When Is Life Insurance Taxable?

It’s all in the details. Life insurance proceeds are income tax free. If you are the beneficiary of an insurance policy, you don’t have to pay taxes on that sum.

However, Kiplinger’s recent article, “Myth: Life Insurance is NOT Taxable,” explains that if it’s large enough, the decedent’s estate—along with 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, and taxes it accordingly. That estate tax is usually due upon death, and it can be significant. If you’re wealthy enough to be worried about this, 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). You name that trust the owner of your life insurance. That way, that particular 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 heir’s income tax and estate tax-free.

You may be a candidate for an 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.) The Act sunsets on Dec. 31, 2025. At that point, unless the law is made permanent, the amount will go back to the old $5 million exemption, indexed for inflation.

An ILIT could save your family up to 40% in federal estate taxes. 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 in a multigenerational trust.

You should use caution because the IRS scrutinizes ILITs carefully. In order to be certain that your ILIT passes IRS muster, you must:

Transfer polices you own to the ILIT, by completing an “absolute assignment” or “change of ownership” form;
Relinquish all ownership rights to the trust. You must keep insurance proceeds out of your estate, by doing the following:

Giving up all ownership rights to the policy, such as the right to change beneficiaries, borrowing from cash values, and making premium payments;
Sign an annual cash partition agreement to create 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 will be able to set this trust up for you correctly.

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 reaches that threshold level. You’ll need to set up the ILIT at least three years before you die.

Call your estate planning attorney to take care of this task, as it’s not likely that you will know when that three-year time period will begin.

Reference: Kiplinger (August 28, 2018) “Myth: Life Insurance is NOT Taxable”