Taxes on Life Insurance?

When people purchase life insurance policies, they designate a beneficiary who will benefit from the policy’s proceeds. When the insured person dies, the policy’s beneficiary then receives a payout known as the death benefit.

Yahoo Finance’s recent article entitled “Will My Beneficiaries Pay Taxes on Life Insurance?” says the big advantage of buying a life insurance policy is that, upon death, your beneficiaries can get a substantial lump sum payment without taxation, unless the amount of the life insurance pushes your estate above the applicable federal estate tax exemption. In that case, your estate will need to pay the tax.

While death benefits are usually tax-free, there are a few situations where the beneficiary of a life insurance policy may have to pay taxes on the lump sum payout. When you earn income from interest, it’s typically taxable. Therefore, if the beneficiary decides to delay the payout instead of receiving it right away, the death benefit may continue to accumulate interest. The death benefit won’t be taxed. However, the beneficiary will typically pay taxes on the additional interest.

So, for example, if the decedent had an insurance policy with a $200,000 death benefit which pays to their daughter at death. The daughter submits a claim after the parent dies and receives $200,736. The $736 is interest generated on the amount of money held by the company post­ death until pay out. The death benefit of $200,000 is not taxable, but the $736 is income taxable as interest, just as though the beneficiary has held the $200,000 in a bank somewhere and generated $736 in interest.

Additionally, the value of the insurance policy is subject to estate tax in most cases. This is true for typical insurance policies where an individual owns a policy on their own life and the proceeds pay out at death (e.g. the $200,000 policy described above). The value of the insurance increases the size of your estate so that if your estate excludes your applicable gift and estate tax exclusion amount (currently about $13,000,000) then your estate will have estate tax to pay.

This obviously doesn’t affect too many people, but many term policies can dramatically increase estate sizes due to their high death benefits.  Some states also have their own inheritance or estate taxes to consider.

Estate planning attorneys, especially when the estate tax exemptions were lower, frequently used life insurance trusts, often called “ILITs” or “Irrevocable Life Insurance Trusts,” to combat this. As the estate tax exemption is currently expected to be cut in half in 2026, these kinds of trusts make sense to use now so that the value of the insurance is removed from your estate in anticipation of a lower exemption.  They work because the client doesn’t have ownership of the insurance policy. It is owned and maintained by the trust without any “incidences of ownership” so that the policy is not considered controlled by the decedent. They will often pay money to the trust which will in turn pay the insurance premiums during life.

I often recommend this to younger clients who are considering life insurance. They may never expect to be estate taxable, but as we don’t know what the future holds, or where politics will take us, we can remove the insurance from their estates now and so not worry about it.

If you want to know more about how life insurance impacts your estate plan, see this article:  https://galligan-law.com/role-of-insurance-in-estate-planning/

As a warning, I’m referring to taxation of life insurance at death. Transferring the policy, withdrawing money or taking a loan from the cash value and surrendering the policy can all have taxable components, so you would want to consult a CPA or attorney on the tax implications before proceeding.

To summarize, beneficiaries usually won’t have to pay taxes on life insurance proceeds. However, some situations can result in a taxable event and in some cases can be planned for in advance.

Reference: Yahoo Finance (Jan. 17, 2023) “Will My Beneficiaries Pay Taxes on Life Insurance?”

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Steps for End-of-Life Planning

Most people don’t consider anything about planning for incapacity or death to be joyful. However, if you consider estate planning documents as a way to share your wishes and make your departure easier for those you love, as well as a means to express your thoughts and feelings, it could make these tasks a little easier and establish a legacy for your loved ones. A recent article from The Washington Post, “6 joyful steps for end-of-life planning,” could help reframe how you think of estate planning.

From a practical standpoint, death and incapacity are complicated for loved ones. There is always an emotional toll which renders loved ones less capable than they typically would be in dealing with post-death tasks.  Preplanning through your estate plan will help ease their burden.

They will appreciate your preparing medical powers of attorney or similar documents which should be created when a person is healthy, and not when they are in a hospital bed. The same goes for funeral arrangements, which are costly. There are so many choices and decisions to make—do your loved ones even know what you want? Leaving instructions in an appointment for the disposition of remains and maybe even prepaying services will remove the burden for loved ones to know what you wanted and dealing with the expense of paying for it.

Digging through a loved one’s credit card bills, cellphone accounts, bank accounts and internet passwords is a big challenge in today’s digital world. It was far easier when there were stacks of paper for every account. Today’s fiduciaries need to have access to more information to avoid lost assets, avoid identity theft and prevent roadblocks to wrapping up your estate.

Here’s a checklist to help get your estate plan moving forward.

1 Estate Planning Notebook. The author of the article called this a crisis planning binder.  We actually give our clients one binder with all the estate planning documents to make it easier for loved ones. You should make additional copies, but keep originals in one place—and tell your fiduciaries where the originals and binder can be found.  You can also include information in the binder to facilitate gathering assets and administering your estate, such as information on bank accounts, contact information for professionals you’ve worked with, information on assets, debts, contracts, the above-referenced final internment instructions and more.

Please see Mary’s article here for more ideas on what to include in the binder:  https://galligan-law.com/not-a-little-black-book-but-a-big-blue-estate-planning-binder/

2 Have a medical power of attorney created while you are having your estate plan made. This tells your loved ones what you want in case of incapacity and end-of-life decisions and isn’t typically what people think about in an estate plan.  Appointing a person to act for you in these situations and communicating these wishes will greatly ease their burden.

