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Life Insurance Is Taxable
Most of us have heard at one time or another that life insurance proceeds are tax free. It’s not true; life insurance proceeds – the face amount of your policy – are subject to estate taxes at the owner-insured’s death. Many people have a hard time believing this at first. After all, you will never get the proceeds of your insurance – it only pays out at your death, and we all know you can’t take it with you! But since you have the power to name the beneficiaries to direct who gets the face amount, the face amount of the policy is counted as part of your estate.
Many years ago, a common practice to avoid estate tax was for spouses to own the insurance on each other’s lives. That had an advantage prior to the 1980s. Then Congress passed the unlimited marital deduction, which allows a person to give their spouse unlimited assets – including the face amount of life insurance – with no estate tax. But the problem that remains is that of passing the remaining money on at the death of that spouse. Having the spouse own it does not solve this.
PROPERLY OWNED, LIFE INSURANCE CAN BE TAX-FREE
That all said, the good news is that life insurance is one of the easiest assets to place into a tax-free form of ownership: in an Irrevocable Life Insurance Trust. Life Insurance can provide terrific leverage as you pass your estate to the next generation. Let’s look at the issues in a question and answer format.
- What does a life insurance trust do?
An irrevocable life insurance trust lets you reduce or even eliminate estate taxes, so more of your estate can go to your loved ones. It also gives you more control over your insurance policies and the insurance proceeds that are paid.
With an insurance trust, the insurance proceeds will not be included in your estate, so you avoid estate taxes on those proceeds. It will also let you control when your children will receive this money (for example, all at once or in installments, or "as needed") and allow you to protect it from their creditors or divorcing spouse. Life insurance trusts are a very common form of "asset protection" trust.
- Maybe I don’t even want any life insurance on my life? I don’t need it!
Life insurance can be an inexpensive way to create wealth for your children; every dollar you spend in premium buys several dollars of insurance. This is what we call leverage. Put a few dollars in, it grows tax-free (with a very significant guaranteed "growth" if you die prematurely) and your family gets many dollars back. And if you do it with no taxes of any kind, by purchasing it through a life insurance trust, it is a very efficient wealth transfer vehicle. Insurance proceeds are available immediately, even if you and your spouse both die tomorrow.
For comparison, consider that many people accumulate a lot of wealth in their IRA or 401k. Leaving your family the IRA is very inefficient: it will be depleted by both estate taxes and income taxes before they can spend it.
- How does an insurance trust reduce estate taxes?
The insurance trust owns your insurance policies for you. Since you (or your spouse, if you're married) don't personally own the insurance, it will not be included in your (or your spouse's) estate - so your estate taxes are reduced.
An example might help: Let's say you are married, with a combined net estate of $2.5 million, $500,000 of which is the face amount of your life insurance. With basic tax planning provisions in your revocable living trusts or wills, coupled with proper titling of assets, you can protect up to $2 million from estate taxes. But at the death of the second of you, your estate would have to pay about $200,000 in estate taxes on the additional $500,000. With an insurance trust, the $500,000 in insurance would not be in your estate. That would save your family $200,000 in estate taxes.
- What if my estate is larger than this?
If your estate will still have to pay estate taxes after you transfer your insurance to a trust, you can reduce your estate tax costs – by having the trust buy additional life insurance. Here are three very good reasons to do this:
First. If the trust buys the insurance, it will not be included in your estate. So the proceeds, which are not subject to probate or income taxes, will also be free from estate taxes.
Second. Insurance proceeds are available right after you die. So your assets will not have to be liquidated to pay estate taxes.
Third. Life insurance can be an inexpensive way to pay estate taxes and other expenses. A great way to leverage your dollars. So you can leave more to your loved ones.
- How does an irrevocable insurance trust work?
An insurance trust has three parties. The Trustmaker (or "Grantor") is the person creating the trust – that's you. The trustee you select manages the trust. And the trust beneficiaries you name will receive the trust assets after you die.
The trustee purchases an insurance policy, with you as the insured, and the trust as owner and beneficiary. When the insurance benefit is paid after your death, the trustee will collect the funds, make them available to pay estate taxes and/or other expenses (including debts, legal fees, probate costs, and income taxes that may be due on IRAs and other retirement benefits), and then distribute them to the trust beneficiaries as you have instructed.
- Why not just name someone else as owner of my insurance policy?
If your spouse owns the policy, then the proceeds are included in their estate, as we pointed out above. If someone else, like an adult child, owns a policy on your life and dies first, the cash value will be in his or her taxable estate. That doesn't help much.
But, more importantly, if someone else owns the policy, you lose control. This person could change the beneficiary, take the cash value, or even cancel the policy, leaving you with no insurance. You may trust this person now, but you could have problems later on. An insurance trust is safer – it lets you reduce estate taxes and keep control.
The way many people move the insurance out of their estate is to have the son or daughter own it. But then there is no way for them to protect the policy and the proceeds from lawsuits, divorces, nursing home costs and other predators that can take assets from them. If you set up the insurance trust for them, then the policy and death benefit can all be protected from such predators, since the policy doesn't legally belong to the child.
- Where does the trustee get the money to purchase a new insurance policy?
From you, but in a special way. If you transfer money directly to the trustee, there could be a gift tax. But you can make annual tax-free gifts of up to $11,000 ($22,000 if your spouse joins you) to each beneficiary of your trust. (This is the amount in 2002, but it will be adjusted over time for inflation.) If you give more than this, the excess is applied to your lifetime federal gift/estate tax exemption.
Instead of making a gift directly to a beneficiary, you give it to the trustee. The trustee then notifies each beneficiary that a gift has been received on his or her behalf and, unless he or she elects to receive the gift now, the trustee will invest the funds – by paying the premium on the insurance policy. Of course, the beneficiaries should be advised of the fact that taking the gift now will undermine the whole program (you can point out to the beneficiary, he would be "shooting himself in the foot") but they must also be legally free to take it.
A life insurance trust is a complicated matter and you should have an attorney represent your interests in setting it up to maximize your control and your flexibility, and to coordinate it's provisions precisely with your personal goals for the distribution of your entire estate. For most people it is much more than just avoiding taxes ... it's leaving a loving legacy that will help the heir, yet never ruin their motivation nor be attached by their creditors or divorcing spouse.
