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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Keeping Beneficiary Designations Up to Date

If you don’t know who your beneficiaries are, then it’s time for a beneficiary designation check. Even if you think you remember, every now and then, they should be checked, according to an article “Are your beneficiary designations up to date?” from Community Voice.

It has become very common for estate plans to be largely controlled through beneficiary designations.  Many people accumulate wealth in 401(K)s or IRAs which pass to named beneficiaries, or clients add named beneficiaries at the suggestion of a banker to avoid probate.  With so many beneficiary designations controlling so many accounts and so much wealth, it’s critical to make sure they reflect your wishes.

I even had a law school professor who suggested one of the worst estate planning mistakes was failing to address beneficiary designations!

Your choices may change with time. When did you open your very first IRA? Do you even remember when you purchased your life insurance policies? If it was back in the 1990s, chances are good the people in your life have changed, as well as your priorities. Your kids are likely grown, or maybe you have more of them!  Maybe one of your beneficiaries has developed some bad habits, and you want to control how the money will impact them.  There are lots of reasons beneficiary designations don’t fit anymore.

When we first filled out the beneficiary designations, we were all confident they’d be the same forever, but time and life have a way of changing things. In five, ten or twenty years, big changes may have happened in your life. Your beneficiary designations and your estate plan need to reflect where you are now, not where you were then.

The best way to address beneficiary designations is reviewing them with your estate plan annually.  If you’re still working, your employer may have changed custodians for your retirement plan and your insurance policy. When a new custodian takes over, sometimes beneficiary designations can get lost in the change, that has happened many, many times.  I’ve also seen companies say they won’t honor beneficiary designations because of internal policy changes.

Life events can also affect your beneficiary designations.  Did you get divorced?  I’d imagine you don’t want your ex as the beneficiary of your accounts.  Do you have minor beneficiaries?  You want to name a custodian of that money in the account plan as part of your designations, otherwise your loved ones are headed to guardianship court.

If you don’t have a beneficiary designation on these accounts, or any account where you have the option to name a beneficiary, you may have a bigger problem. The tax-focused part of your estate plan could be undone if you thought your 401(k) would go to your spouse but your spouse predeceased you.

What’s the best way to handle this?  Make sure your designations coordinate with your estate plan.  What most people don’t realize is that whatever choice you make on the beneficiary designation overrides anything in their estate plan because it passes right to that beneficiary.  That sounds good, but notice most of the problems I’ve recounted are because your circumstances change, or contingencies aren’t adequately planned for.  You also have no control over the contingencies if a named beneficiary should pass away and you failed to address it in the designations.

Your estate plan can cover all of this, which is why directing assets to your estate plan via beneficiary designations might be a great idea.  Everything will go to the persons you intended, but the estate plan will help bypass all of these problems.

Moral to the story, don’t rely on beneficiary designations and make sure you keep them up to date and coordinating with your estate plan to ensure your assets pass to your beneficiaries as you intended.

Reference: Community Voice (September 30, 2022) “Are your beneficiary designations up to date?”

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Estate Planning Checklist

Dying without an estate plan creates additional costs and eliminates any chance your wishes for loved ones will be followed after your death. Typically, people think about a will when they marry or have children, and then do not think about wills or estate plans until they retire. While a will is important, there are other estate planning documents that are just as important, says the recent article “10 Steps to Writing a Will” from U.S. News & World Report.  To help identify those needs, I prepared an estate planning checklist which you can find below.

Most assets, including retirement accounts and insurance policy proceeds, can be transferred to heirs outside of a will, if they have designated beneficiaries. However, the outcome of an estate may be more impacted by Power of Attorney for financial matters and Medical Power of Attorney documents.  To help figure out what you may need, you can use this article as an estate planning checklist.

Here are nine specific tasks that need to be completed for your estate plan to be effective. The documents should be prepared based upon your state’s law with the help of a qualified estate planning attorney.

  1. Find an estate planning attorney who is experienced with the laws of your state.
  2. Select beneficiaries for your estate plan.
  3. Check beneficiaries on non-probate assets to make sure they are current.
  4. Decide who will be the fiduciaries named in your estate plan (e.g. executor, trustee)
  5. Name a guardian for minor children, if yours are still young.

There are also tasks for your own care while you are living, in case of incapacity:

  1. Name a person for the Power of Attorney role. They will be your representative for legal and financial matters, but only while you are living.
  2. Name a person for the Medical Power of Attorney to make decisions on your behalf, if you cannot.
  3. Create a Directive to Physicians (Living Will), to explain your wishes for medical care, particularly concerning end-of-life care.
  4. Tell the these people that you have chosen them and discuss these roles and their responsibilities with them if you are ready

As you go through your estate planning checklist, be realistic about the people you are naming to serve as fiduciaries. If you have a child who is not good with managing money, a trust can be set up to distribute assets according to your wishes: by age or accomplishments, like finishing college, going to rehab, or maintaining a steady work history, and they should not be in charge of your money.

Do not forget to tell family members where they can find your last will and other estate documents. You should also talk with them about your digital assets. If accounts are protected by passwords or facial recognition, find out if the digital platform has a process for your executor to legally obtain access to your digital assets.

Finally, do not neglect updating your estate plan every three to four years or anytime you have a major life event. An estate plan is like a house: it needs regular maintenance. Old estate plans can disinherit family members or lead to the wrong person being in charge of your estate.  See this article for my ideas as to when to update your estate plan and what to consider.  You might find reviewing the estate planning checklist helpful at that time as well.  https://galligan-law.com/when-to-update-your-estate-plan/

An experienced estate planning attorney will make the process easier and straightforward for you and your loved ones.

Reference: U.S. News & World Report (May 13, 2021) “10 Steps to Writing a Will”

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