If your life insurance is part of your estate when you pass away, the payout to your beneficiary might be decreased by estate taxes. As of 2012, the Internal Revenue Service could levy taxes as high as 35 percent against your estate; the rate was to rise to 55 percent in 2013. However, estate taxes at the federal and state levels are applied only if the total value of your estate exceeds exemption limits.
Federal Estate Tax Exemption
As of 2012, your life insurance payout, along with the rest of your estate, was subject to federal estate taxes if the total value exceeded the federal exemption limit of $5.12 million. If you were married, the total exemption limit doubled to $10.24 million. Starting in 2013, the federal exemption limit decreased to $1 million per person.
State Estate Tax Exemption
Your estate, including your life insurance policy, could also be taxed at the state level, depending on where you live. As of 2012, 10 states have estate tax policies. These states set their own estate exemption limits and tax rates. For example, in Washington state, where life insurance is 100 percent included in your taxable estate, the estate tax exemption limit is $2 million. In New Jersey, estates are taxed once the value exceeds $675,000.
You can exclude your policy from your estate to keep estate taxes from taking a chunk out of your life insurance payout. There are a couple of ways to do this. One way is to assign ownership to someone outside of your estate, such as your adult child. You can also name a person, not your estate, as your beneficiary. These changes must be made at least three years before you die.
Life Insurance Trust
If you have no one to assign ownership of your life insurance policy to, and no beneficiary to name, you can set up a life insurance trust. A life insurance trust becomes the owner of your policy, and your proceeds are safe from estate taxes. However, there are drawbacks to a life insurance trust. You cannot borrow money from the life insurance policy if it has a cash value account, and you can't change beneficiaries. The policy become irrevocable as well, which means you can’t get it back. Another drawback is the cost. Setting up a life insurance trust can cost thousands of dollars in lawyer fees and other costs. If you transfer an existing policy, it has to be done at least three years before you die.