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August 11
What You Need to Know About Life Insurance and Estate Taxes

What You Need to Know About Life Insurance and Estate Taxes

Life insurance is an important financial tool that someone can use to protect his or her loved ones from a financial loss associated with his or her death. Life insurance policies are also commonly used to help cover final costs such as funeral arrangements and related expenses. Finally, life insurance may be used as a way for one generation to help pass on wealth to the next. When the final function of life insurance is in play, there are some key things that you need to know about life insurance and estate taxes to help make sure that your beneficiaries do not pay more than necessary.

What Is Estate Tax?

Estate tax is a federal or state tax that is imposed on a deceased person’s estate after he or she dies depending on the taxable value of that estate. Estates which fall under the specified taxable estate are not taxed while estates above the threshold are. The threshold varies from state to state, but for federal estate taxes as of 2014 the amount is $5.34 million. This means that estates with a taxable value under $5.34 million will not be subject to federal estate taxes.

It is also important to note that the surviving spouse of the deceased is never subject to estate taxes. Spouses can inherit any size estate tax free from each other. Charities are also typically exempted from the tax. However, children, other family members, and general members of the public are subject to applicable estate taxes.

Is Life Insurance Taxable?

One of the appeals of life insurance is that proceeds are not considered taxable income for the purpose of the beneficiary’s income taxes. However, life insurance benefits may be taxed in certain instances under the gift tax, which we will discuss in more detail in the next section, as well as under estate taxes. The key factor for whether life insurance is subject to estate taxes is whether or not it is actually considered part of the deceased’s estate. If the deceased person owned the life insurance policy then it is part of his or her estate, but if they did not, even if the policy was on them, then it is not considered part of his or her estate.

How Can Estate Taxes on Life Insurance be Avoided?

Simply put if the person in question does not own the life insurance policy then it is not part of his or her estate. Ownership of the policy can be transferred to another person or to a non-revocable trust in order to exclude it from the insured’s estate. However, if this route is taken, then it is important to take note of the gift tax. The gift tax is a tax imposed on gifts over a certain value, $14,000 as of 2014. However, only the cash value – the amount the owner of the policy would receive if he or she cashed it out – is subject to the gift tax, not the face value of the policy. That means that a life insurance policy for $50,000 with a cash value of $11,000 could be transferred without incurring the gift tax and once ownership of it is passed the $50,000 death benefit will not be counted toward the deceased’s estate.

Are There Any Exclusions on Transferring Life Insurance Policies to Avoid Estate Taxes?

Life insurance policies must be transferred at least three years prior to the person’s death to be excluded from their estate. Furthermore, the person must completely have relinquished all “incidents of ownership” at least three years before his or her death. Incidents of ownership are things such as being able to change the beneficiary, cancel the policy, borrow against the policy, select payout options, etc. The insured should also avoid paying premiums on the policy. Instead they must be payed by the new owner, unless the policy is already payed in full at the time of ownership transfer. However, the insured is allowed to give the new owner money to pay the premiums, up to $14,000 to avoid gift taxes.

Life insurance is an extremely powerful financial tool. In order to maximize its power it is important to consult your insurance agent and when necessary also an accountant. Understanding the ramifications of estate taxes, gift taxes, and life insurance benefits is a crucial step toward making sure your loved ones are taken care of.