Taxation and Your Life Insurance Policy

Question:  when are the proceeds from your life insurance policy taxable?  Answer: when you own your policy!  Okay, that was a bit of a trick question.  Life insurance proceeds are generally federal income tax free and, more often than not, are subject to federal estate taxes.  Today, we’re going to focus on avoiding federal estate taxes with your life insurance policy.

If you keep in mind one simple rule, you’ll go a long way to understanding why certain property is subject to federal estate taxes.  That is rule is that everything you own or control is subject to federal estate tax.  When considering life insurance, this means that, even though the proceeds from your life insurance policy go to your children, for example, those proceeds are included in your estate simply because your owned the life insurance policy!  Federal estate taxation is driven by ownership.  The good news is that the federal estate tax threshold is over $5 million; the bad news is that your life insurance policy can get you there pretty quickly.

So, what to do about it?  Fortunately, the answer is pretty easy:  in order to remove your life insurance policy from your estate, transfer the ownership, i.e., gift, your policy to a third party such as your child(ren).  Be aware that the “Three-Year Rule” applies and states that, if the transfer-or dies within three years of the transfer, the full amount of the proceeds is included in his or her estate as if the transfer was never made.

However, the execution of the above is a bit more complicated. When transferring the ownership of a life insurance policy, consider the following:

  • The new owners must pay the life insurance premiums.  You can gift the premiums to him or her and the recipient can then pay the premium.
  • You forfeit all rights to make any changes to the policy.  Remember: this is an irrevocable gift, and, as such, you lose all control over this property.

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