Tax Implications of Life Insurance Beneficiaries
- Most life insurance policy sales literature states that life insurance proceeds are "generally tax-free." This doesn't tell you a lot about when it is and when it isn't when the designation is, in fact, simple. Life insurance proceeds are income tax-free but are not always estate tax-free. If the insured is also the owner of the policy, the policy death benefits are subject to estate tax. If the insured and owner are different, it isn't.
- Life insurance proceeds, even when considered income tax-free, may still be subject to federal estate taxes if the estate meets transfer tax thresholds. The death benefits are part of the overall estate value. As of 2011, the estate transfer tax is 35 percent on all assets if the estate has a total value of more than $3.5 million. This means $350,000 of a $1 million death benefit is subject to federal estate taxes if the deceased's estate with house, investments and life insurance meets the $3.5 million threshold.
- Because the owner of a life insurance policy has the ability to take the cash value out before the death of the insured, someone seeking to maintain control over the policy can create a life insurance trust. The trust must be irrevocable and neither the insured nor the trust can borrow from the policy. Beneficiaries are irrevocable as well. Existing policies can only be added to a life insurance trust three years after the trust establishment. Additionally, the insured cannot be the trustee; thus, there is an added expense of paying a trustee.
- While many life insurance agents are quite competent in helping you define the owner, insured and beneficiary of a life insurance policy, it is best to get a tax adviser involved before you make a decision. Getting out of a life insurance policy in the early years can be quite costly, both in surrender charges and increased premiums if you are older when establishing a new policy. Rather than undo something, get the right information before establishing a policy.