Estate Planning: Taxation of Life Insurance

Life insurance plays a vital role in many estate plans.  Proceeds can provide essential funds to replace lost earnings, pay debts, finance college tuition expenses, or even cover estate tax liabilities.  However, there is confusion about the taxation of these life insurance proceeds.  Contrary to common belief, insurance benefits are taxable to the estate of the insured.   For many Vermont estates, it is inconsequential because they total under $2,750,000. 

In a Vermont estate with assets greater than the exclusion amount, the assessed tax is 16%.  Accordingly, if you have assets of $2,000,000 and a $1,000,000 life insurance policy  (for a total estate of $3,000,000), the estate tax totals $40,000.  To address this tax liability, it is common to create an irrevocable life insurance trust (referred to as an “ILIT”), which owns the policy and escapes imposition of estate taxes.  For existing policies transferred to an ILIT, it is important to note the 3-year waiting period before it is removed from the prior owner’s estate.  There is no such waiting period for policies originally purchased by the ILIT directly.