How to avoid the federal estate tax when collecting life insurance proceeds

Date: July 19, 2017 By: Bill Bischoff

How to avoid the federal estate tax when collecting life insurance proceeds

Beneficiaries generally receive death benefits free of federal income tax, but what about the federal estate tax?

Having enough life and disability insurance should be a key element of your personal financial game plan. With some advance planning, you can collect life and disability insurance proceeds free of any federal taxes. Here’s how.

Life insurance

The main reason that most people have life insurance is to replace income that would be lost if they die prematurely. In general, a policy beneficiary can receive life insurance death benefit payments free of any federal income tax (and usually free of any state income tax too). That’s great, but what about the federal estate tax? Under the current rules, when you are considered to own a policy on your own life, the death benefit is included in your taxable estate — unless the money goes to your surviving spouse and he or she is a U.S. citizen. When death benefits go directly or indirectly to a non-spouse beneficiary, such as a child or sibling, without passing through your estate, the money is still included in your taxable estate. If the value of your estate — including any included life insurance death benefits that go to someone other than your surviving spouse — exceeds the federal estate tax exemption of: (1) $5.49 million if you’re unmarried or (2) a combined $10.98 million for you and your spouse if you’re married, your heirs will stand in line behind the IRS (and possibly the state death tax collector too). For unmarried folks, having lots of life insurance coverage (often through work) is the most common cause of exposure to the federal estate tax or state death taxes. The larger $10.98 million federal estate tax exemption for married couples makes it less likely that life insurance coverage will trigger a federal estate tax bill. But it can still happen. Here’s the rub. You are considered to own a life insurance policy if you possess so-called incidents of ownership. You have them if you retain the power to change policy beneficiaries, change coverage amounts, cancel the policy, and so forth. As stated earlier, if you are considered to own the policy, the death benefit will be included in your taxable estate for federal estate tax purposes unless it goes to your surviving spouse who is a U.S. citizen. If having life insurance death benefits included in your taxable estate would cause an estate tax hit, the tax planning solution is to set up an irrevocable life insurance trust to own the policy. The trust then pays the premiums, and the death benefits go to whomever you name as the trust’s beneficiaries. Your estate is out of the picture. With this arrangement, there’s no federal estate tax on the death benefit, and there’s no federal income tax either. Naturally, there are a few complexities with this strategy. If you transfer an existing policy to the life insurance trust and die within three years, the death benefits are included in your taxable estate. To avoid this problem, the trust should purchase a new policy on your life. If that’s not possible (say because your health isn’t so great), you may have nothing to lose by transferring an existing policy and trying to outlive the three-year rule. But check with your estate planning pro first, because transferring existing policies with cash values in excess of $14,000 could trigger adverse gift tax consequences. Finally, know this: while setting up an irrevocable life insurance trust can be a great idea, it isn’t a good DIY project. Hire an experienced estate planning pro to get the job done right. Finally, if you’re counting on President Trump’s proposed repeal of the federal estate tax to eliminate this concern, please don’t. Who knows when or if that will actually happen? Not me.

Disability insurance

In addition to having adequate life insurance coverage, you should probably also have long-term disability (LTD) coverage to protect against lost earnings during any lengthy period of disability. But most LTD policies limit benefits to only 60% or 70% of earnings before income taxes. That’s generally OK as long as you don’t have to pay income taxes. But if you do, you’re probably going to lose 30% to 40% (or more) to the IRS and your friendly state tax collector. That could cause your coverage to be insufficient (because 70% of 70% is only 49% of your pretax earnings; 60% of 60% is only 36%. You get the idea. Having to pay tax on LTD benefits can really hurt. Now for the good news. LTD benefits are generally federal-income-tax-free when you pay the premiums yourself (as opposed to your employer paying them). On the other hand, if your employer pays the premiums as a tax-free fringe, any LTD benefits will be fully taxable to you. The same is true if you aside part of your salary to pay the premiums with before-tax dollars under your employer’s cafeteria benefit plan. Here are two strategies to deal with this tax dilemma.
  • If LTD benefits would be taxable because your employer is paying the premiums, the preferred solution is to arrange for the premiums to be paid with after-tax dollars via withholding from your paychecks. That way, the premiums are treated as part of your taxable salary, which will cause a slight increase in your income tax bill. However any LTD benefits will be tax-free, which is the bigger consideration here.
  • The other alternative is to buy a supplemental LTD policy with your own money. The idea is to buy enough extra coverage to cover the income tax hit on the benefits that you would receive under the company-provided coverage. All benefits received under your personal LTD policy will be tax-free because you paid the premiums with your own money.

The last word

Having adequate life and disability insurance coverage is critical, and taxes are a major concern. If you play your cards right, you and your heirs will be better off, and the IRS will be the loser. If you need to make changes to avoid tax problems, please do it now before some unanticipated event happens. After all, that’s what life and disability insurance is for: to protect you from life’s unanticipated twists and turns. Copyright ©2017 MarketWatch, Inc. All rights reserved. Back

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