Does Estate Tax Exemption Apply to a Life Insurance Payout?
Life insurance provides a cash benefit to the survivors of the insured individual, generally tax free, provided there has been no transfer of the policy for value during the life of the policy. Life insurance helps protect the deceased's heirs by providing needed liquidity at death to pay any final expenses or estate taxes, and to fund the deceased's financial obligations to his family and business associates. Life insurance proceeds are not exempt from the estate tax. However, with careful planning, life insurance can often exist outside of the deceased's estate.
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Estate Tax
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As of 2011, only any amounts in an estate exceeding the unified exemption amount of $5 million are subject to estate taxation. Assets in the deceased's taxable estate above that amount are taxed at a rate of 35 percent.
Unlimited Spousal Exemption
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Surviving spouses receive an unlimited exemption from federal estate taxes. That is, they do not pay any estate taxes. Instead, assets pass to them tax free. The surviving spouse's estate must pay taxes upon her death.
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Life Insurance as Part of the Estate
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If the deceased owned a life insurance policy, either directly or through a corporation he owned, that policy -- and its death benefit -- is counted as part of his taxable estate. If he had a net worth of over $5 million to begin with, he will have to pass the entire amount on to his estate. If he is married, his spouse will not have to worry about estate taxes. However, if his spouse was the beneficiary of the policy, the death benefit is taxable when she dies, if she still has the money.
Trusts
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To avoid having the life insurance death benefit charged to the estate itself -- thereby compounding the estate tax -- many wealthy individuals establish a trust to hold the life insurance policy. The life insurance policy then pays a death benefit to the heirs, but the heirs do not need to pay estate tax on the life insurance death benefit. This money is often used to pay the estate tax. This also helps protect heirs from having to liquidate inherited retirement accounts to pay the estate tax and pay income taxes on that money in addition to the estate tax.
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