Are Life Insurance Proceeds Subject to Estate Taxes?
When you receive a death benefit from a life insurance policy, you don't have to pay income taxes on it. The government considers it compensation for a loss. However, that doesn't mean the government won't tax it at some point. If the policy was in the name of the person insured, the payment becomes part of that person's estate, and it may be subject to the estate tax.
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Significance
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Estate taxes are not an issue for most people. The Tax Policy Center of the Brookings Institution and the Urban Institute estimated in 2009 that only 0.24 percent of all estates that year would be subject to the tax. That is because the first $3.5 million worth of every estate is exempt from federal taxes. If your estate is less than that, it will pay no tax; if it's more than that, it will pay taxes only on the amount that exceeds $3.5 million -- so a $5 million estate would pay tax on $1.5 million of its value. Thus, if your estate does qualify for the tax, there could be a significant bite -- up to 45 percent, as of the 2009 tax year, meaning a $250,000 life insurance policy, if fully taxed, would pass only $137,500 to your beneficiary.
Ownership
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When it comes to life insurance proceeds and estate taxes, the key question is who owns the policy. It's a simple determination: If the policy is in your name when you die, it becomes part of your estate and may be subject to tax. If the policy is in someone else's name, then it is not part of your estate. For example, if you purchase a $1 million policy naming your daughter as beneficiary, that $1 million goes to your estate, with tax possibly taken out before being passed to your daughter. But, if your daughter buys a $1 million insurance policy on your life, she gets the money tax-free.
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Exception
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Estate taxes never apply to property that passes directly to a spouse. Therefore, if your spouse is the beneficiary of your policy, there are no estate-tax implications.
Transfers
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If your life insurance policy is in your name and you want to keep it free of estate taxes, there are two things you can do. First, you can transfer ownership of the policy to someone else -- the beneficiary, for example. If you go this route, there are a few things to know. To prevent "deathbed transfers," the IRS still considers the policy to be part of your estate for three years after the transfer. Also, when you transfer ownership of the policy, you have to give up all control over it. If you retain the right to change the beneficiary or the coverage amount, it's still your policy as far as the estate tax is concerned. Finally, the IRS will consider the transfer a gift, and gift taxes may apply -- but the gift tax bite will be substantially less than the estate tax, and it's not due until after your death.
Trusts
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Another option is to establish an irrevocable life insurance trust, which holds the policy outside your estate until your death, then pays the beneficiary. With this option, too, you must establish the trust at least three years before you die. Setting up trusts is legally complicated. Contact a lawyer for help.
Advisory
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Since 2001, the future status of the federal estate tax has been uncertain because of changes to tax law. Congress eliminated the tax entirely for 2010, but scheduled it to come back in 2011. Only a qualified tax adviser can assess your individual situation.
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