Depending on how you manage your estate, the estate size, the type of policy and the mode of payment of the proceeds to beneficiaries, death benefits from life insurance may be subject to federal and state taxation. Therefore, properly arranging your assets and affairs is essential if you want to avoid such payments. This article discusses situations when your life insurance payouts may be taxed by federal and Pennsylvania tax laws and how to prevent massive tax liabilities.
Death benefits are the amounts the insurance company pays beneficiaries after the insured person passes away while the policy is in force. The beneficiaries could be:
The law allows the insurance policyholder to select multiple beneficiaries and allocate what percentage or amount of the payout each beneficiary gets. For example, the policyholder may designate 40% of the amount to be given to charity while the remaining 60% is shared equally between their spouse and children. The policyholder may also add or remove beneficiaries.
Generally, federal life insurance payouts to beneficiaries are excluded from gross income and, consequently, non-taxable. However, there are some exceptions. The size of the estate, the type of policy and the mode of payment to the beneficiaries are some of the determining factors.
Suppose the policyholder delays the payout, and the insurance company holds the money for a period of time, allowing it to generate interest. That interest may be subject to tax. The same applies to interest that accrues when beneficiaries elect to receive the payout as an annuity — a series of payments — instead of a lump sum. A death benefit made payable to an estate — the money, assets and property of the deceased person — may increase the estate’s value and potentially increase estate taxes.
Life insurance may form part of an estate, depending on the circumstances. For example, the policyholder may name their estate as the beneficiary, in which case, the life insurance payout may form part of their estate. Also, if a beneficiary dies before the policyholder, and the policyholder forgets or is unable to name a new beneficiary, the death benefits may form part of the estate.
Beneficiaries may be required to pay estate tax when the life insurance payout becomes part of the estate. Naming your estate as the beneficiary subjects your heirs to the probate process and increases the value of your estate, which could increase the beneficiaries’ tax liabilities. According to section 2042 of the Internal Revenue Code, the value of the life insurance proceeds is included in the gross estate if the proceeds are payable:
Pennsylvania has an inheritance tax in place of a state estate tax. The state’s law generally exempts life insurance proceeds from inheritance taxes in the estate of the decedent, provided it is not an annuity. According to the state’s income tax laws, such proceeds are also not taxable as income. The situation is the same whether the death benefit passes to the estate or directly to the beneficiary.
When the beneficiary takes the death benefit and converts it into a different kind of asset, that can also create a taxable situation. A typical example is when a surviving spouse takes the death benefit and invests the proceeds into a mutual fund. After the surviving spouse passes away, their beneficiaries would pay taxes on proceeds from the mutual fund since those funds are no longer from a life insurance policy.
Creating an irrevocable life insurance trust is an effective way to avoid paying taxes on life insurance policies. We discuss this option in more detail below.
Here are two tips on how you can avoid taxes on life insurance proceeds:
Who owns the policy at the time of the insured’s death may determine whether the proceeds are taxable. So transferring ownership of your policy to another person or entity may help you avoid federal taxation. You may select a competent adult or entity as the new owner and let them pay the premiums on the policy.
You may also gift the person amounts within the federal threshold that they can use to pay some of the premiums, but you cannot pay the premiums directly or otherwise be involved with the policy as this would create some incidents of ownership.
If you transfer your policy, you will be unable to make changes to the policy. However, if you use a relative as the new owner, they can make the changes at your request. The ownership transfer is irrevocable, so it is essential to consider factors such as potential and imminent divorce when selecting the new owner. Also, it helps to obtain written confirmation from the insurance company as proof of a change of ownership.
An irrevocable trust is a trust that cannot be terminated or altered after its creation. It moves the assets from the creator’s control to the beneficiary, reducing the value of the creator’s estate and liabilities from creditors for tax purposes.
For this to work, the trust’s creator cannot be the trustee and may not retain the right to revoke the trust. Depending on the type of policy and the nature of assets in the trust, the creator may make annual cash gifts to the trust to enable the trustee to pay the insurance premiums. The trustee holds the property on behalf of the beneficiary. When the creator dies, the trustee distributes the payouts according to the terms of the trust.
Instead of transferring ownership of the life insurance policy entirely to another person, creating trust ownership may allow you to have some legal control over the policy. It also allows you to ensure that the premiums are paid correctly and promptly.
The IRS has rules to help determine the ownership of a life insurance policy when an insured person passes away. One such regulation, the three-year rule, subjects gifts made within three years of the death to federal estate tax.
The rule applies to establishing an irrevocable life insurance trust and transferring ownership to another person, natural or juristic. This means that if the creator of the insurance policy dies within three years of the transfer, the death benefits are included as part of their estate as if they still own the policy.
The IRS may also consider the incidents of ownership by the person transferring the policy. As noted above, the original owner forfeits their legal rights to change beneficiaries, surrender or cancel the policy, choose beneficiary payment options or borrow against the policy when the transfer is effected. Also, the original owner may not pay the premiums directly to keep the policy running. Doing any of those things will negate the tax advantages of your arrangements.
You can plan your estate yourself, but partnering with an attorney helps enormously. Lawyers have the skill and knowledge to help you arrange your assets properly to mitigate or remove tax liabilities and other legal challenges. Attorneys take the load off your shoulders by helping you file the necessary paperwork, such as forms and tax returns. However, it’s vital to choose an attorney who is experienced in federal and state tax and insurance laws and dedicated to understanding your needs.
Estate planning is essential because it allows you to transfer assets to your beneficiaries without saddling them with tax liabilities. Generally, death benefits from life insurance are exempt from taxes unless the arrangement falls within the federal or state exceptions.
Johnson Duffie is a full-service law firm with decades of experience in insurance, taxes and trust and estate planning and administration, which allows us to deliver personalized legal services to people in Pennsylvania. We can help you plan your estate to mitigate liabilities and taxes so your beneficiaries can enjoy the benefits without challenges. Contact us now and take advantage of our solid partnership!