Wednesday, June 15, 2022

Are Life Insurance Proceeds Taxable To A Trust

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Tax Treatment of Life Insurance Proceeds : Personal Finance & Life Insurance

Yes, when you get the payout. Earnings on the payout of life insurance are subject to income tax on earned interest, dividends and realized capital gains on those invested monies, unless theyre invested into another tax-sheltered plan such as a tax-free savings account, says Wouters. The insurance company handles investment decisions beyond the costs needed to provide pure coverage and administrative fees for permanent life insurance policies . The policy may have growing guaranteed cash values and additional non-guaranteed cash values that depend on factors including claims experience, operational costs, long-term interest rates and investment performance, says Wouters.

How Life Insurance Death Benefits May Be Taxed

One of the benefits of owning life insurance is the ability to generate a large sum of money payable to your heirs upon your death. An even greater advantage is the federal income-tax-free benefit that life insurance proceeds receive when they are paid to your beneficiary. However, while the proceeds are income-tax-free, they may still be included as part of your taxable estate for estate tax purposes.

Section 2042 of the Internal Revenue Code states that the value of life insurance proceeds insuring your life are included in your gross estate if the proceeds are payable: to your estate, either directly or indirectly, or to named beneficiaries if you possessed any incidents of ownership in the policy at the time of your death.

The Tax Cuts and Jobs Act of 2017 determined the exemption amount at above $11.7 million for 2021 , while maintaining the top rate of 40%. Note that not all estates are subject to taxes, however.

Why Is Writing Life Insurance Into Trust So Important

As we’ve said earlier, very few estates actually pay inheritance tax.

So, for most people, the real benefit of writing life insurance into trust means that your family will not need to go through the probate process – which is where your estate is divided up according to your wishes – in order to receive the insurance money.

Probate can be a lengthy process, so having the policy written in trust cuts out delays and ensures your family receives the money much more quickly.

This can be vital after someone dies. If you rely on two incomes to meet mortgage repayments, for example, a long delay due to probate, lasting for six months or more, could have severe repercussions on your ability to repay your mortgage, and could even lead to repossession of your property.

Writing a life insurance policy into trust enables you to avoid this potential pitfall and ensure your loved ones get the benefits as soon as possible.

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Life Insurance Trusts And Estate Taxes

One important factor you need to consider when naming a trust as the beneficiary of a life insurance policy is that by doing so the proceeds may be included in your estate for federal and/or state gift and estate tax purposes. If so, you need to be sure that your estate, with the proceeds included, does not exceed the current lifetime exemption amount or your estate will be subject to estate taxes. This is one of the many reasons why you should always consult with an experienced estate planning attorney before making important decisions that could impact your estate plan.

How Life Insurance Trusts Work

Life Insurance Trusts  Orange County Estate Planning ...

First, you create an irrevocable trust, naming someone else as trustee. Then you transfer the policy into the trust and the trust becomes owner of the policy. You will no longer have any control over the policy, but through the terms of the trust you can determine who will have control, how premiums will be paid, who will benefit from the trust, and how payments should be made to the beneficiary or beneficiaries.

There are three important requirements:

  • The trust must be irrevocable.
  • You cannot be the trustee of the trust.
  • The trust must exist for at least three years before your death.

The first two requirements exist to ensure that you have no control over the policy after you transfer it to the trust. If you do retain control, the IRS will include the policy in your taxable estate. The last requirement is the IRS’s way of prohibiting “last minute” transfers to avoid estate taxes. It seems that it’s okay to avoid estate taxes this way, as long as you plan ahead for it.

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Planning Opportunities And Obstacles

Minimizing probate

If properly drafted, probate may be avoided as the insurance proceeds will pass outside of the estate. This is particularly important in provinces with high probate fees. For example, after the first $50,000 of estate value the probate fees are 1.5% in Ontario and 1.4% in British Columbia.

Provisions in provincial insurance legislation provide creditor protection where there has been a designation of a spouse, child, grandchild or parent of a person whose life is insured . This would appear to be an added consideration when creating an insurance trust as it should be noted that the class identified in the provincial legislation does not include a trustee. Therefore, where the beneficiary is a trust for the benefit of the children of the life insured, creditor protection may not be available.

Read: 5 tax benefits of testamentary trusts

Minor beneficiaries

A minor beneficiary cannot legally discharge the insurance company for payment of the proceeds of an insurance policy prior to reaching the age of majority . This means the insurer must pay the insurance proceeds into court, to a public trustee or to a trustee named in the policy.

