2 August 2013 0 Comments

Tax Advantages Of Life Insurance

tax advantgesLife insurance enjoys some unique tax advantages.  The death benefit is free of income tax and access to cash values during one’s lifetime can also be constructed to be tax free.  In this blog I’ll deal with the death benefit advantages.

With a couple of exceptions, the death proceeds of a life insurance policy (including Modified Endowment Contracts) are not subject to income tax.  The gain over premiums paid can be immense, but no income tax is due.  Even though annuities are issued by life insurance companies, they are not life insurance policies and therefore any gain is subject to income taxation at the death of the annuitant.

Life Insurance death benefits are subject to estate tax, so if the total net estate, including the life insurance proceeds, exceeds the estate tax exclusion a federal estate tax is imposed.  This estate tax can be avoided if ownership of the policy is held by an Irrevocable Life Insurance Trust or other third party.

Exceptions to income tax free death benefits.

There are a couple of situations when life insurance death benefits might not escape income tax:

  • When there is a transfer for value of the ownership of a life insurance policy to a third party
  • When an employer is the owner unless certain notice and consent requirements are followed.

Transfer for value rule and exceptions

If the ownership of a life insurance policy has been transferred for value to a third party,  the death benefit in excess of the premiums paid by the new owner would be subject to income tax.  “Value” might be other than cash.  For example, two shareholders in a corporation might want to use previously purchased, personally owned life insurance policies to fund a buy and sell agreement and therefore they each transfer a policy on their life to their co-shareholder.  No money changes hands, but the “value” was the mutual agreement to transfer policies to each other.  This is a “transfer for value” resulting in income taxation at the time of death.

There are some transfers that are safe from the “transfer for value” rule.  Those exempt transfers are:

  • Transfer to the person insured
  • Transfer to a corporation where the insured is an officer or a shareholder
  • Transfer to a partner of the insured, including LLC partners
  • Transfer to a partnership/LLC where the insured is a partner/LLC owner
  • Transfer as a gift where the cost basis carries over from the transferor to the transferee. 

Employer owned policies

If an employer is the owner of life insurance on an employee that was issued after August 17, 2006, then certain notice and consent forms must be signed by the employer and employee or the entire proceeds in excess of premiums paid could be subject to income tax.

In practice, most life insurance death benefits are passed free of income tax.

Next…taxation of living benefits of life insurance.

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