Advertisement
insurance

Myth: Life Insurance is NOT Taxable

The reality is that life insurance is treated as an asset in your estate. And if the payout pushes your estate past federal or state estate tax exclusion limits, you could be facing a hefty estate tax bill. There is something you can do, though.

You may think that life insurance is tax-free. Unfortunately, the “no tax on life insurance” idea is only partly true: Life insurance is income tax-free. In other words, recipients of a decedent’s life insurance policy do not have to pay income tax on that sum.

However, if it’s large enough, the decedent’s estate — including any life insurance proceeds — could be subject to federal and/or state estate taxes. As an example, let's say you have a $1 million life insurance policy. The IRS deems that policy an asset, just as if you had an investment portfolio worth $1 million. And upon 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 substantial.

Advertisement - Article continues below

If you’re among those wealthy enough to be concerned about this possibility, how can you avoid having your life insurance proceeds included in your estate and therefore possibly subject to the estate tax? You can create an irrevocable life insurance trust (ILIT) and name that trust the owner of your life insurance. By doing so, that particular asset will be removed from your estate. Upon your death, the proceeds from your life insurance will pass on to your heirs not only income tax-free but estate tax-free as well.

Advertisement
Advertisement - Article continues below

Who might 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)*, an ILIT could save your family up to 40% in federal estate taxes. It’s a benefit worth the legal fees and complexity associated with setting up an ILIT. Keep in mind, 12 states, plus the District of Columbia, have their own estate taxes, and their exclusion amounts may be much lower than the federal limits.

Another benefit: 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 his/her lifetime. When that person dies, the proceeds will not be included as part of his/her estate either, but will pass tax-free to your children and then to your grandchildren, as an ILIT in a multigenerational trust.

Advertisement - Article continues below

Be forewarned: The IRS scrutinizes ILITs carefully. In order to make sure your ILIT passes IRS inspection, you must:

  1. Transfer any polices you already own to the ILIT by completing an “absolute assignment” or “change of ownership” form.
  2. Relinquish all ownership rights to the trust. It’s not as simple as you may think. In fact, you can be charged with retaining an ownership right in the life insurance policy without ever having held title to that policy. If you want to keep insurance proceeds out of your estate, you need to:
Advertisement
Advertisement - Article continues below
  • Give up all ownership rights to the policy, including the right to change beneficiaries, borrow from cash values, and make premium payments;
  • Enter into an annual cash partition agreement in order to create separate funds from which premiums are paid so that there is no mistake as to whom the payor/owner really is; and
  • Maintain a change of ownership in an existing policy for at least three years before the insured's death. In other words, you must survive for at least three years after transferring your policy to the trust. Otherwise, the proceeds will be taxed in your estate as if you retained ownership of the policy.

Bottom line: Your heirs will not pay income tax on any life insurance proceeds they receive, but if the estate is large enough, they will pay estate taxes on the policy — unless you set up an ILIT at least three years before your death. And though ILITs can save some families a great deal of money, it’s best to enlist a professional to design a trust that will pass IRS muster.

*The Act sunsets on Dec. 31, 2025, after which the amount will adjust to the old $5 million exemption, indexed for inflation.

Advertisement

About the Author

Ken Moraif, CFP®

CEO and Senior Adviser, Retirement Planners of America

Ken Moraif, CFP, is CEO and senior adviser at Retirement Planners of America, a Dallas-based wealth management and investment firm with over $4.3 billion in AUM and serving over 8,000 households (as of May 2019). He is also the host of the radio show "Money Matters with Ken Moraif," which has offered listeners retirement, investing and personal finance advice since 1996.

Advertisement

Most Popular

Medicare Basics: 11 Things You Need to Know
Medicare

Medicare Basics: 11 Things You Need to Know

There's Medicare Part A, Part B, Part D, medigap plans, Medicare Advantage plans and so on. We sort out the confusion about signing up for Medicare --…
September 16, 2020
Election 2020: Joe Biden's Tax Plans
taxes

Election 2020: Joe Biden's Tax Plans

With the economy in trouble, tax policy takes on added importance in the 2020 presidential election. So, let's take a look at what Joe Biden has said …
September 10, 2020
What Trump's Payroll Tax Cut Will Mean for You
Tax Breaks

What Trump's Payroll Tax Cut Will Mean for You

President Trump issued an executive order to suspend the collection of Social Security payroll taxes. How much could it save you?
September 17, 2020

Recommended

Most-Overlooked Tax Breaks for the Newly Divorced
tax deductions

Most-Overlooked Tax Breaks for the Newly Divorced

Filing taxes after a divorce can add yet another problem to an already long list of challenges. But here are some tips to make your return to single l…
September 18, 2020
Insurance for Long-Term Care at Home
retirement

Insurance for Long-Term Care at Home

In the wake of COVID-wracked nursing homes, increasingly more people are looking at options to age in place with long-term care insurance.
September 17, 2020
A Step-by-Step Guide to Being an Estate Executor
retirement

A Step-by-Step Guide to Being an Estate Executor

Whether you’re planning ahead for your own heirs or have been asked to serve as an executor of an estate for someone else, it pays to understand what …
September 17, 2020
What Trump's Payroll Tax Cut Will Mean for You
Tax Breaks

What Trump's Payroll Tax Cut Will Mean for You

President Trump issued an executive order to suspend the collection of Social Security payroll taxes. How much could it save you?
September 17, 2020