Is life insurance part of an estate after death? Surprising answer

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Paul Sundin, CPA

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Taxation might be the most significant possible complication when we talk about the after-death estate transfer. One question that often comes up: Is life insurance part of an estate after death?

Naturally, people are looking for ways to reduce the tax consequences and allow their heirs to benefit from the received estate as much as possible. 

Life insurance is a popular and most efficient way to ensure that your heirs will be able to receive a large sum of money after your death. Moreover, life insurance proceeds are widely known to be free from income tax.

Life insurance in a taxable estate

However, since Life Insurance proceeds to become a part of the taxable estate, it automatically becomes an object for the Estate Taxes.

Scrabble pieces spelling TAX

There are two scenarios of how Life Insurance Proceeds may become a part of the gross estate:

  • If they are directly or indirectly payable to your estate;
  • If they are payable to named beneficiaries once you possessed any incidents of ownership in the policy at the time of your death.

IRS rules

There is a set of rules developed by the IRS that indicates how to determine who becomes the owner of the life insurance policy once the insured person dies:

  • The Three-year-rule. This principle provides that once the insurance policies gifts occur within three years of death, they automatically become a subject for the Federal Estate Tax;
  • Incidents of ownership. In case of transferring, the original owner must give up all the possible legal rights to change beneficiaries, select beneficiary payment options, surrender, cancel the policy, or borrow against it. Any of those actions may be considered acts of the ownership, and the transferred assets become subject to taxation.

Since most people manage to obtain insurance policies from $500.000 to several million, have some real estate, retirement accounts, savings, and other properties, Estate Taxation may be a severe issue.

As long as the taxable estate depends on the ownership of the policy at the time of the insured’s death, transferring the policy owner can be a solution to this issue that comes at significantly more fair taxation. However, it is crucial to ensure that the original owner of the policy lives more than three years after the transfer and follows the procedure thoroughly.

Several steps can ensure that the transfer will be appropriately executed and grant the life insurance proceeds immunity from Federal taxation:

  • The policy may be transferred to any adult citizen or an entity. It may also be the projected beneficiary of the policy;
  • The new owner should pay the premiums for the policy;
  • The original owner forfeits all legal rights for the policy to avoid the “incident of ownership” case.;
  • Ensure getting written confirmation from the Insurance Company as the legal proof of the ownership change.

It is essential to remember that the insurance policy transfer is an irreversible process. Therefore it is highly not recommended to transfer between spouses or any other relatives that can divorce or execute any other act of legal separation.

Irrevocable Life Insurance Trust (ILIT) is another popular and efficient way to avoid estate taxation in the event of death. In this case, the policy would be held in trust, the original owner forfeits the ownership, and the policy is not considered a part of their estate anymore.

Is life insurance part of an estate after death?

This scenario is quite popular today as it still foresees that the original owner preserves specific legal control over the policy. Moreover, in this case, it is possible to name a trusted family member as trustee to handle the money if you wish to name minor children from a previous marriage or any other minor relatives as beneficiaries of the policy.

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Estate CPA

Gilbert, AZ