Estate Tax and Life Insurance

Posted by David Heller on July 20, 2021

At MHPS, we recently covered an overview of life insurance and estates on our blog. Here, we’ll get more into discussing how life insurance and estate tax works. You may have recently received proceeds from a life insurance policy or you’re starting to plan for your future. If this is the case for you, it’s important that you understand estate taxes.

How Does Estate Tax Work?

Before we start discussing estate tax and life insurance, here is a quick, but important, review of the three roles with an insurance policy.

  1. The Insured – The person whose death triggers the payout of the death benefit.
  2. The Owner – The person who actually owns the policy.
  3. The Beneficiary – The person who receives the payout of the death benefit.

As previously discussed, insurance proceeds are not subject to income tax. However, they are subject to the estate tax. The proceeds of the insurance policy are included in the estate of the owner of the policy, not the insured. Again, often they are one and the same. But technically, the policy proceeds are taxed to the owner’s estate.

The amount that is included in the deceased owner’s estate is the death benefit from the policy. The policy’s cash value has no relevance to the estate tax calculation. So, both (1) a term policy with a $500,000 death benefit, and (2) a whole life policy with a cash value of $300,000 and a death benefit of $500,000, will have the same estate tax inclusion amount of $500,000.

Common Estate Tax Misunderstandings

Some people have suggested that when working with a married couple, making one spouse the owner of the policy and the other the insured of the policy will eliminate the estate tax. Their logic (which is mostly faulty) is that the owner and the insured are different people. So, when the insured dies, he/she did not own the policy. Therefore, it is not part of his/her estate.

This is wrong on several levels. First, there is an unlimited marital deduction for whatever a surviving spouse inherits from a deceased spouse. If the spouse is the beneficiary of the policy, the proceeds will be included on the deceased spouse’s estate tax return. However, there will be no tax assessed as the total amount will be a deduction. The result is not estate tax assessed when the owner/insured spouse dies.

Second, regardless of whether the insured owns the policy or their spouse owns the policy, if the insured dies first, the proceeds are now with the spouse. When the spouse dies later, this money will be part of their estate calculation. So, having the spouse own the policy in hopes of avoiding inclusion in the insured’s estate is meaningless. Inclusion will occur at the spouse’s death.

Another misunderstanding is that the insurance will be part of the insured’s estate only if he listed the beneficiary as the “estate.” This, too, is false. As mentioned above, the identity of the beneficiary does not affect the inclusion of the insurance proceeds in the decedent’s estate. For instance, if Dad owns a policy and he is the insured, the policy’s death benefit is included in Dad’s estate even if the children are named as the beneficiaries.

Get Help Understanding Estate Taxes

If you have any questions about life insurance and estate tax or any other topics related to family wealth preservation, please do not hesitate to get in touch with a Tennessee estate planning lawyer at Martin Heller Potempa & Sheppard, PLLC today.

Contact us to learn more about our estate planning services.

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