April is the month for taxes. A common false assumption around the taxation of life insurance policies is that life insurance is simply tax free, but that’s not entirely true.
What is Life Insurance?
Life insurance is a contract between the owner of the policy and an insurance company on the life of the insured person. In exchange for regular premium payments, the insurance company will pay a death benefit to the beneficiaries named in the policy when the insured party passes away. Life insurance is often sold as a tax-free product because the death benefits paid to the policy beneficiaries are not subject to income tax. However, there are two important ways in which life insurance policies are subject to tax.
Subject to Tax after Death
First, after the death of the insurance person, most policy beneficiaries choose to receive the full death benefit they’re entitled to in one lump sum, but they could choose to have the death benefit paid to them over time in installments. If they choose to receive installment payments, the insurance company will hold the death benefit and invest it until it is fully paid out. During that time, any income earned on the invested death benefit will be taxed annually to the trust if not distributed, or to the beneficiary if distributed.
Subject to Tax- Owner and Insured
Second, and often more importantly, when the owner of a life insurance policy and the insured person is the same individual (which is nearly always the case), it’s very important to know that the death benefits which will be paid on the death of the owner / insured person are included in the owner’s taxable estate for estate tax purposes. This is even more important in Massachusetts, because Massachusetts is tied for the lowest estate tax threshold in the country – if your “taxable estate” exceeds $1 million dollars, you will likely be subject to estate taxes. For example, if you own a life insurance policy on yourself with a $500,000 death benefit, you’re already half-way there. Add in the value of a home, retirement accounts, and your other assets, and many, many Massachusetts residents end up owing estate taxes after their death without ever realizing that was likely.
Strategies
An easy strategy that can avoid this surprise, and that will exclude the death benefits from your estate, in creating and using an Irrevocable Life Insurance Trust (ILIT). With this strategy, you create an ILIT, and then either the ILIT itself purchases a life insurance policy on you, or you transfer an existing policy into the ILIT. (If you transfer the policy into the ILIT, however, it does remain subject to estate taxes if you die within three years.) Using your annual or lifetime gift exemptions, you then gift money into the ILIT every year, and the ILIT uses that gifted money to pay the annual insurance premiums on the policy. It is necessary to take very specific steps each year to ensure the gifts are made correctly, and the premiums can be paid by the ILIT without penalties, but if you follow these steps, the death benefit will be payable to the ILIT when you die and not subject to estate taxes, and the ILIT will then distribute the assets to your beneficiaries.
Life insurance can be a great financial tool, but you, your financial advisor and estate planning attorney should work closely together to ensure you meet your goals. Our estate planning team at Legacy Counsellors is ready to assist you. Contact us today!