It’s all in the details. Life insurance proceeds are income tax free. If you are the beneficiary of an insurance policy, you will not have to pay income taxes when you receive the life insurance proceeds.
However, Kiplinger’s recent article, “Myth: Life Insurance is NOT Taxable,” explains that life insurance payments at death are included in the calculation of a deceased person’s estate value. If the policy is large enough, the decedent’s estate— any life insurance proceeds—could be subject to federal and/or state estate taxes.
For instance, if you have a $1 million life insurance policy, the IRS will deem that policy to be an asset. At your death, the IRS sees it as a million-dollar asset you just transferred to your beneficiaries. Since that estate tax is usually due upon death, this asset can increase the value of your estate. You can avoid having your life insurance proceeds included in your estate and subject to the estate tax, by creating an irrevocable life insurance trust (ILIT), which will own your life insurance and this asset will be removed from your estate (if you have had no control over the policy for at least three years). When you die, the proceeds from your life insurance will pass on to your heirs’ income tax and estate tax-free.
You may be able to create a ILIT if your estate is in excess of the federal “application exclusion amount” ($11.18 million for single individuals and $22.36 million for couples under the Tax Cuts and Jobs Act of 2017.) At that point, note that the current law that governs this estate tax exemption sunsets on December 31st, 2025 and the credit amount will return to $5 million indexed for inflation, unless the law is made permanent.
An ILIT could save your family up to 40% in federal estate taxes by removing the proceeds from your estate calculation. That’s a benefit worth the expense and complexity in setting it up. However, it is important to note that 12 states and DC have their own estate taxes, and their exclusion amounts may be lower than the federal limits.
In addition, an ILIT can help you can avoid tax on both spouses’ estates. Life insurance proceeds can be held in a trust for the benefit of the surviving spouse during her lifetime. When she dies, the proceeds will not be included as part of her estate either. They will pass tax-free to her children and then to her grandchildren, as an ILIT is a multigenerational trust.
You should use caution because the IRS scrutinizes ILIT's carefully. In order to be certain that your ILIT conforms to IRS rules, some requirements are:
- To transfer polices you already own to the ILIT, complete an “absolute assignment” or “change of ownership” form;
- You need to relinquish all ownership rights to the trust and you may not pay the premiums directly.
- All ownership rights to the policy, such as the right to change beneficiaries, borrowing from cash values, and making premium payments, may not be performed by the original owner.
- An annual cash partition agreement to create and separate funds from which premiums are paid; and
- Maintain a change of ownership in an existing policy for at least three years before the insured's death. (You must survive for at least three years after transferring your policy to the trust, or the proceeds will be taxed in your estate like you retained ownership of the policy).
An estate planning attorney is necessary to set this trust up for you.
Bear in mind that while your family may not pay income tax on life insurance proceeds that they receive, they may have to pay estate taxes on the policy, if the estate exceeds the estate tax exemption amount threshold level. You’ll need to set up the ILIT at least three years before you die.
Call our firm, Grimaldi & Yeung, if you want to explore this option and assure your ILIT is created more than 3 years in advance.
Reference: Kiplinger (August 28, 2018) “Myth: Life Insurance is NOT Taxable”