Life Insurance Proceeds

The proceeds from a life insurance policy are not taxable.  The tax-free exclusion is for a death benefit payment that is under endowment contracts, employer’s group plans, worker’s compensation insurance contracts, accident or health insurance contracts. This exclusion does not include policies that were paid in a single premium which are equal to the face value of the policy.

However, if a beneficiary purchased any proceeds from a life insurance policy then taxes, do apply. Let’s say I give my Aunt Jenny $10,000 in exchange for putting my name as one of the beneficiaries to her death benefit worth $100,000.  I would then have to write the $90,000 as income from our deal.  This lump sum is now considered taxable.

Though life insurance policies are exempt from income tax, they are subject to estate tax. One will have to pay estate tax if the policy falls under several conditions: when the proceeds go to the policy holder’s estate, when the dependent or beneficiary is obliged to use the money from the death benefit to pay off debt and other obligations of the estate, and if there have been “incidents of ownership” within three years of the policy holder’s death.

What are incidents of ownership?  This is when a policy holder makes certain changes in the terms of the policy.  These changes include: modification of designated beneficiaries, the right to assign, revoke, and modify assignment of the policy to another party, and the right to borrow against the policy.  Legal techniques that help remove your death benefit from being taxed under the estate law, do exist.  If your expected death benefit is more than $1 million, it’s best to consult an estate planning attorney.

Another feature of the death benefit is that it can be given to beneficiaries in a series of installments. Some funds accrue interest over time, so when it’s time for the insurance carrier to pay the cash benefit to the family members the principal amount has already grown due to the interest rates.  Remember that the principal portion of the benefit is tax free. The interest portion will be considered ordinary income therefore, the beneficiary will have the burden of paying taxes for only the interest both on state and federal levels.

Some plan holders assign a different person to actually own the policy.  If you are planning to do so, it must be done at least three years prior the death of the original policy holder. For example, the living spouse or the children can claim ownership of the policy if there is proof that premium payments were taken out of their personal bank accounts.

Other strategies include the use of irrevocable life insurance trusts, and giving the cash benefit to your heirs as a gift while you are still alive if the amount you will be giving is less than a million dollars.  For some, this is a good option because they will be able to see their loved ones enjoy the money with them.  It is also possible for the beneficiaries to purchase another life insurance for you using a portion of the cash gift.