How to Avoid Estate Tax on Life Insurance Proceeds?

To avoid an estate tax on life insurance proceeds you need to keep them out of the estate and let beneficiaries know how they will be taxed if not claimed immediately. If your life insurance policy is considered an asset in another country then you need to understand how that country treats life insurance proceeds.

Continue reading to understand these taxable situations and how they can be avoided.


How Life Insurance Proceeds May Be Taxed

Life insurance proceeds can be taxed:

  • If they move through the estate
  • If they are not paid out immediately
  • If they are considered part of a United States estate

Understanding each of these scenarios will help you identify these situations.


Proceeds Moving through the Estate

Anything that goes into the estate is subject to taxation. This is because the Canada Revenue Agency charges a sales tax on the value of the estate before assets are allowed to be distributed by the executor.

Life insurance policies are designed to avoid moving through the estate so they can avoid this process. Companies usually set up contracts where they pay a beneficiary upon the death of the insured, but failing to name or update the beneficiary will result in a policy paid to the estate.


Proceeds with a Delayed Pay Out

Beneficiaries can decide to delay the payout of a permanent policy so that it continues to grow in value after the intended payout period. While the original value of the policy remains intact and untaxed, any money made in interest or dividends after that date is subject to income tax.

While this is not an estate tax, it is worth pointing out. Insurance companies in Canada will provide a T5 form to inform the beneficiary of any tax obligations.


Inclusion in Worldwide Assets for U.S. Estate Taxes

In the United States, life insurance proceeds can be taxed. This affects a few different situations.

If you are an American citizen living in Canada and the fair market value of your worldwide assets is less than $11.2 million then you do not owe estate taxes.

If the value is more than $11.2 million, then you owe a tax of 40 percent on any amount over that value.

A Canadian that owns United States assets (situs assets) can avoid tax evaluation if the value of the assets is under $60,000. If the value is more than that then their worldwide assets are evaluated. If it is below $11.2 million, then estate taxes are avoided.

If the worldwide value is found to be over that amount, as a non-U.S. citizen you owe an estate tax of 40 percent on your situs assets. This tax only applies to the value above the original $60,000 threshold.


Ways to Avoid Taxation

It is important to find a way to avoid estate tax on life insurance proceeds so your beneficiaries can obtain the full value of the policy. Without taking proper care you can burden your heirs with increased taxes or difficult to handle situations that do not take advantage of your life insurance policy.


Ensuring a Payout to a Beneficiary

The easiest way to avoid an estate tax on life insurance proceeds is to keep the proceeds out of your estate and have them paid directly to a beneficiary. This is how the life insurance proceeds are intended to be handled, so you do not need to jump through hoops to set this up.

When you are purchasing the policy try to have a beneficiary in mind, whether you decide on a parent, a child, or even a charity. You can forego a beneficiary if you cannot think of one, but you will need to come back to this or risk having the proceeds end up in your estate.

Even if you name a beneficiary, you need to revisit this choice every few years. You might change your mind as your situation changes, or you may have the misfortune of a beneficiary passing before you do.

Updating the beneficiary makes sure that the policy goes where you want it to. You can only do this by updating the beneficiary on file; stating it in your will does not have the power to overrule the life insurance contract.


Transferring the Policy from an Estate that May Owe Taxes

If you want to keep a policy that you own but are not the insured party, you will need to transfer ownership to another person. This is a tricky decision to make because it is only valid if you do not die in the three years following the transfer.

The goal is to end up without any incidents of ownership. The transfer should be sufficient in removing your rights to:

  • Borrow against the policy
  • Surrender or cancel the policy
  • Change the beneficiary on the policy

You also cannot be making payments on the policy after you transfer it. You can gift the new owner an amount to cover the premium payments, but they can choose to do what they want with that money and can deal with the policy as they see fit.

Transferring the policy cannot be changed, and you give up any rights you had as a policyholder. The most beneficial way to handle a policy transfer is to designate a contingent owner to receive the policy upon your death instead of sending it to your estate as an asset.


Utilizing a Trust to Avoid Taxation

In most cases, it is preferred to set up an Irrevocable Life Insurance Trust (ILIT). This is a tool for removing the policy from your estate worldwide, so even U.S. estate taxes cannot touch it.

When setting up an ILIT, you designate a trustee to administer the policy, and you name beneficiaries for the trust. The trustee administrator cannot be you, your spouse, or a beneficiary, but you have more power in an ILIT than a complete transfer of policy.

Setting up an ILIT is best done when you purchase the policy because it is subject to the same 3-year rule as a policy transfer.


Final Thoughts

Avoiding estate tax on life insurance proceeds is essential to getting the most out of your policy. Contact Sim Gakhar today to check in on the potential tax implications of your policy and to work out a way to avoid estate tax on life insurance proceeds.


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