Life Insurance Estate Tax: Taxing Your Legacy

Estate taxes aren’t something we usually worry about–after all your estate needs to be worth more than the exemption amount in order to be federally taxed: the exemption amount for 2014 is a whopping 5.34 million. While this is a high number for many, it’s not the only kind of estate tax. Many states include a state estate tax, including Massachusetts, and any estate over 1 million is taxable. While even 1 million seems like a lot of money, there’s one thing that may tip your estate over this limit: your life insurance payouts. While the intention of your policy was to safeguard your loved ones, the payout from the policy might increase the holdings of the estate so much that it become vulnerable to estate taxes.

How Estate Tax WorksLife Insurance Estate Tax, TJ WOODS INSURANCE AGENCY, INC., Worcester, MA

In short, an estate tax is a tax on your right to transfer your property at the time of your death. Estate not only cover any actual real estate you might have, but also any other assets you have that can have market value. This includes cash and securities, annuities, businesses, and other physical items that can be assessed at a fair market value (not necessarily what you paid for them). After adding all of this together, you get the “Gross Estate,” and after removing certain deductions, you get the “Taxable Estate.” If that amount is higher than state or federal exemptions, you could be taxed, and have to file a return.

How Life Insurance Trusts Work

If you have a substantial life insurance policy, you may wish to avoid having the payout go to your taxable estates. One way is to transfer the policy out of your possession with the use of an irrevocable trust. By creating this trust and naming someone else as the trustee, you remove your ability to control the policy, instead rules are placed into the trust: how the policy will work, including how premiums will be paid, who will benefit, and how beneficiaries will receive the payout.

The trust must include the following:

  • The trust must be irrevocable.
  • The trustee cannot be you.
  • The trust must be made at least three years before your death.

You can still pay premiums normally on the life insurance (doing so it not an “incident of ownership”), but you might consider a single-premium policy that only requires a single lump-sum.

Another Option for Your Policy

Instead of give the policy to a trust, you can simple give it to another person. While significantly simpler, there are several problems to watch out for. The first is that the policy itself has a certain value, and if that policy exceeds the gift tax (currently $14,000), your estate will be taxed on that transfer. Check to see the value of the policy. Also, much like the trust, you give up your control of the policy when you transfer it to another person. The same three year period must exist been transfer and death.

For many, these problems will not be a concern, but if you are worried that your policy might invoke estate taxes (and the lengthy process thereof) to your loved ones, you should consult both accounting and insurance experts. At the TJ Woods Insurance Agency, we have experience with all forms of insurance, including life insurance, and we can help you find (and if need transfer) the perfect policy to put your mind at ease. After all, life insurance is about making your loved ones secure–not stressed about more taxes.