If there is one thing most people “know” about life insurance — aside from the oft-repeated notion that almost everyone should have a policy — it’s that life insurance proceeds are tax-free.
As with most generalizations about law and finance, though, this assertion is mostly true. If you have life insurance, or are thinking about getting it, you may want to do yourself (and your beneficiaries) a favor by digging a little deeper. This will help prevent any surprises when it comes to potential tax issues.
Free from Income Tax, Not Estate Tax
Indeed, one of the biggest benefits of life insurance is that proceeds are not subject to federal income tax. According to the IRS:
“Generally, if you receive the proceeds under a life insurance contract as a beneficiary due to the death of the insured person, the benefits are not includable in gross income and do not have to be reported.” –IRS.gov
However, life insurance proceeds may still be included in the value of your estate, for purposes of estate tax. In fact, under Section 2042 of the tax code, the value of life insurance proceeds must be included in the value of your estate under two circumstances:
If the proceeds are payable to your estate they will be included in the value of the estate. This one makes sense, and seems intuitive to most people. Yet, naming one’s estate as the beneficiary of their life insurance (or their retirement accounts) is a fairly common occurrence.
The second, and much less obvious, circumstance can occur even when an actual person is named the beneficiary. If you have any “incidents of ownership” over the insurance policy, the proceeds from that policy will be included in your gross estate.
According to Investopedia, incidents of ownership exist on a policy if you have the right to change the beneficiary, transfer ownership of the policy, or use the policy as collateral for a loan.
Who Pays Estate Tax?
If you’ve never heard of the estate tax, or thought it was only a “tax on the rich,” you’re not alone. In fact, even the IRS acknowledges that most reasonably simple estates will not require an estate tax return. Estate tax is imposed on estates with gross assets exceeding the exemption amount – a threshold dollar figure that is indexed for inflation. For tax year 2016, that amount is $5.45 million per person. (The top estate tax rate is currently set at 40%.)
Most people see a number with that many zeros and figure they do not need to worry about estate tax. For the most part, that is true. Only about 2 of every 1000 people end up with estates large enough to subject them to the estate tax. For now at least, most view the estate tax as a problem for the “1%.”
While a $5mm estate may be a bit more than the average person can reasonably expect to leave behind, the estate tax exclusion amount has not always been so high. In fact, Congress has seen fit to change the exemption amount quite a bit in the last few decades.
Related: 3 Estate Planning Documents You Must Have
As recently as 2001, the estate tax was imposed on estates exceeding $675,000. With an estate tax threshold that low, when you take into account rising home values, 401(k) and IRA balances, and cash savings, the possibility of qualifying for estate tax becomes much more plausible.
No one can say for sure whether the estate tax exclusion amount will go up or down in the coming years. It seems safe to say that one shouldn’t dismiss the possibility of paying estate tax, though.
Using an ILIT to Avoid Estate Tax
One way to avoid having the life insurance proceeds included in your gross estate is to structure the policy in such a way that you avoid the aforementioned “incidents of ownership.” This can be accomplished through the use of an Irrevocable Life Insurance Trust.
An Irrevocable Life Insurance Trust (ILIT) is pretty much what it sounds like. That is to say, an ILIT is a trust that (generally) cannot be modified or revoked once it is created.
In order to understand how and why setting up a life insurance policy this way works, a brief primer on life insurance is necessary. When it comes to life insurance, there are four main parties involved: the insurance company, the beneficiary of the policy, the insured (the person whose life is insured by the policy), and the owner of the policy.
The policy owner is the one who has the rights afforded to them by the insurance contract. The owner is the one who can, for example, name the beneficiary, surrender the policy, or transfer ownership. Notably, the owner and insured do not have to be the same person (though commonly are); this is what makes the ILIT possible.
The basic structure is simple. You set up an ILIT, then the ILIT purchases the insurance policy (as the policy owner). You are the named insured (ie: it’s a policy on your life), and the trust names a beneficiary (just as you would if you were the policy owner). Obviously, there are some additional considerations and nuisances, but that is the gist of it.
One of the key things to consider is who makes the premium payments. In order to preserve the integrity of the ILIT structure, the trust – not you – must pay the premiums. However, in most cases this hurdle is easily overcome by using the annual gift tax exclusion.
Under the tax code, each individual is allowed to gift an amount to any other individual tax-free. In 2016 that amount is $14,000. That means that you can make a monetary gift to the trust for the amount of the premium payments. (Assuming, of course, that you’re able to keep the annual premiums below the $14,000 limit.) The trust then uses that money to pay the insurance premiums, thus avoiding any incidents of ownership on your part.
The policy pays out to the beneficiary named (rather than to your estate). The value of those proceeds is then excluded from the gross estate value. Thus, they avoid being subject to gift tax, regardless of the size of your estate.
Additional Benefits to Using an ILIT
On top of the estate tax benefits, the use of an ILIT can present other advantages as well.
For instance, as with most other trusts, an ILIT can be more highly-customized. It can be structured so as to not to pay the beneficiary (or beneficiaries) immediately. This can be useful with a minor beneficiary, or one incapable of handling a sudden, large payment. This allows the trustee of the ILIT to act as a supervisor or manager of the funds in the trust. They can distribute the funds according to the wishes of the grantor (trust maker), and the terms of the trust.
Along those same lines, an ILIT can provide a certain level of asset protection to the beneficiaries. This is because the beneficiaries do not own the ILIT. Because of this, the assets of the ILIT are hard for creditors (and courts) to reach.
That being said, it is worth noting that using an Irrevocable Life Insurance Trust is a complicated and highly specialized technique. As such, it is always advisable to consult with your estate-planning attorney and/or financial advisor when considering making these sorts of significant changes to your estate plan.