Get legal assistance when preparing for taxes on life insurance benefits

Dear Jonathan: Several years ago I purchased a 20-year term life insurance policy on my life with a death benefit of $3 million. The premiums were reasonable and since my wife and I had saved very little for retirement, I wanted to make sure that she was taken care of if I died first. Unfortunately, my wife passed away last year. Rather than let the policy lapse, I thought I would keep it in place for my children. I recently read an article, however, that said life insurance is taxable when the insured on the policy dies. What does this mean? Are my children going to get stuck with a huge tax bill because of this life insurance?

Jonathan Says: There are many rules and regulations involved regarding the taxation of life insurance, whether it is federal estate tax or federal income tax, and this area of the law can get very complicated. Generally speaking, life insurance death proceeds are not subject to federal income tax so your children will receive the death proceeds income tax free.

On the other hand, life insurance death proceeds are subject to federal estate tax and are included with the balance of your other assets when determining your taxable estate. So, if at the time of your death, you have an estate worth $500,000 without counting the death benefits from your life insurance policy, when adding those death benefits, your taxable estate would now be $3.5 million. That is the bad news; the good news is that federal law provides an exclusion from federal estate taxes for estates valued at $5 million or below. Consequently, if the total value of your estate, including the $3 million death benefit, is below $5 million, there will be no federal estate tax due at the time of your death.

However, if the death proceeds from the life insurance policy increases the size of your estate to an amount in excess of $5 million, you would now have an estate that would incur a federal estate tax at your death unless you did some type of further planning. One type of planning that is indicated in this instance is to remove the value of the life insurance policy from your estate so that that policy is not taxed as part of your estate at your death. One way this is done is by setting up an irrevocable life insurance trust, known as an ILIT. This is a special type of trust that is established for the purpose of owning (and being the beneficiary of) life insurance on the life of the person who created the trust (the “grantor”). If done properly, when the grantor dies, the trust as the beneficiary will receive the death benefits. Those death benefits will not be taxed in the grantor’s estate and those proceeds will be distributed to the beneficiaries named in the trust pursuant to the terms stated therein.

There are a myriad of tax rules which need to be complied with when creating and administering an ILIT in order to keep the life insurance proceeds out of the grantor’s estate. One of those rules is that if you transfer a life insurance policy you already own to an ILIT, you must survive that transfer by three years in order to keep the death benefit out of your taxable estate. This is to avoid people making death bed transfers of their insurance policies to an ILIT for the purpose of avoiding or reducing federal estate taxes. This three year survivorship rule only applies, however, when transferring life insurance policies to an ILIT; if the ILIT purchases a new life insurance policy on the grantor’s life, as opposed to the grantor transferring an existing life insurance policy to the ILIT, the three year survivorship rule does not apply in that instance.

If you have any further questions regarding the taxation of life insurance or if you have any interest in establishing or setting up an ILIT, you should consult with an estate planning professional in your area who is experienced in this area. Good luck.

Jonathan J. David is a shareholder in the law firm of Foster, Swift, Collins & Smith, P.C., in Grand Rapids, Mich.