Life Insurance Tax: Decedent's Gross Estate

Life insurance proceeds are typically not taxable as income, but they can be taxed as part of an estate if the amount passed to heirs exceeds federal and state exemptions. The proceeds are generally not taxable as gross income for the beneficiary, but there are situations where the beneficiary may be taxed on some or all of the proceeds. For example, if the policyholder delays the benefit payout and the money is held by the insurer, the beneficiary may be taxed on the interest generated. The proceeds are also taxable if they are payable to the decedent's estate or if the decedent had ownership incidents in the policy at the time of their death.

Naming an estate as a beneficiary

Naming beneficiaries is an essential part of estate planning. Beneficiary designation is the act of naming the person who will inherit an asset after the account owner's passing. Some common examples include life insurance policies, retirement accounts, and financial accounts. When the account owner passes away, their assets are then transferred to the beneficiary they designated.

It is possible to name your estate as the beneficiary of your assets. Your will would then name the specific individuals that these assets should be distributed to, in what proportion, and any other applicable provisions. However, this could subject your heirs to exceptionally high estate taxes and increase the value of the estate. It is also important to note that if you do not name a beneficiary, your assets will likely be held in probate, which can be a lengthy and complicated process.

If you are married, there may be specific rules that apply if you want to designate someone other than your spouse as the beneficiary for certain assets, such as IRA accounts. Despite common restrictions, there are strategies to designate minors as beneficiaries, such as creating a trust or establishing UGMA or UTMA accounts.

When designating a beneficiary, it is important to be as specific as possible. Provide the full legal name and contact information of your desired beneficiary or beneficiaries. You may also include their relationship to you, mailing address, email, phone number, date of birth, and Social Security number. This will help financial services or insurance companies verify and locate your beneficiaries.

Incidents of ownership

The question of incidents of ownership arises when determining tax responsibility in cases where a person gifts a life insurance policy to another person or entity. When transferring a policy, the original owner must give up all legal rights and must not pay the premiums to keep the policy in force.

In the context of life insurance being taxed to a decedent's gross estate, incidents of ownership play a crucial role. If the decedent possessed incidents of ownership in the policy at the time of their death, the proceeds of the life insurance policy may be included in their gross estate for tax purposes. This is outlined in Section 2042 of the Internal Revenue Code.

It is important to note that the three-year rule applies in this context. If the insured transfers the policy within three years of their death, the proceeds will still be included in their gross estate, and the beneficiaries may face estate tax consequences. This rule aims to prevent tax avoidance by discouraging individuals from transferring ownership of their life insurance policies shortly before their death.

Estate tax rules

Estate tax, also known as the "death tax", is a federal tax levied on a dead person's inherited assets. The Internal Revenue Service (IRS) considers estate assets to include interests in real estate, cash, securities, insurance, trusts, annuities, business interests, and other assets. The tax is calculated based on the current fair market value of the assets, not the original value at the time of purchase.

The estate tax ranges from rates of 18% to 40% and generally applies to assets over a certain threshold. In 2024, the IRS exempts estates valued at less than $13.61 million from the tax, and this exemption rises to $13.99 million in 2025. These exemptions are per person, so a married couple could double the exemption amount.

In addition to federal estate tax, your assets may also be subject to state estate tax if you reside in a state that imposes this tax. Currently, 12 states and the District of Columbia charge estate taxes, with exemption levels varying from state to state.

When it comes to life insurance, the proceeds are generally not taxed as income to the beneficiary. However, the entire value of the insurance proceeds is typically taxed as part of the insured's estate. If the proceeds are payable to the decedent's estate or any other beneficiary, they are included in the gross estate if the decedent possessed incidents of ownership in the policy at the time of death.

To reduce estate tax liability, individuals can consider strategies such as charitable giving, setting up irrevocable trusts, or establishing an irrevocable life insurance trust (ILIT). Transferring ownership of life insurance policies more than three years before death can also help minimize taxes, as gifts made within three years of death are subject to federal estate tax.

Death benefit

Life insurance death benefits are typically not taxable as income. However, they can be taxed as part of an estate if the value transferred to heirs exceeds federal and state exemptions. The estate tax exemption amount varies by state, ranging from $1 million to $7 million, with tax rates as high as 20%. Additionally, the federal exemption amount for 2022 was $12.06 million, increasing to $12.92 million in 2023, with a top tax rate of 40%.

The proceeds of life insurance policies are generally included in the gross estate if payable to the decedent's estate or any named beneficiaries, provided the decedent possessed incidents of ownership at the time of death. Incidents of ownership refer to the practical power to control the policy, rearrange economic interests, or affect payable benefits. This includes the ability to change the beneficiary, borrow against the policy, or cancel the policy.

To avoid taxation on life insurance proceeds, it is advisable to transfer ownership of the policy to an irrevocable life insurance trust (ILIT). By doing so, the proceeds are not included in the insured's estate, and the trust beneficiary can be designated. However, the three-year rule applies, meaning that gifts of life insurance policies made within three years of death are still subject to federal estate tax. Therefore, it is essential to plan early.

It is worth noting that if the beneficiary is a young child or dependent, the proceeds may be paid in installments, and the beneficiary will be taxed on the interest generated. Additionally, if the policyholder delays the benefit payout, the beneficiary may be taxed on the interest accrued during that period.

Irrevocable life insurance trust

Life insurance proceeds are generally taxable as part of the insured's estate. However, proceeds are not taxable as gross income to the beneficiary. An irrevocable life insurance trust (ILIT) is a legal arrangement that can help to reduce the tax burden on your estate and your beneficiaries.

An ILIT is a type of trust that holds one or more life insurance policies and is funded during the insured's lifetime. The trust is irrevocable, meaning it generally cannot be changed or revoked once created. The main purpose of an ILIT is to decrease the value of an individual's estate, thereby reducing the estate tax paid on the life insurance benefits passed from the grantor to the beneficiary. This is achieved by transferring assets from the grantor to the trust, which then uses a life insurance policy to distribute the proceeds to beneficiaries upon the death of the insured.

By placing life insurance policies into an ILIT, the death benefit is excluded from the grantor's estate, and the proceeds can be passed on to beneficiaries free of estate tax. This can be especially beneficial for individuals with rapidly appreciating property or a growing business, as it helps to avoid the need to sell high-value assets to cover estate taxes and other expenses. Additionally, an ILIT can help protect government benefits for beneficiaries with special needs, ensuring that inherited assets do not interfere with their eligibility for programs such as Social Security Disability Income or Medicaid.

While an ILIT offers significant benefits, it is important to consider the drawbacks. One major downside is the irrevocable nature of the trust, which means the grantor gives up all rights to the property in the trust, including the choice of beneficiaries and the conditions under which they receive assets. This loss of control over the policy means the ILIT is primarily for legacy purposes rather than personal or retirement expenses. Additionally, the three-year rule applies to ILITs, meaning gifts of life insurance policies made within three years of death are still subject to federal estate tax.

Frequently asked questions