For a variety of reasons, many people adamantly believe the following assertion is true: “life insurance is tax free.”  Despite being a common belief about taxes, it is simply not true. For the most part, when people talk about life insurance being tax free, they are referring to the death benefit of a life insurance policy which typically pays out only after the insured individual has passed away.  Which tax are they referring to?  Usually income taxes. What is typically meant is that the death benefit of a life insurance policy is generally not considered taxable income to its death beneficiary. Although, it is true that the death benefit does not represent taxable income in the hands of its beneficiary, this is not the same thing as “tax free.”  Only one specific part of the policy (its death benefit) avoids tax to one specific individual (its beneficiary), and only if it moves in a certain way (at death). With that many caveats, there is bound to be a catch.

In most cases, the largest surprise for people, especially in Washington, is that the death benefit of a life insurance policy is taxable in the estate of the owner for the purpose of the estate tax—an entirely different type of tax from income taxes.  Although that statement is one hundred percent true, it bears repeating: the estate tax is imposed on the death benefit of life insurance even if no income tax applies.  The income tax benefits of life insurance do very little to shield the policy from the estate tax, as it is levied as a tax wholly separate from income tax.

The next question people often have is regarding the fact that life insurance typically is not payable to the estate—so how could it have estate taxes?  The answer is that Congress decided many decades ago that people should not be able to avoid estate tax just because they successfully avoided probate of their legal estate.  Although the death benefit of a life insurance policy usually moves to an individual beneficiary outside of probate, the IRS disallows this strategy as an estate tax avoidance tool. Instead, the Internal Revenue Code imposes estate tax on the death benefit of any life insurance policy on the decedent’s life so long as the decedent owned it and could control its beneficiary. This means many life insurance policies where the owner is also the insured individual are subject to estate taxes when that individual ultimately passes away.  Due to Washington’s perilously low estate tax exemption (only $2,193,000 as of the time of this article, one of the lowest exemptions and highest rates of tax in the country), many Washington residents unintentionally find their estates subject to estate taxes for no other reason than life insurance.

What can be done? So long as a person is at least aware of this potential future tax liability, there is a lot that can be done.  For starters, is the tax liability worth avoiding or minimizing at all?  If so, then there is an array of tools that attorneys often suggest including making gifts or buying more coverage to prepare for the estate tax bill.  If, however, there is a true need for tax efficiency in a life insurance policy, this often suggests having a conversation with your attorney about putting together an “Irrevocable Life Insurance Trust” (ILIT). This trust would be the owner of the policy rather than the insured and, if done correctly, provides a method whereby the death benefit of the policy can escape the original owner’s estate for estate taxation purposes.  If creating estate tax efficiency in light of a possible future Washington (or federal) estate tax liability is of interest to you or someone you know, please do not hesitate to contact the attorneys at Holmquist & Gardiner.