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Top Ten Things to Know about Life Insurance and Taxes

Frequent tax law changes require professional counsel when using life insurance as a method of reducing the burden of taxes assessed on surviving family members.

Estate Value

Federal tax laws changed dramatically at the end of 2010 with the end of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). The federal estate tax threshold returned to $1 million because Congress allowed the law to revert back to levels prior to 2001. Everyone with an estate value exceeding $1 million will be subject to federal estate taxes. Life insurance policies that are included in the estate can be removed through various means and a financial professional can provide the exact advice necessary to achieve this. Many estate planners provided a life insurance quotation based on the $3.5 million estate tax threshold prior to 2009. Those large policies were put into effect based on an estate tax law that has changed significantly.

Incidents of Ownership

When a life insurance policy is purchased, the person who pays the premium is designated by the insurance company and the IRS as the owner of the policy. Some financial advisors will recommend changing the owner of the policy to remove the policy from the estate when the taxable threshold is within reach. If the change of ownership happens within three years of the death of the insured, the IRS will dispute the policy ownership and assess the appropriate taxes. Consideration must be given to the entire value of the estate at the time a life insurance quotation is sought to prevent an incident of ownership.

Designate the Owner of the Policy

Because a free term life insurance quote will reveal the affordable premium associated with term insurance, people will purchase large policies to provide for various family needs after their death. If the estate tax threshold is within reach, the beneficiary should be designated as the policy owner from the time the policy is underwritten. If that person cannot afford the premium, every premium must be paid from an unrestricted checking account that bears the name of the beneficiary. When the death benefit is paid, the IRS will dispute the ownership of the policy based on who actually paid the premiums.

Irrevocable Trusts

Another way to remove the insurance policy from the estate is to establish an irrevocable trust. Owners of very large estates will often purchase term life insurance to cover the anticipated taxes since the free term life insurance quote revealed an affordable source of additional funds. An issue arises when the paid death benefit adds to the value of the estate. Financial planners will encourage the insured to assign ownership of the term life insurance policy to a newly established irrevocable life insurance trust. The trustee must have all of the ownership rights on the life insurance policy. Every detail must be addressed to use this tool effectively to avoid an IRS dispute. An experienced financial advisor can direct this process.

Interest is Taxed

While income tax is not assessed on the death benefit paid from an insurance policy, any accrued interest on the death benefit will incur federal income tax. From the legal death date until the day the check is issued by the insurance company, interest will be accrued and then paid to the beneficiary. On large life insurance policies, the interest paid could be thousands of dollars. Since the insurance proceeds are generous, most recipients can pay the income tax on the interest without hardship.

Payments are taxable

Insurance death benefits should be received in one lump sum to prevent the accrual of interest which will incur income tax. Other financial instruments exist to aid in the management of the large sums of money paid from an insurance policy. When the death benefit from a life insurance policy remains in the possession of the insurance policy and annual or monthly payments are made to the beneficiary, the interest portion of the payout is subject to federal income tax. Tracking the interest amounts can be difficult throughout the year, and paying a lump sum of taxes at the end of the year may inflict hardship on the payment recipients.

Income and Estate Taxes

Death benefits paid from a life insurance policy are not assessed income tax at the federal or state level. This does not mean that the proceeds paid by the insurance company are not subject to other kinds of taxes. Some states have assessed estate or inheritance taxes against estates of every size for many years. With the fiscal health of many states, one of the changes that many state governments will make is to add estate or inheritance taxes in the coming years. Additional life insurance could relieve the anticipated tax burden. A free term life insurance quote might reveal the advantage of paying the annual premium on a policy large enough to offset future state taxes.

Marital Deduction

Whenever someone dies and their spouse is named beneficiary on the life insurance policy, 100 percent of the paid death benefit is exempted from income tax. The death benefit paid to the spouse increases the value of the estate that will be passed to the family in the event of the death of the surviving spouse. Financial adjustments will be required if the tax thresholds are within reach after the death benefit is received. An experienced financial advisor can develop a method of protecting the assets from loss through estate taxation.

Loan vs. Surrender

Life insurance policies that carry a cash value are more expensive when a life insurance quotation is provided by the insurance company. There are a number of reasons to carry these types of policies, but care must be exercised if the policy is used for cash prior to death while the policy is still in force. A loan taken against the cash value and repaid within the stated term will not be added to the annual income, so no income tax will be assessed. Some hardship cases can be filed where some portion of the cash value is surrendered and remains exempt from income tax. Most partial or total policy surrender actions will result in the assessment of income tax on the amount of the surrender.

State Laws

Every state has different inheritance tax and estate tax rules. While states do not collect income tax on the death benefit from an insurance policy, there are a few states that do assess inheritance or estate taxes. If the deceased party lives in a state with an estate tax, the taxes will be assessed at the current tax rates. If the beneficiary of the entire estate lives in another state with an inheritance tax, the amount received will be taxed there. Some life insurance exemptions apply at the state level, but certain states assess estate and/or inheritance tax on the proceeds from insurance policy death benefits. These laws change every year and close attention must be paid to the estate’s value.