Are the Proceeds of Life Insurance Policy Taxable?

Life insurance refers to pre-need contract entered between two parties – the insurance company and the client. Generally, life insurance is understood as benefits that can be received from a person-insured who died for some reasons. The amount of money to be given in full to the beneficiaries is free of tax obligation. It means that the recipients cannot be charged with tax evasion due to non-declaration of the money they received from the insurance company.

Now, when does the obligation to pay tax may come in? There are cases that the policy holder would include demands that the distribution of the money to the beneficiaries should only be done after a year or more after the holder’s death. When it happens the money may stay longer under the insurer’s care and it would mean having steady stream of interest over years of pending distribution. Now, when the time comes that the money should be given out to its beneficiaries, both the capital and interest are given. The capital is not chargeable with tax but the interest is not because it is treated as regular income just like the earnings one can get from employment. The beneficiaries must be honest enough to stipulate the interest of the capital in their tax forms as this is declared as regular profits.

But there is one important thing that people should know in buying life insurance. Although it is non- taxable income, it becomes one when it is classified as “incidents” policy or the buyer have some control over the insurance policy such as transfer it to someone else, change the recipient, or get some revenue after some period of maturity of the policy. When that happens, it will be taxed.

So remove the “incidents” and apply for ILIT or the Irrevocable Insurance Trust and totally invalidate your claim as insurance beneficiary if you will not do that remember that the Internal Revenue Service (IRS) implements the three-year rule about life insurance. When a policy holder dies within three years, he is still considered the owner of insurance policy which is the basis of federal estate tax to execute its law even if the policy-holder is already dead.

Under the federal estate tax, the total income of an individual that can be excluded from being obligated is raised from $2 million to $3.5 million from 2006 to 2009. These amendments will expire in 2010. After that, the figure is reset to $1 million as a taxable exempted amount; this is according to Internal Revenue Code (IRS), Section 2042. It means, that both the principal and the interest you get as life insurance owner is treated as part of the total assets. So, if all is added and you found to have $2 million in your name, it will be taxed.

Therefore, it would be wiser to get a good financial adviser before buying a life insurance policy in order to understand its pros and cons. Try to spend time knowing the provisions and ask for longer time before you decide to get one.