For many people, life insurance policies are passed on to their beneficiaries, tax-free. But if your policy pushes the value of your estate above the exemption level of that year, your heirs might need to pay estate taxes.
When you might be charged a life insurance estate tax
In the US, you have the right to leave your property — including a life insurance policy — to a beneficiary after your death. The government has a right to tax the value of that property when you die. This is known as the estate tax.
In these cases, life insurance might affect your estate planning.
The payout could cause your estate to lose tax exemption status
The IRS sets a threshold for estate taxes. In 2020, it’s $11.58 million. If you’ve named your estate or someone other than your spouse as the beneficiary of your life insurance policy — like a child, grandchild or friend — that policy will count toward the total worth of your estate.
This means that if your estate is worth more than $11.58 million, it will be subject to federal estate taxes — and your heirs will have nine months to pay the tax after your death. Because of this tax, they won’t receive the full proceeds of the life insurance policy.
The government charges a 40% tax, which applies to the amount above the exemption. Let’s say you have a $12.58 million estate. The tax due would be $400,000 (40% of $1 million).
If your estate is worth less than $11.58 million, your heirs won’t owe any federal estate taxes.
Your state might charge a tax, too
These are the states that levy an estate tax in 2020, along with their thresholds:
- Connecticut: $5.1 million
- District of Columbia: $5.76 million
- Hawaii: $5.49 million
- Illinois: $4 million
- Maine: $5.8 million
- Maryland: $5 million
- Massachusetts: $1 million
- Minnesota: $3 million
- New York: $5.85 million
- Oregon: $1 million
- Rhode Island: $1.58 million
- Vermont: $4.25 million
- Washington: $2.193 million
If you live in one of these states and have an estate that exceeds its tax exemption level, know that your heirs may have to cough up a second tax.
You’re using the policy to help your beneficiaries pay estate taxes
If your estate is valued at $11.58 million or more, you may take out a life insurance policy specifically to help your heirs pay for those tax bills.
Typically, this tactic is used by wealthy individuals whose estates are tied up in non-liquid assets, such as property. Since your heirs only have nine months to pay estate taxes, this ensures they’re not forced to sell those assets if the market isn’t favorable. The life insurance policy can take care of the tax.
The 5 best life insurance companies for high net worth individuals
How an ownership transfer can help you to avoid estate taxes
To prevent your life insurance payout from becoming part of your estate, consider transferring ownership of your policy to another person or entity.
There are two paths you can take:
- Transfer your policy to someone else, like your spouse or children
By doing this, you’re relinquishing control over the policy — which means the new owners can do anything they’d like with it, including cashing it in.Once the ownership transfer is complete, the new owners must pay the premiums on the policy. However, you can gift up to $15,000 in 2020 and potentially give the new owner some money to cover those premiums.
Ownership transfer is irrevocable — even in the event of a divorce — so choose the new owner carefully.
Did you know?
You can pass on your entire estate to your spouse tax-free as long as they’re a US citizen. This tax rule is known as the “unlimited marital deduction.” If you go down this route, tax is only payable upon the death of the surviving spouse.
- Transfer your policy to a trust
If you want to maintain some legal control over the policy, you could create an irrevocable life insurance trust (ILIT). You can’t be appointed its trustee, but you can still decide who benefits from the proceeds of your life insurance policy. Since you’ll no longer be the owner of your policy, it won’t be included in your estate. An ILIT can’t be changed. To keep your policy in force, the trust or another individual will need to continue paying the premiums. If you create an ILIT for minor children from a previous marriage, you’ll be allowed to name a family member as the trustee to help handle the proceeds from the policy.
The three-year rule
If you die within three years of transferring the policy, it will still count as part of your estate — which means your heirs could end up paying estate taxes. Plus, the transfer could be subject to gift taxes if your life insurance policy has a cash value of more than $15,000.
The key takeaway? If you’re planning to transfer ownership of your policy, do it as soon as possible.
Compare life insurance companies
For those with large estates, life insurance is an important part of estate planning. If your estate is valued at over $11.58 million, there are a few strategies you can employ to avoid the estate tax — like transferring ownership of your policy. But that can’t be reversed.
When you’re shopping around for coverage, compare life insurance companies — and pay special attention to insurers that cater to wealthy individuals.
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