Posts Tagged ‘life insurance’

Generally, the answer is “no,” life insurance death benefits are not subject to Federal Income tax.

However, there are some exceptions that can cause a life insurance death benefit to be included in an insured’s estate and subject to Federal estate tax and estate administrative expenses.  The three typical situations when life insurance is included in a decedent’s gross estate include:

1. When the death benefit is payable to the insured’s estate;
2. When the insured possessed “incidents of ownership” in the policy at the time of death;
3. When the insured transferred “incidents of ownership” by gift within 3 years of death.

An explanation follows which explains each exception, respectively, in greater detail:

1. Life Insurance death benefits are not generally part of the probate estate.  A probate estate involves the passing of the decedent’s (the insured individual who died) will through the local court system where they lived.  Instead, life insurance death benefits pass by contract provisions directly to the beneficiary of the life insurance contract.  The proceeds of a life insurance death benefit become part of the probate estate if they are paid to, or for, the benefit of the insured’s estate, or to the executor for the benefit of an insured’s estate.

To avoid this problem, do not name your estate as beneficiary of the life insurance contract.

1. An “incident of ownership” of a life insurance contract is any right to the policy’s economic benefits.  These include the rights to; change the beneficiary, assign the policy, borrow on the policy, surrender the policy, exercise any other contract right or privileges.

To remove life insurance death benefits from Federal estate tax, the insured must give up all significant rights and privileges under the contract.  A typical method to give up incidents of ownership is to place the life insurance policy in an irrevocable life insurance trust.

1. The last exception is related to the second one (“incidents of ownership,” above).  Life insurance is included in the estate of an insured if they transfer incidents of ownership in the policy by gift within 3 years of his or her death.  Transfers made more than 3 years before death are not included in the estate.  For example, a transfer of the life insurance policy’s incidents of ownership from the insured to an irrevocable life insurance trust must occur more than 3 years before the insured’s death to be excluded from the estate, and thus avoid Federal estate tax.