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.

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

HSAs Get Even Better
Financial Planning

HSAs Get Even Better

Workers have more options with flexible spending accounts, too.
July 2, 2020
Find a Great Place to Retire
happy retirement

Find a Great Place to Retire

Our cities provide plenty of space to spread out without skimping on health care or other amenities.
July 2, 2020
What Are the Income Tax Brackets for 2020 vs. 2019?
tax brackets

What Are the Income Tax Brackets for 2020 vs. 2019?

The IRS unveiled the 2020 tax brackets, and it's never too early to start planning to minimize your future tax bill.
June 20, 2020

Recommended

20 IRS Audit Red Flags
tax returns

20 IRS Audit Red Flags

There's no sure way to avoid an IRS audit, but these red flags could increase your chances of drawing unwanted attention from the IRS.
July 1, 2020
10 IRS Audit Red Flags for Retirees
retirement

10 IRS Audit Red Flags for Retirees

Watch out: These things can increase the chances that the IRS will give your tax return a closer look.
July 1, 2020
Exit Strategies for Charitable Remainder Trusts
estate planning

Exit Strategies for Charitable Remainder Trusts

CRTs offer tax and income-planning flexibility as life changes over the years.
July 1, 2020
For Financially Responsible Kids, Do NOT Do These 3 Things
family savings

For Financially Responsible Kids, Do NOT Do These 3 Things

The key to putting your kids on the right financial path can be boiled down into one sentence.
July 1, 2020