |
| No, if the proceeds are payable in installments | |
| No, if the proceeds are payable to a beneficiary and the policy is owned by an irrevocable trust | |
| No, if the proceeds are payable to a beneficiary and the policy is owned by a separate entity outside of the estate | |
| No, if the proceeds are payable to a beneficiary and the policy is owned by the beneficiary | |
| No, if the proceeds are payable to a beneficiary and the policy is owned by the insured, and the trust owns the policy | |
| Incidents of ownership | The right of the insured or their estate to the economic benefits of the policy |
| The power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain a loan against the surrender value of the policy |
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What You'll Learn
Proceeds from life insurance on the decedent
The proceeds of life insurance policies on the decedent's life are generally includable in the gross estate if the proceeds are payable to the decedent's estate or for its benefit. This is true even if the beneficiary is someone else, as long as the decedent possessed incidents of ownership in the policy at the time of their death. The term "incidents of ownership" refers to the right of the insured or their estate to the economic benefits of the policy. This includes the power to change the beneficiary, surrender or cancel the policy, assign the policy, revoke an assignment, pledge the policy for a loan, or obtain a loan against the surrender value of the policy.
However, there are ways to ensure that life insurance benefits are not includable in the decedent's estate. One way is to set up an irrevocable life insurance trust (ILIT), where the trust owns the policy, but the decedent is the insured. By not owning the insurance individually, the death benefit is not included in the decedent's estate value, and estate tax liability issues can be avoided. This strategy can also help to avoid the probate process, making the distribution of benefits easier.
Another strategy is to use buy-sell agreements, where life insurance is obtained to fund a business interest under a "cross-purchase" arrangement. This will not be taxed in the estate unless the estate is named as the beneficiary. Additionally, it is important to be strategic about beneficiaries to minimize the impact of estate taxes. For example, listing only two individuals on the contract instead of three can help avoid tax issues.
Overall, it is important to carefully consider the ownership of life insurance policies and how they fit into the larger financial picture when planning an estate to ensure that benefits are distributed as intended and to avoid unnecessary taxation.
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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 occurs even if the person chooses not to act on it and even if they don't borrow from the policy. Simply having the ability to do so gives the insured person incidents of ownership.
There can be estate tax exposure even if the insured does not own the life insurance policy. The incident of ownership trap often appears in situations where life insurance is owned by shareholders and used to fund a buy-sell agreement between or among them. For example, if a decedent owned a policy of insurance on his life and, four years before his death, assigned his entire interest in the policy to his wife, retaining no reversionary interest, the proceeds of the policy would not be included in his gross estate.
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. This is the case even if the policy is not owned by the insured. 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.
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Estate tax liability
Firstly, it is important to understand the concept of "incidents of ownership." This term generally refers to the right of the insured or their estate to the economic benefits of the policy. It includes the power to change the beneficiary, surrender or cancel the policy, assign or revoke an assignment, pledge the policy for a loan, or obtain a loan against the surrender value. If the decedent possessed any incidents of ownership at the time of their death, the life insurance proceeds may be includible in their estate for tax purposes.
One way to avoid including life insurance proceeds in your estate is to establish an irrevocable life insurance trust (ILIT). By transferring ownership of the policy to a trust, you no longer possess incidents of ownership, and the proceeds are not included in your estate. It is important to note that you cannot be the trustee of the trust and must not retain any rights to revoke it. Additionally, the three-year rule applies, meaning that if you transfer ownership of the policy within three years of your death, the proceeds may still be subject to estate tax.
Another strategy to consider is purchasing life insurance through a business entity. For example, if you own a business, you can have the entity purchase life insurance for the owner/operators and place it into an ILIT. This ensures that the insurance remains intact for those who remain in the entity, even if individuals choose to leave.
It is worth noting that not all estates are subject to taxes. The estate tax threshold for 2023 is $12.92 million per person, and this amount is expected to decrease in the coming years. Proper estate planning can help minimize tax liability and ensure that your heirs receive the maximum benefit.
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Irrevocable life insurance trust (ILIT)
An Irrevocable Life Insurance Trust (ILIT) is a legal arrangement that seeks to minimize an individual's current tax burden and the impact of taxes on their estate. It does this by transferring assets from the individual to a separate legal entity (the trust). The trustee, who can be a friend, a relative, or an independent professional, uses these assets to purchase a life insurance policy in the individual's name and will continue to pay the premiums so the policy remains in force.
The main advantage of an ILIT is that it helps to avoid having the death benefit of a life insurance policy included in the individual's estate for federal estate tax purposes. This is because the trust owns the policy, not the individual, and therefore the value is not included in the individual's estate value. The individual can still direct, through the trust document, how and when the death benefit is used and for whom. An ILIT can also be used to manage and distribute the proceeds that are paid out upon the individual's death, according to their wishes.
Another benefit of an ILIT is that it can help to preserve assets for beneficiaries who require ongoing care, such as those with special needs. By removing taxable assets from the individual's current portfolio, an ILIT may help lower their current tax burden and ensure that inherited assets don't interfere with a beneficiary's eligibility for government benefits such as Social Security Disability Income or Medicaid.
It is important to note that establishing an ILIT requires the individual to give up all rights to the property in the trust, including who the trust beneficiaries are and under what circumstances they receive the assets. This means that the individual can no longer use the life insurance policy for their personal or retirement expenses. ILITs are also complex legal instruments, and it is recommended that individuals consult a tax attorney, trust officer, or financial professional before setting one up.
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Beneficiaries
When it comes to an estate, it is important to look at the entire financial picture of your life and how different assets, policies, and investments can help take care of your loved ones and your estate after you pass away. Life insurance can be a great way to support your legacy after you're gone—but only if it's used in the correct manner.
Life insurance proceeds usually bypass the estate and go directly to named beneficiaries. However, if there are no beneficiaries, the proceeds may become part of the estate assets. If the death benefit goes directly to designated beneficiaries, the money does not go to your estate. As a result, the life insurance payout would not be subject to probate. Instead, the life insurance contract dictates where the money goes before the money ever reaches your estate.
It is also important to be strategic about your beneficiaries to help minimize the impact of estate taxes and maximize the impact your assets can have on your loved ones. Working with a financial advisor can help ensure your estate plans are carried out according to your wishes and help your money go further towards supporting your family after you're gone.
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Frequently asked questions
Life insurance proceeds are not automatically included in the estate of the deceased. However, if the deceased's estate is the beneficiary of the insurance proceeds, or if the deceased possessed certain economic ownership rights (known as "incidents of ownership") in the policy at their death, then the insurance will be included in the taxable estate.
"Incidents of ownership" refer to the right of the insured or their estate to the economic benefits of the policy. This includes the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain a loan against the surrender value of the policy.
You can avoid having life insurance proceeds included in your estate by transferring ownership of the policy to a separate entity outside of your estate, such as a trust. An irrevocable life insurance trust (ILIT) is a common vehicle for this purpose. By placing the insurance policy into an ILIT, the trust owns the policy, and the value is not included in your estate value.
In addition to helping you avoid estate tax liability issues, using a trust to own your life insurance policy can help you avoid the probate process, making the distribution of benefits easier and simpler for everyone involved.
Yes, it is important to be strategic about your beneficiaries to help minimize the impact of estate taxes. Listing only two individuals on the contract, for example, can help you avoid certain tax issues. Additionally, consider the benefit amount and how it may increase your estate value, potentially triggering state and/or federal estate taxes.
