Taxes on Life Insurance?

When people purchase life insurance policies, they designate a beneficiary who will benefit from the policy’s proceeds. When the insured person dies, the policy’s beneficiary then receives a payout known as the death benefit.

Yahoo Finance’s recent article entitled “Will My Beneficiaries Pay Taxes on Life Insurance?” says the big advantage of buying a life insurance policy is that, upon death, your beneficiaries can get a substantial lump sum payment without taxation, unless the amount of the life insurance pushes your estate above the applicable federal estate tax exemption. In that case, your estate will need to pay the tax.

While death benefits are usually tax-free, there are a few situations where the beneficiary of a life insurance policy may have to pay taxes on the lump sum payout. When you earn income from interest, it’s typically taxable. Therefore, if the beneficiary decides to delay the payout instead of receiving it right away, the death benefit may continue to accumulate interest. The death benefit won’t be taxed. However, the beneficiary will typically pay taxes on the additional interest.

So, for example, if the decedent had an insurance policy with a $200,000 death benefit which pays to their daughter at death. The daughter submits a claim after the parent dies and receives $200,736. The $736 is interest generated on the amount of money held by the company post­ death until pay out. The death benefit of $200,000 is not taxable, but the $736 is income taxable as interest, just as though the beneficiary has held the $200,000 in a bank somewhere and generated $736 in interest.

Additionally, the value of the insurance policy is subject to estate tax in most cases. This is true for typical insurance policies where an individual owns a policy on their own life and the proceeds pay out at death (e.g. the $200,000 policy described above). The value of the insurance increases the size of your estate so that if your estate excludes your applicable gift and estate tax exclusion amount (currently about $13,000,000) then your estate will have estate tax to pay.

This obviously doesn’t affect too many people, but many term policies can dramatically increase estate sizes due to their high death benefits.  Some states also have their own inheritance or estate taxes to consider.

Estate planning attorneys, especially when the estate tax exemptions were lower, frequently used life insurance trusts, often called “ILITs” or “Irrevocable Life Insurance Trusts,” to combat this. As the estate tax exemption is currently expected to be cut in half in 2026, these kinds of trusts make sense to use now so that the value of the insurance is removed from your estate in anticipation of a lower exemption.  They work because the client doesn’t have ownership of the insurance policy. It is owned and maintained by the trust without any “incidences of ownership” so that the policy is not considered controlled by the decedent. They will often pay money to the trust which will in turn pay the insurance premiums during life.

I often recommend this to younger clients who are considering life insurance. They may never expect to be estate taxable, but as we don’t know what the future holds, or where politics will take us, we can remove the insurance from their estates now and so not worry about it.

If you want to know more about how life insurance impacts your estate plan, see this article:  https://galligan-law.com/role-of-insurance-in-estate-planning/

As a warning, I’m referring to taxation of life insurance at death. Transferring the policy, withdrawing money or taking a loan from the cash value and surrendering the policy can all have taxable components, so you would want to consult a CPA or attorney on the tax implications before proceeding.

To summarize, beneficiaries usually won’t have to pay taxes on life insurance proceeds. However, some situations can result in a taxable event and in some cases can be planned for in advance.

Reference: Yahoo Finance (Jan. 17, 2023) “Will My Beneficiaries Pay Taxes on Life Insurance?”

Continue ReadingTaxes on Life Insurance?

The Basics of Estate Planning

Every now and again, it’s helpful to go back to the basics.  This blog will go back to the basics of estate planning to talk about how and why everyone should have an estate plan.  Forbes’ recent article entitled “Estate Planning Basics” explains that everybody has an estate.

No matter how BIG or small your net worth is, estate planning is a process that addresses how and to whom you leave your assets when you die and names decisionmakers who will wind-up your affairs at death and make financial, medical or personal decisions for you if you cannot yourself.

An estate is nothing more or less than the sum total of your assets and possessions of value. This includes:

  • Your car
  • Your home
  • Financial accounts
  • Investments; and
  • Personal property.

Part of estate planning is deciding which people or organizations are to get your possessions or assets after you’ve died.  This includes determining how to give it to them, and that plan addresses concerns such as marital status of the beneficiary, how they are with money, addiction problems, taxes and so on.

It’s also how you leave directions for managing your care and assets if you are incapacitated and unable to make financial or medical decisions. That is done with powers of attorney, a healthcare directive and a living will.

This is a very important aspect of estate planning, and you can learn more here:  https://galligan-law.com/power-of-attorney-why-it-is-important/

One of the biggest reasons people don’t have an estate plan is they assume they have no “estate” to be concerned with.  It might be true they don’t have much money, but everyone should consider naming individuals to act for them if they become incapacitated, ill or otherwise need help making decisions.

It also designates who can make critical healthcare and financial decisions on your behalf should you become incapacitated. If you have minor children, your estate plan also lets you designate their legal guardians, in case you die before they reach 18. It also allows you to name adults to safeguard their financial interests.

You can also create a trust to safeguard a minor child’s assets until they reach a certain age. You can also keep assets out of probate. That way, your beneficiaries can easily access things like your home or bank accounts.

All estate plans should include documents that cover three main areas: asset transfer, medical needs and financial decisions. Ask an experienced estate planning attorney to help you create your estate plan covering these three basic areas.

