Is Life Insurance Taxable to an Estate?

Life insurance provides income tax-free death benefits to your beneficiaries in the event of your death. However, life insurance is included in the calculation for estate taxes. If you have a large life insurance policy, you should understand how this might impact your family at your death so that you can make proper financial plans to avoid leaving behind a large financial burden.

Process

When you die, your death benefit is passed to your beneficiaries income tax-free. But, the death benefit of the policy is used in the calculation of estate taxes. This means that your death benefit is added to the rest of the value of your estate. If your estate value exceeds $5 million (as of 2011), then your family will be subject to an estate tax of up to 35 percent on all amounts above the $5 million exemption.

Significance

The estate and gift taxes have been merged together (as of 2011), so a large exemption amount may keep you from paying estate taxes on your assets. In 2010, there is no estate tax. This means that if you die in 2010, you may leave behind an unlimited number of assets and none of them will be taxed. In 2011 and 2012, the law prevents this and instead imposes a maximum tax of 35 percent.

Solution

Even though there is an estate tax in 2011 and 2012, the exemption amount is $5 million. So, unless you have significant wealth, you won't be subject to the estate tax. To prevent your policy from being included in your estate, you have a couple of choices. Your life insurance policy may be removed from your estate by setting up a life insurance trust. The life insurance trust transfers ownership of the policy from you to the trust. You are not allowed to access any cash values of the policy or make any changes to the policy (since you are not the owner of the policy), but you won't have to worry about the policy being included in the calculation of your estate. Alternatively, you may transfer ownership of your policy to another individual. If you do this, it will have the same effect as if you transferred the policy to a trust. You lose ownership over the policy, but the death benefit is not included in the calculation of estate taxes at your death.

Consideration

When purchasing life insurance, you should only purchase as much insurance as you need. Excess life insurance may create a future liability for your family. Also, the type of life insurance you choose could make a difference as to whether you are subject to estate taxes or not. Cash value life insurance may be used as a savings or to supplement your retirement income through policy loans. When taking policy loans, the available cash value and death benefit decreases. Regular borrowing during your lifetime, without lapsing the policy, may provide you with a way to use up enough of your savings (which you would have to do anyway when you retire) without creating an estate tax liability at your death.

Alternatively, you may want to consider using a reverse mortgage on your home or keeping a mortgage on your home throughout your retirement. A reverse mortgage turns your equity into a savings you can spend during your life without having to repay the mortgage until you and your spouse either die or move out of the home. The loan amount counts as debt, which offsets any assets you have. This, in turn, reduces the total value of your estate. While it's important not to burden yourself with too much debt, debt may be used as a tool to keep your estate small enough that your family avoids paying estate taxes.

References

• "Ernst & Young's Personal Financial Planning Guide, 5th Edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
• "Life Insurance"; Kenneth Black, Jr., Harold D. Skipper, Jr.; 1994
• "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007