Will life insurance proceeds be included in an estate?

When a person with a life insurance policy dies, there is a lot of confusion about the taxation of the proceeds. The tax consequences of being the beneficiary of a life insurance policy can be confusion, but this information should help.

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Policy Proceeds and Your Estate

Whether the proceeds from your life insurance policy end up in your estate or not depends on who owns and controls the policy. If you own the policy, the proceeds will be added to your estate.

To be more specific, if you have, at the time of your death, an ‘incidence of ownership’ in the policy, the proceeds will be considered part of your estate. An incidence of ownership means that you can change, use or benefit from the policy.

So if you can change the beneficiary or take out a loan against the policy, you have an incidence of ownership and the proceeds become part of your gross estate.

Here’s an example. Sam buys a $100,000 life insurance policy on himself and names his wife Sally as the beneficiary. Sam is the owner of the policy and he pays the premiums. When Sam dies, Sally gets $100,000, and $100,000 is added to Sam’s gross estate for the purpose of figuring out the estate tax.

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Changing Ownership of a Policy

If you own a life insurance policy on your own life and you want to change the ownership to avoid having the proceeds added to your estate, you also need to give up control of the policy. The new owner needs to pay the premiums and also must have control over any changes to the policy.

If you want, you can give money to the new owner to pay the premiums, up to the maximum annual gift tax limit which is $14,000 through 2017. This means you can give someone up to $14,000 each year to pay the premiums on the policy on you and still not be considered to have an incidence of ownership.

Here’s an example. Sam buys a $500,000 life insurance policy and names his son Scott as the beneficiary. Sam is the owner of the policy and pays the premiums.

When Sam is 70 years old, he reads this article and decides he’d better change the ownership of his policyso the proceeds won’t be added to his estate. But Scott can’t afford to pay the $10,000 annual premium.

So Sam changes the ownership of the policy to Scott and gives Scott $10,000 every year, which Scott uses to pay the premium on the insurance policy on Sam’s life. When Sam dies at age 85, Scott gets $500,000 from the insurance policy and Sam’s gross estate is not affected.

Keep in mind that changing the ownership of the policy is subject to the ‘three-year rule.’ If the ownership of the policy is changed within three years of the death of the insured, the ownership change does not prevent the proceeds from being added to the decedent’s estate.

So, in the above example, if Sam had died at age 72, two years after changing the policy ownership, Scott would still get the $500,000, but the amount would also be added to Sam’s estate for purposes of calculating the estate tax.

An Irrevocable Life Insurance Trust

The owner of a life insurance policy does not have to be a person. It can be an entity, and many people create an irrevocable life insurance trust, or ILIT, to own their life insurance policies.

The trust is the owner and the beneficiary of the life insurance policy. This means that the insured does not have an incidence of ownership in the policy and therefore the proceeds are not added to the insured’s gross estate when they die.

Another advantage of an ILIT is that it can be used to structure the proceeds for beneficiaries who may not be able to receive a significant amount of money at one time.

Sometimes this is because they are minors, and sometimes it is because they have issues like substance abuse or difficulty handling their financial affairs.

The ILIT can stipulate that the proceeds be paid out to the beneficiaries on a periodic basis, or that someone else is named the trustee to distribute the money according to the wishes of the decedent.

Here’s an example of how to use an ILIT. Sam has a life insurance policy on himself and one on his wife Sally. Their son Scott is the beneficiary of both policies. Sam has struggled with substance abuse and has declared bankruptcy, but is now sober and had a regular job. Still, he realizes, as so Sam and Sally, that it’s difficult for him to handle money.

So Sam and Sally set up an irrevocable life insurance trust, and transfer ownership of their policies to the trust. When they die, ten years later, the policies pay out the proceeds to the trust, which sends Scott a check every month based on the instructions of Sam and Sally.

The Real Story on Estate Taxes

If you’re concerned about estate taxes, it’s important to know where you stand. A lot of people are very concerned about paying estate taxes when, in fact, they may never have to.

First of all, if you die before your spouse, unless your will says otherwise, all of your assets pass to your spouse. There is no estate tax due in this case, which is known as the marital deduction.

If your spouse dies first, and you now own all of the marital assets, your estate will be subject to tax if it is above a certain threshold.

In 2017, the Federal estate tax exclusion in $5,490,000. That means that you would have to have a gross estate greater than $5,490,000 in order to be subject to estate tax.

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Estate Planning

Some people use life insurance policies, usually held in an ILIT, to effectively ‘cover’ the estate taxes they anticipate will be owed. This strategy allows the heirs to inherit the full amount of the decedent’s estate, with the proceeds from the life insurance policy being used to pay the estate taxes.

This often requires a significant insurance policy, since only those estates valued at over $5,490,000 are taxed.

The amount of estate tax would need to be estimated, and a policy purchased with a death benefit of approximately the same value.

An estate planning attorney should be consulted when employing this strategy.

The issues around estate taxes and estate planning can be complex, but understanding how to keep life insurance proceeds out of your taxable estate doesn’t need to be. Still, a tax advisor and estate planning attorney would be good allies to have as you consider these questions.

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