Reference: Forbes (Nov. 16, 2022) “Estate Planning Basics”

Continue ReadingThe Basics of Estate Planning

Top 10 Success Tips for Estate Planning

Unless you’ve done the planning, assets may not be distributed according to your wishes and loved ones may not be taken care of after your death. These are just two reasons to make sure you have an estate plan, according to the recent article titled “Estate Planning 101: 10 Tips for Success” from the Maryland Reporter.

There are several other key tips for estate planning for you to consider, here are 10 of them:

Gather Asset Information.  This should include all your property, real estate, liquid assets, investments and personal possessions, and not just assets you think your Will will control, gather it all.  With this list, consider what you would like to happen to each item after your death. If you have many assets, this process will take longer—consider this a good thing. Don’t neglect digital assets. The goal of a careful detailed list is to enable your fiduciaries to quickly identify, gather and ultimately distribute your assets.

One more key thing, put this list in a place that’s accessible.  Don’t assume technology will make that possible as an era of passwords and high security, although great in most contexts, makes accessibility difficult for your family.  Instead, consider sharing information with them in advance so they are prepared to deal with this.

Meet with an estate planning attorney to create wills and/or trusts. These documents dictate how your assets are distributed after your death. Without them, the laws of your state may be used to distribute assets. You also want to pick the person whose job it is to wind-up your affairs, and these documents name the person responsible for carrying out your instructions.  If you already have estate planning documents, you should have them reviewed from time to time as clients sometimes out grow their estate plans, or have better options on how to accomplish their goals.

Anecdotally, I participate in estate-related study groups, message boards and other groups in which lawyers workshop estate problem.  The hardest cases to figure out and the hardest cases to get a satisfactory conclusion for are very typically cases where no estate planning was done.

If you don’t have an estate plan and want ideas on how to start the process, see this article:  https://galligan-law.com/how-to-begin-the-estate-planning-process/

Guardians for minors, the person who will raise your minor children if you should pass.  You can nominate who will serve as their guardians.

Beneficiaries named?  Now, very frequently people tell me in consultations that they don’t need an estate plan, because they have beneficiaries named on all of their assets. That is virtually never true, however, for this list’s purposes, I say it is worth reviewing which assets should name beneficiaries (e.g. life insurance or retirement funds) and confirm they match what you want.

One of the difficulties with beneficiary designations is that they are like old estate plans, people set them, and then never change them.  I’ve seen ex-spouses left on them, mistakes like naming only one child to receive everything because they will “do the right thing,” not having contingencies if the named person predeceased, and so on. They also write their own rules on contingencies.  So, if you leave your IRA to 3 named children, but one of them is deceased, their portion may go to their siblings, or maybe their children, or even possibly your estate.  The answer lies in the plan documents, so it is important to consider them in your estate plan.

Also, clients may have excellent wills that address all form of concerns.  But, then names one child as beneficiary of their assets.  That typically means the will has to be probated (did you have a beneficiary on your house?), but zero cash to fund it.  That is not an enviable position for the executor.  Plus, if the will establishes trusts, plans for minors or incapacitated beneficiaries, or any of the many other problems you can proactively plan for, but the asset goes directly to a person instead, all of those protections and solutions were circumvented.  So, speak with your estate planning attorney to ensure the beneficiary designations work with your estate plan.

Make your wishes crystal clear. Legal documents are often challenged if they are not prepared by an experienced estate planning attorney or if they are vaguely worded. You want to be sure there are no ambiguities in your will or trust documents. Consider the use of “if, then” statements. For example, “If my husband predeceases me, then I leave my house to my children.”  This is especially true in contingencies, which I’ve found people typically haven’t considered.

Trusts may be more important than you think in estate planning. Trusts allow you to take assets out of your probate estate and have these assets managed by a trustee of your choice, who distributes assets directly to beneficiaries. You don’t have to have millions to benefit from a trust.  I’ve written extensively about the benefits of trusts, so you can find several articles elsewhere on that topic.

List your debts. This is not as much fun as listing assets, but still important for your executor and heirs. Mortgage payments, car payments, credit cards and personal loans are to be paid first out of estate accounts before funds can be distributed to beneficiaries. Having this information will make your executor’s tasks easier.

Plan for digital assets. If you want your social media accounts to be deleted or emails available to a designated person after you die, you’ll need to start with a list of the accounts, usernames, passwords, whether the platform allows you to designate another person to have access to your accounts and how you want your digital assets handled after death. This plan should be in place in case of incapacity as well.

Plan for Incapacity.  All too often, clients only think of estate planning in the context of their passing.  That is of course part of it, but sometimes it is even more critical to consider incapacity.  What happens with your assets if your health doesn’t permit you to handle your own finances?  Who would speak for you?  Do you want them to do whatever they want, or do you want to give them direction?  This is extremely important as it directly affects your well-being as this person will pay for your daily needs and medical expenses.

Plan for Long Term Care. The Department of Health and Human Services estimates that about 70% of Americans will need some type of long-term care during their lifetimes. Some options are private LTC insurance, government programs and self-funding.

The more planning done in advance, the more likely your loved ones will know what to do if you become incapacitated and know what you wanted when you die.

Resource: Maryland Reporter (Sep. 27, 2022) “Estate Planning 101: 10 Tips for Success”

Continue ReadingTop 10 Success Tips for Estate Planning