Life insurance can be an inexpensive way to replace lost income, provide cash to repay debts and pay for funeral expenses when a person passes away. By naming a beneficiary of the life insurance policy, the value of the life insurance policy passes to another person, entity or company when the policyowner passes away. There are many ways to use life insurance as a tool in a financial plan.
When a person passes away, life insurance on the deceased person’s life or policies where the deceased had incidents of ownership (see below) are included in the gross estate.
The gross estate is the total value of all assets the person owned at the time of death.
Some additional considerations:
After determining all of the assets owned by the deceased, a formula exists to determine which assets are taxable and how much tax is owed. Typically, life insurance is not taxed but is included in the gross estate because it is an asset.
A person has incidents of ownership if able to make certain changes to a policy while still alive.
The following create incidents of ownership according to Internal Revenue Code, section 2042:
A beneficiary is the person or entity named on the life insurance policy who receives the money at the time of death.
This applies to whole life, universal life and variable life policies. Term life insurance policies do not have any cash value so they are not subject to this rule.
After determining incidents of ownership, the person settling the estate sees if any of the policies have been transferred to another person or entity in the past three years. If the person who died signed over a life insurance policy within three years of death, it would be included in the gross estate. If it had been longer than three years, it would not be subject to the three-year rule and so not be included in the gross estate.
Transferred within 3 years of death = Policy is included in the gross estate
Transferred more than 3 years before death = Policy is not included in the gross estate
The idea behind the three-year rule is to disincentivize people from giving away their assets when death is imminent to avoid paying estate taxes.
How much is included in the gross estate?
The amount included the gross estate usually is the same as the amount the beneficiary will receive.
Ten states are community property or quasi-community property states and treat life insurance differently from separate property states. In separate property states, each person’s assets are added to the gross estate upon death. Generally, in community property states, one half of the life insurance is added to the gross estate. The other half is owned by the decedent’s spouse.
The following states are community property or quasi-community property states.
Alaska, Arizona, California, Idaho, Louisiana, Nevada,
New Mexico, Texas, Washington and Wisconsin
But even among this group of state, different rules apply when it comes to how life insurance is added to a gross estate. It does not impact how much the beneficiary receives. The beneficiary receives the death benefit and any cash value accumulated, if applicable.
California and Washington follow the appointment rule.
Texas, Louisiana, and New Mexico follow a rule called the inception of title.
Alaska, Arizona, Idaho, Nevada & Wisconsin
The remaining community or quasi-community property states divide the amount in half and the half owned by the person who died is included the gross estate.