Does Life Insurance Count Towards the Two Million for Federal Estate Tax?
Estate taxes only apply to estates with values above a set limit. Though Congress raises the exemption for some tax years, Internal Revenue Service regulations set the minimum limit at $2 million. A large life insurance policy can sometimes trigger a federal tax for an estate that would have otherwise been exempt. Whether or not the life insurance policy counts toward the limit depends on who owns the policy at the time of the covered individual's death.
About Estate Tax
An individual's taxable estate is the fair market value of the individual's property minus funeral expenses, outstanding debts, charitable deductions and the value of any property left to a spouse. Federal tax law allows the estates of decedents to exclude a certain amount of their estate's taxable value from estate tax calculations. If an estate's total taxable value is greater than this exemption, the IRS will assess a tax on the excess amount.
Life Insurance Rules
According to the IRS, life insurance always becomes part of a decedent's taxable estate if the proceeds were payable to the estate itself. In cases where the proceeds pass directly to heirs, the IRS considers life insurance proceeds a part of the decedent's estate if the decedent was the legal owner of the policy. The IRS defines the policy's owner as anyone who can make changes to the policy or borrow against its value.
If you are the legal owner of your life insurance policy at the time of your death, it will count toward your estate tax exemption. To avoid taxation, you can transfer ownership of the policy to another person. However, someone else must own the policy for a minimum of three years before your estate can exclude the policy from its taxable value. You can also avoid estate taxes by placing the policy in an irrevocable trust, but you must form the trust at least three years before you die.
If you transfer ownership of your life insurance policy to a named beneficiary, the transaction qualifies as a taxable gift. If the value of the policy exceeds the gift tax exemption, you may owe tax on the transfer. If you choose to avoid estate taxes by transferring your life insurance policy to a trust, the trust must be irrevocable. If the trust is revocable, the IRS will still consider you the policy's owner since you retain the authority to make changes.
Amanda McMullen is a freelancer who has been writing professionally since 2010. She holds a bachelor's degree in mathematics and statistics and a second bachelor's degree in integrated mathematics education.