Is There Estate Tax on Life Insurance?


Quick Article Guide

1. When Life Insurance Benefits Are Subject to Tax
2. Life Insurance Ownership and Estate Tax
3. How To Transfer Life Insurance Ownership

We receive a lot of calls from potential clients and referrals with questions about their coverage. One common question we hear often; “Is there Estate Tax on Life Insurance?”

For most individuals who purchase life insurance to pay off debts and final expenses, the answer is, “No”. However; depending on the value of your estate, your life insurance policy may create an additional tax liability for your heirs or dependents.

Sound complicated? Don’t worry we’ll walk you through the process…

When Are Life Insurance Benefits Subject to Estate Tax?

Every year the IRS readjusts the estate tax exemption limits and the estate tax rates, but most of our client’s estates grow at a faster pace than the increasing exemption amounts. As of 2016, a federal estate tax will be imposed on estates worth over $5.45 million, or for couples with a combined estate value of $10.90 million or more.

If your estate exceeds the federal tax exemption for the year, your heirs will be looking at federal tax rates as high as 40%. In addition to federal estate taxes, your heirs may also be facing an additional inheritance tax of 16%, depending on the state you reside in. Here’s the catch: If you control your own life insurance policy, according to the IRS section 2442, the payout from your life insurance will be considered as part of your estate. In other words, when you pass away, all of your assets including the life insurance will be added together. If your estate’s value exceeds the estate tax exemption for the current year, the value of your estate that exceeds the exemption is subject to estate tax.

The only exception to the federal estate tax law is that life insurance proceeds are a 100% marital deduction. A marital deduction allows you to transfer an unlimited amount of assets to your spouse’s estate tax free, but when they pass away, your estate will still face estate taxes. The federal taxes on your estate are due within nine months after you pass away, and they must be paid in cash. This can create a headache for your heirs, forcing them to have a “fire sale” to quickly raise cash to prevent the IRS from seizing your property. To avoid paying taxes on the payout of your life insurance policy, you must separate your life insurance policy from your estate. Here’s how it works…

Life Insurance Ownership and Estate Tax

To avoid taxation of your life insurance policy, you cannot own your own life insurance policy. But, you can create an irrevocable life insurance trust also known as an “ILIT”. An “ILIT” allows you to dictate your final wishes and avoid the IRS’ tax implications. By naming your ILIT as the owner of your policy, you will separate your coverage from your estate and avoid estate taxes. Your life insurance policy will create an influx of cash at your passing and in-turn, this cash can be used to pay off any outstanding estate tax obligations.

By settling these taxes with your life insurance policy, you are ensuring that your loved ones will not be forced to sell off important family heirlooms such as real estate, artwork, jewelry, and even businesses. We all know that the IRS tax laws are not always black and white; we speak to dozens of client’s every month that seem lost in this process. In fact, the majority of life insurance agents never work with affluent clients that need this type of coverage.

This inexperience creates misunderstandings in the life insurance industry, and often times, an inexperienced agent will recommend term life insurance instead of permanent coverage for estate protection.

If you outlive your policy, you have wasted your hard earned money. Sadly, the call centers that you see on TV are usually set up only to focus on term life insurance coverage, and they are more concerned about keeping their investors happy than their clients. Term life insurance is very inexpensive because the life insurance company expects you to outlive it, not exactly a good idea for estate planning. In order for your family to benefit from the life insurance, you must outlive your life insurance policy.

We often receive calls from client’s who have been rejected by their bank or estate attorney for buying term life insurance. The attorney or bank will not accept the liability of creating an estate plan that is funded by a term policy that will likely expire before you do. We offer dozens of options for permanent coverage with rates and coverage guaranteed until age 90, 95, 100, 110, 120, or 121. These policies work just like a term policy with guaranteed rates and coverage, but they offer life insurance coverage that extends to the age of 90 or later.

How to Transfer Life Insurance Ownership

The best way to maintain some legal rights over your life insurance policy but still protect the proceeds from Estate Taxes is by creating an Irrevocable Life Insurance Trust or “ILIT”.  Since the trust acts as both the owner and the beneficiary of the policy the proceeds remain separate from your estate, eliminating estate tax obligations on your policy. 

When creating your ILIT, you will need to appoint a trustee who will handle the proceeds of your estate and life insurance payout, as directed by your trust, after you pass away. The best time to create an ILIT or irrevocable life insurance trust is before you buy your life insurance coverage. If you have already purchased your life insurance coverage, you want to create an irrevocable life insurance trust as soon as possible.

There is a “three year rule” that applies when transferring an existing life insurance policy to an ILIT. If you pass away within 3 years of transferring your policy into an ILIT, the IRS will not recognize your irrevocable trust. This is because the IRS does not want people to be able to maintain control of their life insurance policy until they are terminally ill. Some of our clients find it easier to apply for a new policy to fund their irrevocable life insurance trust with, but if you’re uninsurable, your only choice is to transfer your current policy into an irrevocable life insurance trust. While setting up an “ILIT” tends to be more complicated than transferring a policy to an individual, you will be able maintain some legal rights over the policy as well as ensure that the premiums are paid on your coverage so the policy does not lapse.  

In many cases, Irrevocable Life Insurance Trusts are a great way to preserve your estate and protect the benefits of your life insurance policy from costly estate taxes. We’re here to help you get the process started, but we always recommend speaking with an attorney who specializes in trusts or estate planning.

Estate Planning with Life Insurance

When it comes to estate planning, everyone’s situation is different. Whether or not your heirs end up paying estate taxes on life insurance benefits depends on the steps that you take to make sure the policy does not become a part of your taxable estate. If you’re not sure of how to get the process started, that’s okay. We are here to help! At JRC Insurance Group, our licensed agents are experienced in estate planning and would be happy to help you protect and pass on your assets to your loved ones, not to Uncle Sam.

Be sure to also read our article on the 7 Costly Errors to Avoid when estate planning with life insurance.

We work directly with over 40 top-rated different life insurance companies which allows us to shop the market to ensure that you receive the best deal available. We are not a high volume call center that focuses on quotas and sales goals. We take the time with every client to make sure you understand your options. Give us a call today for a FREE consultation and you’ll see why were different. Don’t take our word for it; our client’s tell our story the best. Please read the testimonials our clients have sent to us by clicking here, or give us a call, Toll free: (855) 247-9555

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Cliff Pendell

VP of Marketing at JRC Insurance Group
Cliff is a licensed life insurance agent and one of the owners of JRC Insurance Group. He has helped thousands of families of businesses with their life insurance needs since 2012 and specializes with applicants who are less than perfect health. In his spare time he enjoys spending time with family, traveling, and the great outdoors.
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