Chelsey Tucker graduated with a Bachelor of History degree from Metropolitan State University in 2019. She now writes about insurance with her specialty being life insurance and has been quoted on Help Smart Phone and MEL Magazine.

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Dan Walker graduated with a BS in Administrative Management in 2005 and has been working in his family’s insurance agency, FCI Agency, for 15 years. He is licensed as an agent to write property and casualty insurance, including home, auto, umbrella, and dwelling fire insurance. He’s also been featured on sites like Reviews.com.

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Reviewed by Daniel Walker
Licensed Auto Insurance Agent

UPDATED: Mar 19, 2020

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Death benefits from life insurance policies are not usually taxed, but this is not a hard and fast rule. There are several factors that can determine whether or not life insurance benefits are taxed.

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If the cash value part of a permanent life insurance policy becomes very high, the funds turn into what is called a modified endowment contract. This will be taxed in some way, whether upon initial payment of the money, or during the beneficiary’s life.

Beneficiaries and Taxes

Also, remember that just because a beneficiary is not taxed on the amount he or she receives from a life insurance policy does not meant that he or she will not be indirectly taxed. The amounts of any life insurance policy that a person owns, meaning a policy in which the insured can borrow against, surrender, or change the beneficiary of, will be included in the estate. All the amounts will then be subject to an estate tax, which can be up to 45%.

Here is an example of the above scenario. If someone has a life insurance policy for $500,000, after the estate tax is levied, the money the beneficiary receives may be closer to $275,000. While the beneficiary will not have to pay any taxes on that $275,000, that is still a lot less than the benefactor intended for him or her to receive.

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Irrevocable Life Insurance Trust

To get around this, you might want to consider setting up an Irrevocable Life Insurance Trust (ILIT). This is a trust that allows you to ability to avoid estate taxes. If you place a life insurance policy in such a trust, then it is considered to belong to no one. You don’t own it because you are not able to cancel the policy or change it in any way; the Irrevocable Life Insurance Trust is both the owner and the beneficiary.

Upon your death, your ILIT will get all the proceeds and will be responsible for holding them for the beneficiaries. You will name the beneficiaries when you set up the trust account, and then you will be removed from any ownership of the life insurance policy or policies.

This is fine and legal; however, the IRS requires that the beneficiaries of the policies be named at least three years prior to your death if you are trying to trying to transfer policies into the trust. This rule can be avoided altogether if the Trust itself is named as the beneficiary of the life insurance policy, or if the Trust purchases the policy. If you die within the three years after transferring the life insurance policy to the ILIT, however, then the proceeds will still be subject to estate taxes.

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Many people, when they have a spouse, will add what is called a “fail-safe clause” to the Trust. This clause says that the proceeds of any policies that have not reached that three-year mark will go directly to the surviving spouse, and will qualify for the marital deduction. There will be no taxes on those proceeds, but the proceeds will be included in the estate of the spouse.

The Irrevocable Life Insurance Trust can still transfer the proceeds of the policy to the beneficiary or beneficiaries just as quickly as without the Trust, but what happens to the funds is very different. The funds in the trust are not at all subject to any estate taxes which means that the beneficiary will directly receive all the proceeds from the policies.

Dynasty Trust

Some go even further, and set up a Dynasty Trust, which makes use of a generation-skipping tax exemption and can secure funds for multiple generations that are not impacted by estate taxes. Benefactors, when setting up this kind of trust, can have more control over who gets money, and when. More responsible beneficiaries can have more immediate access to the funds, and the less responsible can have more “spendthrift clauses” in place. A Dynasty Trust is trickier, as it involves setting aside inheritance for a longer period of time and determining more long-acting trustees. There are more decisions to make over how much control the trustees get.

You will want to sit and talk with your financial advisors and insurance agents to get an idea about what your options are to determine what is right for you and your family. Only a real professional can give you full information about these matters to help you make some of the most important decisions you can make.

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