When properly structured, a life insurance policy can pay death benefits that are exempt from federal income and estate taxes. However, that doesn’t mean life insurance death benefits are exempt across the board; It’s important that you understand how your policy should be structured if you want to maximize your chances of being tax exempt from a death benefit.
Taxable to the policyholder
Higher cash value permanent or whole life insurance policies available to policyholders. If the policyholder decides to take out a loan against the policy’s cash values, the loan is generally not taxable. If the loan is not paid off before the policyholder dies, the death benefit will be reduced by the amount of the loan. If, instead of taking out a loan, the policyholder decides to surrender their policy to receive all cash values and lapse the policy, then the cash value proceeds may be taxable. In general, any amount received in excess of the amount of premiums paid on the policy will be considered a gain and may be subject to tax.
Taxable to inheritance
If the policyholder does not name a person or trust as the beneficiary of their insurance policy, the proceeds of the death benefit will be paid to their estate. When this happens, the life insurance policy proceeds are calculated as part of the deceased person’s gross estate, which may be subject to federal estate taxes.
This is relatively easy to avoid by simply naming a non-owner as your primary beneficiary or by making a trust the primary beneficiary. When naming one person as the primary beneficiary and trying to avoid estate taxes, it is important that you also name a contingent beneficiary who will receive the benefit in the event the primary beneficiary predeceases you.
Another way life insurance death benefits can become part of an estate is if the insured’s spouse is named the beneficiary of the life insurance policy. When your spouse receives the income from the death benefit, these funds are paid out and become part of your spouse’s liquid assets. They can then be invested or saved. When that spouse dies and their assets are transferred to your estate, the income from your death benefit will become part of your total estate and may be subject to federal estate taxes. The easiest way to avoid this is to leave your death benefit in the hands of a trust.
Taxable to beneficiaries
If the beneficiary you name on your life insurance policy is also the policy owner, then that person has an ownership incident in your cash values. As such, when benefits are paid, they could be considered taxable income for that individual. By retaining ownership of your own policy or having a trust that owns the policy, you can avoid this outcome.
When death benefits are paid, your beneficiaries will be asked to choose a method for the insurer to make payments. They can choose to have the insurer pay benefits as a lump sum, which is a lump sum payment that comprises the entire portion of the death benefit, or they can choose to have the benefit paid in installments. By choosing the death benefit installment method, the death benefit will continue to earn interest. Any portion of a fee that was earned through this continued accumulation of interest may be subject to tax. When a lump sum payment is made, if your beneficiary invests the lump sum and your investment makes a profit, then you could be exposed to short-term or long-term capital gains tax when you dispose of the asset. They may also be subject to taxes on dividends and interest earned on the investment.
Purchasing a life insurance policy without considering the potential tax ramifications for your estate and beneficiaries is a bad idea. Instead, call us. Together we can look at the many angles of tax and estate planning and develop a plan that helps minimize the tax liability your beneficiaries will face while maximizing the amount of death benefits they can use to improve their lives.
