Tax Consequences of Changing Beneficiaries on a Life Insurance Policy

Life insurance provides valuable income and peace of mind to families suffering from a death. It generally doesn't trigger a tax liability for the beneficiary since death benefits do not count as taxable income. But if you own the policy, the proceeds are added to the value of your estate when calculating estate taxes. Some people gift the ownership of the policy to the beneficiary, thus removing it from their estate.

What Are the Life Insurance Beneficiary Tax Implications?

When you take out a policy against your own life, the insurance company will ask you to designate a beneficiary or beneficiaries, such as your spouse and children. The beneficiary receives the proceeds of the policy upon your death. If there is more than one beneficiary, they receive the proceeds in whatever percentages you designate – 50/50, 70/30 or anything else that adds up to 100 percent.

Under the current tax code, death benefits do not count as taxable income. This means that your named beneficiaries get the payout tax free, with two major exceptions.

Exception No. 1: Delay the Payout and Interest Income is Taxable

As a policyholder, you can elect to delay payment of the death benefit for a given period, or request that the insurance company pays the proceeds in installments. For example, you might specify certain conditions that the beneficiary has to satisfy before receiving her payout, such as finishing college or reaching the age of 25.

The funds held by the insurer will earn interest from the time you die to the date of the payout. When a payment is made to the named beneficiary, that payment may include the death benefit plus interest earned on the death benefit. In this situation, the beneficiary will have to pay income taxes on the interest amount. To be clear, the tax liability is only on the accumulated interest, not the face value of the insurance benefit.

For instance, if the policy is set to pay out $750,000 in death benefits but earns 5 percent interest for 12 months before being paid out to the beneficiary, the beneficiary will owe taxes on the $37,500 growth. The beneficiary should add the amount to her ordinary income in the year the interest payment was received.

Exception No. 2: Estate Taxes on Life Insurance Payouts

Although beneficiaries do not pay income tax on the insurance proceeds, the payout can be considered part of your estate in some circumstances. It depends on who owns the policy. Typically, the policy owner is the deceased insured. For instance, if a woman wants to buy $1 million worth of insurance on her own life, she is the policy owner. Her life is insured, and she may name her son as the beneficiary.

When the woman dies, the insurance proceeds are paid to the son. However, because the woman owned the policy, the death benefit is included in the woman's estate for the purpose of calculating its taxable value. Estate taxes apply to estates worth more than $11.18 million in 2018. This means that if the woman's estate – that's all her assets minus her liabilities – is worth more than $11.18 million at death, then estate taxes are owed on everything above that amount. If her estate is worth $12 million, estate taxes are due on $820,000. In 2018, estate tax is levied at a flat rate of 40 percent, so the amount due is $328,000.

Had the $1 million life insurance policy not been included in the estate, then the estate would be worth $11 million and no estate taxes would be due – a savings of $328,000.

How Does Changing the Beneficiary Impact the Tax Position?

In the majority of cases, changing the beneficiary is a tax-neutral event. If you keep ownership of the policy and simply name a new beneficiary to receive the insurance proceeds at your death, then the new beneficiary will receive the proceeds income tax-free when you die. The proceeds still form part of your estate for estate taxes.

But what if you don't own the policy? Life insurance policies can be bought, sold and gifted like any other asset. It's also possible to take out life insurance on someone else's life.

Suppose, for example, that the son had taken out the life insurance against his mother's life. He owns the policy. On her death, the benefits are paid to the son or to any beneficiary he nominates. Now, when the mother dies, none of the insurance policy proceeds will fall within the mother's estate because she doesn't own the policy. The son receives the death benefit free of both income and estate taxes.

Changing the Ownership as an Estate Planning Technique

As you can see, changing the ownership of a life insurance policy is an important tax-saving strategy for very large estates. If you think you're going to exceed the estate tax exemption, then you might consider gifting your life insurance policy to the beneficiary to avoid paying estate taxes. The saving could be considerable.

Don't forget about federal gift taxes, however. The IRS requires that you report all gifts over the value of $15,000 per recipient, per year. If you transfer a life insurance policy to the beneficiary and it's worth more than $15,000 in 2018 and 2019, then it's considered a reportable gift. The life insurance company will figure out the value of the gift using a complex calculation called the "interpolated terminal reserve value" of the policy. You don't need to know the details, just the value. The value of the gift will eat into your $11.18 million lifetime exemption and potentially reduce the amount of tax-free transfer you can make later in your life and at death.

Timing is Everything When Gifting a Life Insurance Policy to Children

While transferring the policy should remove it from your taxable estate, timing is everything. Die within three years of the change of ownership, and the IRS will still add the full value of the death benefit to your estate for taxation purposes. If you're worried about ill health, don't wait. Take some advice about transferring the policy now to avoid any adverse tax consequences.

Bear in mind that once you transfer the policy, you no longer own it and you cannot change the coverage or designate a new beneficiary. Once it's gone, it's gone.

Transferring Life Insurance into Irrevocable Trust

Some people place their life insurance policies into an irrevocable life insurance trust, rather than assigning them to their children or beneficiaries. This keeps the insurance payout out of your estate since the trust will own the policy for you, but it also gives you maximum control over how the money is spent.

With an irrevocable life insurance trust, the trustee will take ownership of the insurance policy and must follow the instructions you write in the trust. For example, you can specify who the beneficiaries are, how much they receive and when. Most people name their spouse, children and grandchildren as beneficiaries of the trust, but it's up to you.

Note that if you transferred the policy to the trust within three years of your death, it would still be subject to the estate tax. The rules here are complicated, and this is one area where you definitely need some tax and legal advice so you can optimize your taxes.