Life insurance can be an effective part of estate planning, and can provide a significant benefit to a decedent’s surviving family members. While life insurance planning is a commonly used estate planning tool, there are several commonly held misconceptions about the tax treatment of life insurance proceeds. Many believe that life insurance proceeds are tax free in all circumstances. While it is true that life insurance proceeds are often tax free, there are specific circumstances in which life insurance can be subject to estate tax. Understanding the tax consequences of life insurance is important in order to maximize the amount that passes to the beneficiaries under the policy.
In order to understand when proceeds from a life insurance policy might be taxable, it is helpful to understand that there are three types of taxes that could potentially affect the proceeds distributed from a policy: income tax, inheritance tax, and estate tax.
Income Tax Treatment
The first question many people have about life insurance is whether the beneficiaries of the life insurance proceeds will be taxed on the amount they receive as a death benefit from the policy. The short answer is no; beneficiaries of life insurance policies will not pay income tax on amounts received from life insurance that has paid out at a loved one’s death.
Beneficiaries do not pay income tax on life insurance proceeds despite the fact that the government uses a very broad definition for defining income under the tax code. Subject to exceptions within the tax code, the IRS considers income to be, “all income from whatever source derived.” Although life insurance proceeds would seem to fit into this broad definition of income, section 102 of the tax code specifically exempts amounts received as inheritances from the definition of income, and beneficiaries will therefore not have to pay income tax on the life insurance proceeds they receive.
Inheritance Tax Treatment
An inheritance tax is a type of tax that is imposed on a person who inherits money or property. An inheritance tax is distinct from an estate tax, which is imposed on the estate of a decedent, and is described further in the following section. There is neither a federal inheritance tax nor a Washington State inheritance tax. Life insurance beneficiaries therefore need not be concerned with inheritance taxes unless they live in a state with an inheritance tax such as Iowa, Kentucky, Maryland, Nebraska, New Jersey or Pennsylvania.
Estate Tax Treatment
An estate tax is a tax levied on the value of a decedent’s estate before any distribution is made to beneficiaries. A taxpayer’s estate can be generally described as the assets that an individual owns upon death. The estate tax is the type of tax most likely to affect life insurance proceeds. To understand whether or not estate tax will apply to life insurance, it is necessary to understand the basics of both the federal and Washington State estate tax.
Very few people are affected by the federal estate tax, due to the large exemption amounts currently available to taxpayers. As of 2016, a single taxpayer has a 5.45 million dollar estate tax exemption amount, which means that taxpayers will pay federal estate tax only on the amount of their estate that exceeds 5.45 million. This exemption amount may be ported among spouses for a combined amount of 10.9 million dollars. The end result is that unmarried individuals with less than 5.45 million in assets, and married individuals with less than 10.9 million in assets generally avoid paying the federal estate tax completely. Data from the past tax year shows that less than one percent of taxpayers paid any federal estate tax in 2014.
Like its federal counterpart, Washington State’s estate tax also provides for an exemption amount, but at a lesser level. The current Washington State estate tax exemption amount is just over two million dollars for unmarried individuals. In contrast to the federal estate tax, for which combining spousal exemption amounts is relatively easy, married couples in Washington State must use specific tax planning mechanisms if they want to take advantage of both spouse’s two million dollar exemption.
The difference between the federal and state exemption amounts means that an unmarried taxpayer who dies with an estate valued over two million dollars — but less than 5.45 million — will pay Washington State estate tax, but not federal estate tax. An unmarried taxpayer who dies with an estate valued over 5.45 million dollars will pay both a Washington State and federal estate tax, subject to certain exceptions, deductions, and considerations beyond the scope of this article.
Is the value of a life insurance policy included in a taxpayer's estate?
With the basic estate tax exemption considerations in mind, the real question becomes, “is the value of a life insurance policy included in a taxpayer’s estate?” The answer is that, in many cases, life insurance proceeds are included in an individual’s estate for tax purposes, and therefore face the possibility of being subject to the estate tax. Section 2042 of the tax code explains that life insurance proceeds are considered part of a taxpayer’s estate if the taxpayer has any “incidents of ownership.” While the rules and regulations pertaining to this clause are extensive, it suffices to know that this rule means that if someone owns life insurance and has the power to designate the beneficiaries of the policy, that person thereby has incidents of ownership and the proceeds are included in his/her estate for estate tax purposes.
For illustration purposes, we will use the example of Caleb, an unmarried man whose assets/estate consists of the following:
- home equity of one million dollars;
- a savings account worth one million dollars; and
- a life insurance policy of one million dollars.
We will assume that Caleb owns his life insurance policy, like most of us, and has the power to designate and change the beneficiaries under his policy. If Caleb were to die this year, his estate would be composed of three million dollars (the total amount of his home equity, savings account, and life insurance proceeds). Caleb’s estate would have to pay Washington State estate tax on the amount exceeding two million dollars (in his case, on one million dollars), thereby costing Caleb approximately $100,000 in taxes. Caleb’s three million dollar estate would be under the 5.45 million mark for federal estate tax purposes and he would thereby avoid paying federal estate tax.
If, however, Caleb’s life insurance policy paid out four million dollars, instead of one million dollars, then his estate would total six million dollars (one million in home equity + one million in savings + four million in life insurance proceeds) and he would have to pay Washington State estate tax on the amount that exceeds two million dollars (four million) and both federal and Washington State estate tax on the amount exceeding 5.45 million dollars (.55 million). With Washington State estate tax rates ranging from 10 to 19 percent, and federal rates ranging from 35 to 40 percent, it is easy to see how ignorance of the tax attributes of life insurance proceeds can lead to significant tax payments when death payouts push an individual’s estate over the two million mark.
The good news, however, is that it is relatively simple to remove life insurance proceeds from the equation that the IRS uses to calculate a decedent’s taxable estate. The IRS views the power to change beneficiaries as an incident of ownership that causes the life insurance proceeds to be included in a decedent’s estate. A common way to remove life insurance proceeds from this equation, therefore, is to transfer the life insurance policy into an irrevocable trust under which the person granting the policy gives up the right to change the designated beneficiaries. This trust is called an Irrevocable Life Insurance Trust (or ILIT). Although the person transferring the policy loses the ability to modify the trust or change the beneficiaries in the future, the named beneficiary of the policy becomes the ILIT, and the beneficiaries of the ILIT are typically family members of the former policyholder. The end result is normally that the life insurance proceeds pass to the correct family members.
The tax planning behind ILIT trusts is beyond the scope of this article, but it suffices to say that simply moving a life insurance policy into an ILIT more than three years before death, if done correctly, will cause life insurance proceeds to be excluded from an individual’s estate for tax purposes.
Life Insurance planning can be an effective estate planning tool. For many people whose combined assets are below the two million mark upon death, life insurance proceeds will likely pass to beneficiaries tax free. Life insurance proceeds, however, are considered part of an individual’s taxable estate if the decedent had the power to change the beneficiary designation. In cases where the amount of life insurance proceeds are substantial and would cause the value of an individual’s estate to rise above the two million mark, the decedent’s estate might be faced with an unexpected estate tax burden. Relatively simple tax planning can remove life insurance proceeds from the estate of a decedent, however, thereby avoiding or reducing any potential estate tax owed upon death.
Have questions regarding tax planning or any of the taxes outlined above? Contact one of our Kirkland estate planning attorneys.