Income payable to minor beneficiaries

The payment of the expenses is for the benefit of the minor and will be considered to be paid to the minor. Since the income is taxed in the minors hands and not at the trust level, little or no tax may be payable on the distribution.

Multiple trusts

When You Profit From Surrendering Your Cash Value Policy

After buying a replacement term life policy, getting the payout from your cash value account, and then surrendering your permanent life policy, you may owe taxes. Bummer! If the amount you receive is more than what youve paid in fees and premiums over the life of the policy , youll need to report that amount as extra income. But take heartthis hardly ever happens.

Note: The order here is important. You never want to be even a moment without life insurance coverage. Dont worry if youre double-covered for a few days with both whole and term insurance. Make sure the term is in force before surrendering your whole life and receiving the cash value amount.

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Trust Income Tax Returns

An insurance trust generally will be treated as a grantor trust for income tax purposes, which means that the grantor is liable for the payment of tax on any income generated by the trust. Among other reasons, a trust is a grantor trust when trust income may be used to pay the premium on insurance policies on the grantor-insureds life, or the terms of the trust permit trust income to be distributed to the grantors spouse. Because most insurance trusts are funded only with insurance, generally no income, deductions, or credit will be generated, and thus the trust will not have any filing requirements. However, if assets are added to the trust that produce items of income, deduction or credit, these items will have to be reflected on the income tax return of the grantor. The Trustee should then consult his tax advisor to discuss filing requirements.

Special Characteristics Of Employer

Irrevocable Life Insurance Trusts Explained | Illinois ILITs for Estate Tax Planning

If the premiums on any insurance policies held in the trust are paid by the insureds employer , in part or in whole, the IRS has taken the position that while employment continues such payments are considered taxable income to the employee, limited in the case of group life insurance to the premium attributable to coverage in excess of $50,000, and as gifts by the employee to the trust owning the policy. Depending on the terms of the governing trust, Treasury rulings indicate that the $15,000 annual gift tax exclusion may be available for such gifts to the trust.

The desirability of continuing the group insurance policies and the trust after retirement of the insured requires consideration before his or her retirement.

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What Is Line 12100

Line 12100 is the line where a taxpayer reports the earnings on certain life insurance policies that is shown on the T5 slip issued by the insurance company.

How is it used? Wouters explains: The reported earnings on certain life insurance policiesmost often coming from a direct policy loan, withdrawal or surrender of a permanent life insurance policy that has an accumulated valueis treated like other investment income. Its ordinary incomenot capital gainsand is fully taxable. It increases both gross income and net income on a recipient individuals tax return. The amount that needs to be reported is shown on the T5 slip issued by the insurance company.

Irrevocable Life Insurance Trust

It is generally well known that life insurance proceeds, in most cases, pass to the named beneficiary free of any income tax. Less well known, however, but vitally important, is that the payout from a life insurance policy is generally included in the gross estate of the policy owner for estate tax purposes at the policy owners death and is potentially subject to federal and state estate taxes. At the current federal estate tax rate, , a significant portion of the life insurance proceeds would be payable to the Internal Revenue Service for federal estate tax instead of passing to the policy owners beneficiaries.

An irrevocable life insurance trust takes advantage of a purposeful loophole created by Congress. If an ILIT is created to own the life insurance policy and the proceeds of the life insurance policy are payable to the trustee of the ILIT upon the insureds death, then the proceeds are not included in the insureds estate and, therefore, are not taxable for federal estate tax purposes. This is true even though the insured gives the money to the trustee of the ILIT to pay the annual premiums of the life insurance policy.

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Do I Have To Pay Taxes On Money Received From A Life Insurance Policy

When a life insurance policy payout is made in the UK, it’s not taxed.

However, although a life insurance payout is not subject to any kind of specific life insurance tax, it could be considered part of your ‘estate’, which is subject to inheritance tax .

Your estate is the money, investments, pensions, assets, property and anything else of value which remains after your death.

Whether your family have to pay tax on the proceeds from your estate depends on your financial situation at the time of your death.

It depends on the total value of your estate and whether your life insurance is in a trust, whether a life insurance policy payout might be taxed before your family and loved ones get to use it.

Read our guide to learn more about the rules on tax and life insurance, and how you can legally and safely avoid having any of your life insurance payout taxed.

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Another Option For Your Life Insurance Policy

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A more simple method of keeping the money from a life insurance policy out of your taxable estate is to just give the policy to someone else. While this is absolutely easier and will have the same effect on your estate taxes, there are some serious downsides.