3 Have an estate plan created with an experienced estate planning attorney. Without an estate plan, the laws of your state determine how your property is distributed.  Most people mistakenly assume that the law will quickly and easily let property pass to their loved ones, but that is often not the case, or worse, they make bad assumptions about which loved ones inherit.

Estate plans are also state-specific, so a local estate planning attorney is your best resource. Be wary of online documents—if they are deemed invalid, or even worse, valid but terrible, you will have greatly increased the cost, time and energy of your estate administration, and may still not get what you wanted.

4 Make a digital estate plan. No doubt you have more than one email account, shopping accounts with more than a few retailers, credit cards, car leases or loans, home mortgage payments, social media, cloud storage, gaming accounts and more. Without a complete and comprehensive list of all accounts, your executor won’t know what needs to be closed, where your personal documents or photos live or how to retrieve them.

5 Plan your Final Internment. This isn’t always easy for a person to do, but if you find it difficult, imagine how your loved ones will feel.  Even if you don’t prearrange, many states, Texas included, provide the power to name a person to execute your wishes for final internment and to describe those wishes.  This is often called an appointment for the disposition of remains. You’ll feel better knowing your wishes will be followed, whether it’s for a “green” funeral or a cremation, with a long period of mourning following your faith’s tradition or a short memorial service.

6 Write a letter of intent and any final farewells. This is an opportunity to share your thoughts with those you love, with healthcare providers and anyone else who matters to you, about healthcare decisions at end of life, or to convey your values, hopes and dreams for those you love.  This is similar to the “ethical will” and leaves the legacy of your values to your loved ones.

When these issues are complete, you’ll be surprised at the sense of relief you feel.

Reference: The Washington Post (Jan. 5, 2023) “6 joyful steps for end-of-life planning”

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What Happens With Joint Property?

Virtually every estate administration case we handle joint property, or “joint tenancy” as it is sometimes called.  This is most commonly true when the decedent was married, but often occurs when a deceased parent included a child on their bank account or a friend so that “money is available” when something happens to them.  But, joint property can have unintended consequences to your estate, so it is important to understand the different types of joint property according to a recent article titled “Everything you need to know about jointly owned property and wills” from TBR News Media.

This becomes an important issue because depending on the type of joint tenancy, your Will may or may not be necessary to convey it to your beneficiaries. It is also true that using certain types of joint tenancy may bypass your intended estate plan or have tax, government benefits and other consequences, so it is critical to understand the differences and to ensure the type of joint tenancy you are using matches your plan.

Joint Tenancy with Rights of Survivorship. Joint tenancy with rights of survivorship means that there are multiple owners and that upon the death of one, the other owners automatically become the owner of the account.  This process happens by virtue of the titling, and doesn’t require probate to make it happen.  Usually, a death certificate is sufficient to remove the deceased owner.

Most people assume when they see two owners on a bank account that it is owned as joint tenants with rights of survivorship.  In truth, this is something that you elect when you create the account or add a name, and many times bank personnel elects this without discussing it with you.  The best way to determine if your account has rights of survivorship is to check with account card at the bank, although some statements or accounts will also say “JTWROS.”  That is short for “Joint Tenants with Rights of Survivorship”.

Tenancy by the Entirety. This type of joint ownership is only available between spouses and is not used in all states. It definitely exists in Pennsylvania, and is the default way of taking title to real property that is purchased during marriage.  A local estate planning attorney will be able to tell you if you have this option. As with Joint Tenancy with Rights of Survivorship, when the first spouse passes, their interest automatically passes to the surviving spouse outside of probate.

There are additional protections in Tenancy by the Entirety making it an attractive means of ownership. One spouse may not mortgage or sell the property without the consent of the other spouse, and the creditor of one spouse can’t place a lien or enforce a judgment against property held as tenants by the entirety.

Tenancy in Common. This form of ownership has no right of survivorship and each owner’s share of the property passes to their chosen beneficiary upon the owner’s death. Tenants in Common may have unequal interests in the property, and when one owner dies, their beneficiaries will inherit their share and become co-owners with other Tenants.

The Tenant in Common share passes the persons designated according to their will, assuming they have one. This means the decedent’s executor must “probate” the will for the executor to have control of it. Sometimes this is very critical to leave assets as Tenants in Common because you want your portion of an asset to go to a trust or not to the other owner.

In all of these, it is important to recognize that joint tenants are not always necessary.  First, adding a co-owner could affect your estate plan, as is generally described above.  Also, adding a person is a gift, which may have adverse effects on your beneficiary if they suffer a disability, and has gift tax consequences to yourself.  It may also subject “your” money to the creditors of the new owner.

For those who only want “check writing authority,” it actually is possible in Texas to get authority to sign checks only without being an owner, although most banks encourage joint ownership as it is less risky to them.

All in all, it is important to makes sure that the ownership and titling of your assets fits with your estate plan.  A comprehensive estate plan, created by an experienced estate planning attorney, ensures that both probate and non-probate assets work together.

Reference: TBR News Media (Dec. 27, 2022) “Everything you need to know about jointly owned property and wills”

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