Generally speaking, when the beneficiary of a life insurance policy receives the death benefit, this money is not counted as taxable income, and the beneficiary does not have to pay taxes on it.
However, situations can exist where the beneficiary is taxed on some or all of a policy's proceeds. If the policyholder elects not to have the benefit paid out immediately upon their death but instead held by the life insurance company for a given period of time, the beneficiary may have to pay taxes on the interest generated during that period. And when a death benefit is paid to an estate, the person or persons inheriting the estate may have to pay estate taxes on it.
However, there are several ways, detailed below, that these estate taxes may be avoided.
- Usually, there are no taxes owed when a life insurance policy beneficiary receives the death benefit; however, there are a few exceptions.
- If the policyholder has arranged for the insurance company to hold the policy for a few months before transferring it to the beneficiary, then the interest earned in that interim period would usually be taxable.
- If the policyholder made the policy's beneficiary an estate rather than an individual, the person or people inheriting the estate might have to pay estate taxes.
What is Life Insurance?
Income earned in the form of interest is almost always taxable at some point. Life insurance is no exception. This means when a beneficiary receives life insurance proceeds after a period of interest accumulation rather than immediately upon the policyholder's death, the beneficiary must pay taxes, not on the entire benefit, but on the interest. For example, if the death benefit is $500,000, but it earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth.
According to the IRS, if the life insurance policy was transferred to you for cash or other assets, the amount that you exclude as gross income when you file taxes is limited to the sum of the consideration you paid, any additional premiums you paid, and certain other amounts—in other words, you can't overpay for a policy as a way to cut your taxable income.
Estate and Inheritance Taxes
One poor decision that investors seem to frequently make is to name "payable to my estate" as the beneficiary of a contractual agreement, such as an individual retirement account (IRA), an annuity, or a life insurance policy. However, when you name the estate as your beneficiary, you take away the contractual advantage of naming a real person and subject the financial product to the probate process. Leaving items to your estate also increases the estate's value, and it could subject your heirs to exceptionally high estate taxes.
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: (1) to your estate, either directly or indirectly, or (2) to named beneficiaries if you possessed any "incidents of ownership" in the policy at the time of your death.
Using an Ownership Transfer to Avoid Taxation
Federal taxes won't be due on many estates; due to the Tax Cuts and Jobs Act (TCJA) of 2017, the exemption amount was increased to $11.7 million for 2021 and $12.06 million for 2022. Meanwhile, the maximum estate tax rate is capped at 40%.
Many of the changes enacted by the Tax Cuts and Jobs Act, including the higher federal estate tax exclusion, are currently set to expire at the end of 2025 unless Congress extends them.
For those estates that will owe taxes, whether life insurance proceeds are included as part of the taxable estate depends on the ownership of the policy at the time of the insured's death. If you want your life insurance proceeds to avoid federal taxation, you'll need to transfer ownership of your policy to another person or entity.
Here are a few guidelines to remember when considering an ownership transfer:
- Choose a competent adult/entity to be the new owner (it may be the policy beneficiary), then call 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 $15,000 per person in 2021 and $16,000 in 2022, so the recipient could use some of this gift to pay premiums.
- You will give up all rights to make changes to this policy in the future. However, if a child, family member, or friend is named the new owner, changes can be made by the new owner at your request.
- Because ownership transfer is an irrevocable event, beware of divorce situations when planning to name the new owner.
- Obtain written confirmation from your insurance company as proof of the ownership change.
Using Life Insurance Trusts to Avoid Taxation
A second way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT). To complete an ownership transfer, you cannot be the trustee of the trust, and you may not retain any rights to revoke the trust. In this case, the policy is held in trust, and you will no longer be considered the owner. Therefore, the proceeds are not included as part of your estate.
Why choose trust ownership rather than transferring ownership to another person? One reason might be that you still wish to maintain some legal control over the policy. Or perhaps you are afraid that an individual owner may fail to pay premiums, whereas, in the trust, you can ensure that all premiums are paid promptly. If the beneficiaries of the proceeds are minor children from a previous marriage, an ILIT will allow you to name a trusted family member as trustee to handle the money for the children under the terms of the trust document.
Regulations on Life Insurance Policy Ownership
The IRS has developed rules that help determine who owns a life insurance policy when an insured person dies. The primary regulation overseeing proper ownership is known in the financial world as the three-year rule, which states that any gifts of life insurance policies made within three years of death are still subject to federal estate tax. This applies to both a transfer of ownership to another individual and the establishment of an ILIT.
If you die within three years of a transfer of ownership, the full amount of the proceeds is included in your estate as though you still owned the policy.
The IRS will also look for any incidents of ownership by the person who transfers the policy. In transferring the policy, the original owner must forfeit any legal rights to change beneficiaries, borrow against the policy, surrender, cancel the policy, or select beneficiary payment options. Furthermore, the original owner must not pay the premiums to keep the policy in force. These actions are considered part of the ownership of the assets, and if any of them are carried out, they can negate the tax advantage of transferring them.
However, even if a policy transfer meets all of the requirements, some of the transferred assets may still be subject to taxation. If the current cash value of the policy exceeds the gift tax exclusion of $15,000 in 2021 and $16,000 in 2022, gift taxes will be assessed and due at the time of the original policyholder's death.
The Bottom Line
It's not uncommon for individuals to be insured under a life insurance policy for $500,000 to several million in death benefits. Once you add in the value of your home, your retirement accounts, savings, and other belongings, you may be surprised by the size of your estate. If you factor in more years of growth, some individuals may be facing an estate tax issue.
A viable solution to this is to maximize your gifting potential and to transfer policy ownership whenever possible at little or no gift-tax cost. As long as you live another three years after the transfer, your estate could save a significant amount of tax.
Robert E. Maloney, AEP
Squam Lakes Financial Advisors, LLC, Holderness, NH
A will can include an "apportionment clause” that leads to tax liabilities for the beneficiary. The clause may state, for instance, that if there are any estate taxes due, they will be paid proportionally by the beneficiaries who receive the assets from the benefactor. Under this circumstance, there would be an estate tax due, but not an income tax. It is possible that some income tax may be due when the life insurance company pays out the proceeds of the policy to the beneficiary over an extended period of time. The face amount of the policy, however, is received income tax-free. The law also requires the insurance company to pay interest to the beneficiary from the date of death until they pay out the proceeds.