First, you need to worry about gift taxes. Your estate will be liable for any gifts that you make larger than $16,000 per recipient, per year. Any gift tax will likely be less than the estate tax burden if you leave the policy in your estate , but you should still look into what gift taxes you’ll incur by transferring your policy. Learn more about Reducing Estate Tax by Making Gifts.

Also, to keep your policy out of your estate, when you give it to another person you must give up all control over the policy. You cannot change the beneficiaries, borrow against the policy, change or cancel the policy, or do anything else that the IRS might construe as an “incident of ownership.” And, whoever you give the policy to will be able to do all of those things. So you must carefully consider whether you trust that person with the policy. While it’s not right for everyone, some people will decide to proceed this wayif they do, it’s because they absolutely trust the recipient.

As with a life insurance trust, this transfer must be made at least three years before death.

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  • Person B the policy owner
  • Person C the beneficiary

When the owner of a policy appoints a fourth party another beneficiary the Goodman Triangle occurs, and their payout is considered a gift. Unlike life insurance payouts, gifts are subject to taxes, and the owner of the policy is responsible for that tax payment.

Heres an example:

Jerry has two children, Mike and Bob. Mike takes out a life insurance policy on Jerry for $1 million with the understanding that the payout is split between the two siblings.

Bob is named the beneficiary but isnt listed as an owner of the policy. When the death benefit is paid out, Mike and Bob both receive $500,000.

But because Bob isnt listed as an owner, his half is considered a gift from Mike the owner of the policy. Mike is now responsible for the gift tax on $500,000.

How can you avoid the Goodman Triangle?

To avoid running into the Goodman Triangle, list all beneficiaries as owners of the policy or register an irrevocable life insurance trust as owner of the policy. Youll need to pay a fee, but it keeps the death benefit and estate separate and avoids gift taxes.

Are Life Insurance Living Benefits Taxed

Many life insurance policies come with the option of accelerating a portion of your death benefit if you become terminally or chronically ill. This option is helpful as severe illnesses often come with incredibly high hospital and treatment costs. If you are diagnosed with an illness and decide to receive accelerate your death benefit, itâs typically not taxable. From a tax perspective, itâs essentially viewed as you being the beneficiary to a life insurance payout.

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Do I Pay Tax On A Life Insurance Policylike Whole Life Insurancewhen It Accumulates Value

It depends. Growth is tax-sheltered up to certain limits set in the policy and according to legislationas long as that growth is not taken out of the policy, says Wouters. The accumulated value is paid out as part of the tax-free death benefit when the life insured passes away.

But is it taxable if you decide to cash it out? Thats up for the insurance company to figure out. The insurance company calculates what is reportable as taxable income, says Wouters. If so, they send out a tax slip to the policy owner. If you wish to cancel or surrender your life insurance policy, you can let your financial advisor or the insurer know by calling or writing a letter. The provider may also require you to fill out a cancellation form. It may be a similar process for withdrawing or borrowing cash from your policy, but you need to keep paying premiums to keep your coverage in force.

Perform An Ownership Transfer

Is Life Insurance Tax free? Estate Taxes on Life Insurance & Life Insurance Trusts (“ILITs”)

You may need to transfer ownership of your life insurance policy to avoid the proceeds becoming part of your estate. Whether or not taxes are due can depend on the policy owner at the time of death of the insured. Just be careful when performing the transfer as the IRS has very specific rules regarding ownership transfers. The transfer itself might be subject to gift tax that will be due when it comes time to file your tax return.

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When Does It Make Sense For A Trust To Own Your Life Insurance Policy

Estate planners and insurance professionals often recommend that people create a separate trust to own life insurance policies. Whether a life insurance trust makes sense for you depends on your goals and a number of other factors.

Why own life insurance in a trust?

If you own a life insurance policy, you probably know that the beneficiaries youve named to receive the insurance proceeds when you pass away get that money income tax-free.

However, payout on a life insurance policy may not be exempt from estate tax, which is why planners often recommend that a trust own your life insurance policy instead of you owning it.

If youre married and you name your spouse as the beneficiary of a life insurance policy that you own, theres no estate tax on the insurance proceeds when you pass away because the payment to your spouse qualifies for the unlimited marital deduction from estate tax.

How it works?

Existing insurance: If you already own one or more life insurance policies, you can change ownership from your name to your insurance trust.

First, you would work with an estate planning attorney to create the trust document. Youll want to consider who will act as trustee of the trust and under what circumstances your beneficiaries will have access to the insurance proceeds.

There are two wrinkles, however:

The mechanics

  • Premium notices will be sent to the ownerin this case the trustee or trustees.
  • Make sure the trustees let you know when they receive a premium notice.
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