Life Insurance and Tax Implications

Like so many other things in life, taxes can play a role in your insurance decisions.

As you may or may not know, life insurance might provide an income tax-free death benefit far greater of the premiums paid. However, much of the life insurance proceeds might be wasted if the ownership and beneficiary designations are not properly set in place.

So what should you know regarding your life insurance choices and taxes?

Due to federal and/or state estate taxes, a tax could be imposed on all the property that you have control of at your death. This tax must be paid from your estate, and does not attach if, as a general rule, your property is valued at less than your estate tax exemption figure.

For those individuals who own a life insurance policy, or you or your estate is tabbed as beneficiary, the policy death benefit will add to your estate. If, following including your life insurance death benefit proceeds, your estate is still valued at less than your estate tax exemption figure; no federal estate tax will be assessed. Therefore, your policy's death benefit proceeds can be passed on to any of your heirs, and need not be required to cover your estate tax liability.

If you are the owner of property greater than your estate tax exemption amount, you could have a taxable estate. If you own a life insurance policy or name either yourself or your estate as beneficiary, there is the possibility you have exposed the policy's death benefit proceeds to estate taxes.

As a result of this, when estate tax is a concern, an insurance policy on your life is typically best owned by another individual.

Individuals can establish an irrevocable trust to be the owner and beneficiary of your life insurance policy. As an alternative, you may have your adult children own, and be beneficiaries of the policy. Either might avoid inclusion of policy proceeds in your estate.

Meantime, third-party owners might be able to lend these proceeds to, or purchase assets from, your estate to provide cash to satisfy your estate tax liability.

It is important to note that when the owner is a third party, and if the beneficiary passes away prior to you (the insured), the proceeds might go to the estate. Consider naming a contingent beneficiary to the policy to ensure that the proceeds go straight to that person, thereby staying away from probate and estate taxes.

Finally, any gift of life insurance to a third party (excluding one's spouse) might involve gift tax issues.

Also, in the event you fail to survive your gift by a period of three years, the policy returns to the estate.

As with any financial decisions you may be contemplating, be sure to speak with the appropriate financial advisors so you are not left with the short end of the stick.