Overview of Life Insurance and Estates

Posted by David Heller on July 16, 2021

Many clients have one or more life insurance policies; some may have been personally purchased and others may be provided by an employer as a benefit. Who is listed as what role can impact how the life insurance proceeds pass, to what extent they are taxable, and when the tax is assessed.

The three roles with an insurance policy are, somewhat obviously:

  • The Insured – The person whose death triggers the payout of the death benefit. Many times, this person is also the owner, but this does not have to be the case. Also, with second-to-die policies, there are two insureds that need to be considered.
  • The Owner – The person who actually owns the policy. The identity of the owner is the most important question for life insurance and estate tax issues. The owner of the policy will include the death benefit in his estate.
  • The Beneficiary – The person who receives the payout of the death benefit. It is important to know who is designated as the insurance policy’s primary and contingent beneficiaries. This is important if the client desires a “per stirpes” distribution to his children. Most insurance policies are distributed on a “per capita” basis if the children are individually named.

Most of the time the insured and the owner are one in the same. But it does not always happen that way. This is especially true when a trust is used to protect the distribution of the policy’s proceeds at the insured’s death. If the death benefit is to pass to a trust, then the trust will need to be listed as the beneficiary. And if the client is looking to reduce estate tax, then the trust might also be listed as the policy’s owner.

Many people are told that the proceeds from life insurance are “tax free.” Because there are different types of taxes, that is not exactly true. Both income tax and estate tax issues come into play with life insurance proceeds.

Life Insurance And Income Tax

Under the IRS tax code, the receipt of life insurance proceeds are not considered income to the beneficiary. For example, if a child receives a payout of $500,000 from a policy, the child does not include that amount on his/her income tax return for that year. Some people have taken this concept too far and think that the life insurance proceeds are tax free forever, with even future proceeds from the money that’s invested. This is not correct. If the life insurance money is invested and produces income, like interest from a CD, then that interest will be subject to income tax.

Even though the insurance proceeds are not subject to income tax, 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 in the same. But technically, the policy proceeds are taxed to the owner’s estate. The amount that is included in the 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.

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

For instance, if a father owns a policy and he is the insured, the policy’s death benefit is included in his estate tax calculation, even if the children are named as the beneficiaries. It is not the case that the insurance is subject to estate tax only if the “estate” is named as the beneficiary! Some clients have the misconception that naming a person instead of the estate protects the death benefit from estate tax. This is not true.

Contact the Estate Planning Attorneys of Martin Heller Potempa & Sheppard, PLLC.

If you have any questions or comments about this topic, please do not hesitate to contact the estate planning lawyers at Martin Heller Potempa & Sheppard, PLLC.

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