Is Life Insurance Taxed for Policy Owners or Beneficiaries?

Scenarios When Life Insurance Is Taxed and How to Avoid Them

We briefly discussed the taxation of both term and permanent life insurance policies. Now, let’s delve deeper into these scenarios and how to avoid them.

The Goodman Triangle a.k.a. Unholy Trinity

A life insurance policy involves three roles: the owner, the insured, and the beneficiary. More often than not, one person fills two of those roles.

If there are three different people to fill each role, the IRS views the death benefit as a gift from the owner to the beneficiary.

The payout could be subject to gift taxes if it exceeds gift tax exclusions, which only apply if the owner has gifted more than $17,000 annually or $12.92 million in their lifetime.

This arrangement is often called the “unholy trinity” or “Goodman Triangle,” named after a court case that set a precedent for this rule.

How to Avoid This Tax

Avoiding the Goodman Triangle tax scenario requires careful planning in designating the policy owner, insured, and beneficiary.

The easiest way to avoid this potential tax is to have the policy owner and beneficiary be the same person.
Another option is to have the insured also be the policy owner, which means the value will be included in the insured’s estate for tax purposes.
Creating an Irrevocable Life Insurance Trust (ILIT) to own the policy is another effective solution.

Transfer-for-Value

One of the key benefits of any kind of life insurance is the tax-free death benefit for beneficiaries. However, transfer-for-value rules could void this tax-free status.

If you’re considering selling your life insurance policy, be aware that the new owner might need to pay income taxes on the death benefit when it’s paid out.

According to the transfer-for-value rule, if a life insurance policy is sold, some of the death benefits could be taxable.

The taxable amount would be the death benefit payout minus the amount paid for the policy.

How to Avoid This Tax

There are exceptions to the transfer-for-value rule. If the policy owner transfers the ownership to one of the following, income tax won’t be applied:

Modified Endowment Contracts (MECs)

Single-premium life insurance policies gained popularity following a tax code overhaul in 1986. These policies worked much like whole life insurance but with one substantial upfront payment instead of several over time.

This format allowed policyholders to overfund their policy, thus enhancing the payout. Furthermore, borrowing against the policy’s value was possible, transforming these policies into somewhat of a tax-free private bank account.

To close this tax loophole, Congress introduced the “Modified Endowment Contract” or MEC classification through what is known as the 7-pay test.

Features points of the 7-pay test and MECs include:

The 7-pay test limits contributions made to a policy within its first seven years.
If contributions exceed this limit, the policy becomes an MEC.
Any distribution from a MEC policy results in income taxation if there is a gain in the contract no matter how the distribution occurs; partial withdrawals or loans are treated the same way.
Additionally, an extra tax penalty applies if loans are taken out against an MEC before the policyholder turns 59 ½.

How to Avoid This Tax

Avoiding turning your life insurance policy into a MEC primarily involves you keeping track of your life insurance premium payments.

Familiarize yourself with the guidelines set by the 7-Pay test and avoid overpaying during those years.
Consider spreading your premium payments out over a long period.
Consult with a financial advisor who can guide you.

Most life insurance buyers don’t have to worry about this issue. It typically takes a substantial overpayment beyond what most policy owners could afford to push a policy into the territory of becoming a MEC.

Estate Size

Estate taxes are payable on property included in your estate at death if the gross value exceeds available deductions and credits. As of 2023, the established federal estate tax exemption is $12.9 million per individual and $25.84 million per married couple.

Life insurance is often one of the most valuable assets in an estate. Owning a policy at death could push you over this threshold. It’s not unusual for individuals to have life insurance policies worth millions of dollars.

Furthermore, your state could impose its own estate or inheritance taxes.

While neither you (the deceased) nor your beneficiaries (who receive the payout tax-free) will be directly affected by this potential tax, your estate’s heirs may feel the impact. During the estate settlement process, any outstanding taxes and debts are settled before anything else, including inheritance.

Scenarios when life insurance is included in your estate:

When life insurance proceeds are payable to your estate.
If you possessed an incident of ownership in the policy at the time of your death.
If you transferred ownership of the policy within three years of your death.

An incident of ownership means you have some control over the policy (i.e. beneficiary changes or cash value access). Establishing an irrevocable trust as the owner voids those privileges. A revocable trust lets you maintain control, but the policy is included in your estate for taxation.

How to Avoid This Tax

Because the federal estate tax exemption amounts are so high, most families do not have to worry about this tax. But it’s still important to know how to avoid the situation.

To protect your heirs from excessive taxes, consider the following strategies to keep your life insurance out of your estate:

Designate specific primary and contingent beneficiaries to avoid proceeds being defaulted to your estate.
Transfer the ownership of your life insurance policy to a trustworthy family member or friend. Remember, this means surrendering all control to the new owner.
Name your spouse your primary beneficiary. Proceeds payable to a spouse qualify for the federal estate tax marital deduction, and the total value is deducted from your gross estate.
Set up an ILIT to own the policy.
Gift the policy to a beneficiary.

Transferring Wealth to Younger Generations

The Generation-Skipping Transfer (GST) tax is a federal tax in the U.S. that applies to assets transferred to individuals who are more than one generation below the grantor, such as grandchildren or great-grandchildren. This tax is in addition to any potential gift or estate tax.

Like the gift and estate tax exemptions, GST tax exemptions are $12.9M per person or $25.84M for a married couple, and therefore, many families do not have to be concerned about this tax.

How to Avoid This Tax

Once again, trusts come into play to protect life insurance proceeds from taxation. A Generation-Skipping Trust (GST) allows for the transfer of assets to younger generations and avoids or lessens the impact of taxes.

Here’s how it works:

The grantor, typically a grandparent, establishes a GST trust and names their grandchildren the beneficiaries.
The grandparent purchases life insurance on themselves and names the trust the owner and beneficiary of the policy.
The grandparent transfers money into the trust, and the trust then uses this money to pay the policy premiums. This transfer may be subject to gift tax, but they can use their annual gift tax exclusion or their lifetime gift tax exemption to minimize or eliminate this tax.
Upon the grandparent’s death, their death benefit is paid out to the trust, which can then make distributions to the grandchildren.

This is a simplified example. To set up a GST, work with an experienced attorney.