The beneficiaries of life insurance policies have greater tax benefits than beneficiaries of trusts, if the life insurance proceeds are directly transferred to the beneficiary upon the death of the insured and not included in the estate. If this is true, the principal amount of the life insurance proceeds is tax-free. However, distributions from a trust are considered taxable income, and the beneficiary must include the amount as part of his gross income.
Trust Estate Taxes
There are generally no tax benefits for creating a living trust, also known as an inter vivos trust. However, there are tax benefits for creating a testamentary trust, whereby the beneficiary is entitled to the trust property upon the death of the trustor. By creating separate testamentary trusts to be distributed to different beneficiaries rather than one trust with a lump-sum amount of money, it can ultimately minimize the amount of taxes allocated to the estate. Because testamentary trusts are taxed at graduated tax rates, separate testamentary trusts with smaller amounts will have lower amounts of estate taxes than a single testamentary trust with a large sum of money.
The taxable income transferred to a trust is taxed in the same manner as the income tax guidelines for individual taxpayers. The fiduciary of the trust is required to file a trust income tax return using Form 1041, if the trust receives income of $600 or more for the year. When taxable income from the trust is transferred to the beneficiary, the trust is entitled to a deduction of the distribution income. The amount of the distribution deduction is calculated using Form 1041, Schedule B. The beneficiary of a trust must pay the income taxes from his share of the proceeds of the trust distributions, but the amount is limited by the sum of the trust’s distribution deduction. In other words, the amount that is calculated for the trust’s distribution deduction will equal that amount of taxable income for the beneficiary.
Life Insurance Estate Taxes
The value of life insurance proceeds transferred to the estate is added to the total amount of the estate property, which can result in higher federal estate taxes. When the proceeds of a life insurance policy are considered payable to the insured’s estate, the value of the policy is subject to estate taxes. Also, if the insured transferred the policy to a person or entity and died within three years after the transfer, the proceeds of the life insurance policy will be calculated into the amount of the gross estate and subject to federal estate taxes.
Life Insurance Beneficiary
When the policy passes outside of the estate and is transferred to the beneficiary, the proceeds are not subject to estate taxes. The principal amount of the insurance proceeds is not taxable, but any interest accumulated on the life insurance proceeds is considered taxable income and must be included in the beneficiary’s gross income. This is usually the case when the proceeds are paid in installments over a period of time, and the proceeds earn interest over time.
- Internal Revenue Service: Instructions for Form 1041
- Internal Revenue Service: Life Insurance Proceeds
- Internal Revenue Service: U.S. Income Tax Return for Estates and Trusts
- Internal Revenue Service: Income Taxation for Trusts and Decedents' Estates
- Internal Revenue Service: Life Insurance and Disability Insurance Proceeds