There are actually two short answers here – no, and sometimes. Confused? It’s actually not that complicated. There are two answers, because there are two potential tax liabilities that could be incurred as a result of receiving life insurance proceeds.
Regular Income Tax Liability
This is the tax liability that most people are most immediately concerned with. After all, if you suddenly receive a six-figure benefit from the payout of a life insurance policy from a loved one, it seems to make sense that there will be some sort of tax liability connected with that payout.
In reality however, life insurance proceeds are generally not subject to ordinary income tax. That’s certainly true when the beneficiary is the spouse of the insured decedent. But it’s also true of the decedent’s other heirs.
As a general rule, life insurance proceeds are not subject to regular income because the premiums paid are not deductible from the insured’ income. Therefore, the death benefit pay-out passes without being subject to income tax liability.
Estate Taxes – the Potential “Gotcha Tax”
Estate taxes are far more likely to occur with life insurance proceeds than income taxes, though most people are less aware of them, or how and when they apply. In most cases, and for most people, estate taxes will not apply to life insurance proceeds. When they do, it typically involves very high value estates. It all depends on what the life insurance proceeds do to the decedent’s estate valuation.
How does life insurance figure into the estate tax picture? While life insurance proceeds are not taxable as ordinary income, they are required to be added to the estate of a decedent. That means that if a person dies and leaves an estate worth $2 million, plus $500,000 life insurance policy, the estate will be valued at $2.5 million for estate tax purposes.
Life insurance proceeds received as a result of the death of a spouse will not be subject to estate taxes since it is effectively a transfer between spouses. And even when proceeds pass to beneficiaries who are not spouses, the estate tax will usually not be triggered unless those proceeds, when combined with the decedent’s other assets, exceed certain thresholds.
For federal estate tax purposes, the estate is not subject to the estate tax until it exceeds $5.45 million. That’s the estate tax threshold for 2016, but the amount of the threshold is increased periodically. Still, with a threshold that’s that high, most estates will not be subject to Federal estate taxes, even when life insurance is included.
A much more common estate tax concern is at the state level. Several states have estate tax thresholds that are below the federal level. In most such cases, the state estate tax threshold is well below the federal, often falling between $1 million and $2 million. At the extreme is New Jersey, where the estate tax threshold is triggered at only $675,000.
Fortunately, there are a couple of ways to avoid incurring the estate tax.
Transfer the Policy to Someone Else
This involves transferring the policy to another individual. That means that you will no longer own the policy, and will have no control over it in the future. You will not be able to make changes to the policy, including changing the beneficiary or any of the other terms of the policy.
There are a couple of important limitations with this strategy:
Three year look-back. If you transfer a life insurance policy to another person, and you die within three years of the transfer, the life insurance policy proceeds will still be included in your estate. This means that you will not be able to avoid the estate tax by transferring the policy “on your deathbed”. It is a long-term strategy, that must be put in place well before.
Gift tax. This is not a problem with term life insurance policies, because they do not accumulate cash value. But it could become a problem with whole life policies, and other life insurance types that include an investment provision. Since you will be transferring a life insurance policy to another individual, the cash value included in the policy will be considered a gift for tax purposes.
For 2016, you can gift up to $14,000 without incurring the gift tax. If the cash value of your life insurance policy is less than $14,000, no gift tax will be owed. But if the cash value exceeds $14,000, you may incur a gift tax. (Your accountant however can usually get around this by filing IRS Form 709, which enables you to apply the excess amounts against your $5.45 million lifetime estate limit.)
Transfer the Policy to a Trust
You can also transfer the policy into a life insurance trust, which will be an excellent strategy in the event that there is no individuals whom you are comfortable enough to trust in taking ownership of the policy and allowing it to payout according to your terms.
Just as is the case with transferring the life insurance policy to an individual, if you transfer it to a trust, the trust becomes the owner of the policy. That is to say that you will have no control over the policy from that point forward. However, the trust is also the beneficiary of the policy, and you can decide who the beneficiaries will be, and what the monetary distribution will be as part of the trust when you create it.
In order for you to be able to exclude the proceeds of the life insurance policy from your estate, the trust must be set up as an irrevocable trust, which means that you cannot dissolve it once it is created. In addition, you cannot be a trustee on the trust – all connections between you and the life insurance policy must end, apart from the fact that the policy will pay out on your death.
These tax exemptions are a big part of what makes life insurance attractive as a way to transfer wealth to your heirs upon your death. And that’s over and above the more obvious benefits of providing money for final expenses.
