Are My Life Insurance Proceeds Taxable?

In most instances, life insurance proceeds are income tax free to the beneficiary but are taxable to your estate if you owned the policy on your life or retained any “incidents of ownership” such as the right to change the beneficiaries or borrow against the policy.  If this is the case, the life insurance proceeds will be included in your taxable estate.  In Massachusetts, if your estate is over $1,000,000.00 you will pay a Massachusetts estate tax even if there is no federal estate tax due.

There is a way to avoid estate taxes, both state and federal, on life insurance and that is to have an irrevocable life insurance trust or ILIT own and hold the policy or policies.  You would make periodic gifts to the trust to cover the cost of the premiums.  If this is a whole life policy, it is possible that at some point the cash value could be used to pay the premiums but that is another topic.  At the time of your death, the insurance proceeds will be paid to the trust and distributed in accordance with the trust terms.  Your contributions to the trust (premiums) are subject to gift tax but may be structured so as to fall within the annual gift tax exclusion or lifetime exemption.

It is best to establish the trust and have the trust purchase the policy, but, if you have a policy that you would like to transfer to an ILIT, this can be done with the caveat that if you die within three years of transferring the policy to the ILIT, the proceeds will be “pulled” back into your estate with certain exceptions.  It is best to speak with an estate planning attorney who will work with the life insurance company to insure that your policies are held in a manner that is beneficial to you and your beneficiaries.