Is life insurance subject to estate tax?

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One of the big benefits of life insurance is that the proceeds are paid to the beneficiaries without incurring Federal income tax. Many people assume that this means there are no tax consequences whatsoever to the proceeds from a life insurance policy.

This is not true. The face value, or death benefit, of a life insurance policy is included in the owner’s estate, and may be subject to estate tax if it applies.

So, while life insurance proceeds do not trigger Federal income tax, they may trigger estate tax.

In fact, depending on the size of the estate and the size of the policy, life insurance proceeds may cause the entire estate to become taxable, even if it might not have been taxed without the insurance policy.

One common question that comes up is: do life insurance policies form part of an estate?

Careful planning can minimize or even eliminate the amount of estate tax your life insurance policy will incur. Here are some things you should know about life insurance and estate taxes.

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Policy Ownership

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The taxation of life insurance policy proceeds is governed largely by who owns the policy.

If you own the policy yourself, the proceeds will be added to your taxable estate.

If your gross estate exceeds a certain amount, you will be subject to estate tax. In 2015, this amount is $5,430,000, so you would have to have an estate of at least that size in order to be subject to estate tax.

This sounds like a lot of money, but consider that your assets include your home and its contents, any other real estate, your retirement accounts, and other investments.

Then consider that these assets will continue to grow.

If you add all this up, and then add on a life insurance policy with a $1 million death benefit on top of it, you may be surprised to find that you may very well be subject to estate tax. Taking the life insurance proceeds out of the equation may mean the difference between owing estate tax on your entire estate and owing no tax at all.

If another person or entity owns your policy, the proceeds will not be included in your estate. For this reason, many people will have the policy owned by their spouse or children. One important caveat here is that the owner of the policy must pay the premiums.

If your children are the owners of the policy, the premium payments must come from them. You can, however, give your children money each year which they can use to pay the premium. The limit to the amount of money you can give someone each year without having to file a gift tax from is $14,000 in 2015.

The Internal Revenue Service refers to “incidents of ownership” to determine the true owner of a life insurance policy. You can be considered to have an incident of ownership if you:

  • can change the payment options on the policy, from annual to lump sum, for example,
  • can borrow against the cash value in the policy,
  • can cancel or surrender the policy, or
  • can name beneficiaries on the policy.

In order for the policy to be excluded from your taxable estate, each of these functions must be performed by someone other than you, and you must not be able to perform them yourself.

In short, the owner of the policy has control over the policy. If it is a whole life or universal life insurance policy, it may have cash value which can be withdrawn or borrowed against by the owner without your consent.

Keep this in mind when you are deciding who should own your policy.

Irrevocable Life Insurance Trusts

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Many people establish a trust to own their life insurance policies, and to be the beneficiary of the proceeds when they die.

If you go this route, be sure to establish an irrevocable life insurance trust, commonly referred to as an ILIT.

If you establish an ILIT, you will need to choose someone to be the trustee.

You cannot be the trustee and you cannot revoke, or cancel, the trust.

Only the trustee can make decisions about the payment terms and beneficiaries, and the disposition of the policy or its cash value.

If the trust is also the beneficiary of the policy, the trust documents will stipulate who can receive money from the trust once you have passed away.

This gives you the ability to indicate not only who will receive the money, but under what circumstances.

If you have minor children, for example, you can specify that they will only receive their share of the proceeds once they reach 18 or 21 years old, for example, or after they graduate from college. Until the time they can inherit the money, the trustee will manage it within the trust.

In the terms of the trust, you can also specify that your beneficiaries get a monthly income stream from the policy proceeds, rather than a lump sum. This can be helpful if you have one or more beneficiaries who would not be able to handle receiving a large sum of money all at one time.

Pay close attention to the ‘irrevocable’ part of an irrevocable life insurance trust. This type of trust cannot be amended or changes once it has been established.

For that reason, be very careful to account for any future possibilities when you set up the trust.

For example, if you are bequeathing money to married children, specify what will happen if there is a divorce. Specify how the money will be distributed if one of your children predeceases you, or if additional children or grandchildren are born after the trust is established.

Other Important Things to Remember

The owner of the life insurance policy must pay the premiums. The origin of the funds used to pay those premiums could be a gift from the insured, but that gift is subject to the gifting limits set forth by the IRS. This is true whether the gift is made directly to an individual or to a trust.

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Keep careful records of gifts and premiums paid to eliminate any question or confusion.

If your death occurs within three years of transferring the ownership of a life insurance policy to another person or to a trust, the proceeds will be subject to estate tax as they would if they had not been transferred.

This so-called three-year rule makes it prudent to be sure that the correct person or entity is named as the owner when the policy is first taken out, rather than trying to transfer ownership later on.

There are many factors to consider when you are choosing and applying for a life insurance policy.

Deciding who or what will own the policy is one of them. By setting up the policy correctly when you purchase it, you can save money for your beneficiaries down the road.

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