26 March 2012 0 Comments

Tax Free Is Good!

I’ve now wrapped up a two-part discussion of the pros and cons of Life Insurance provided by an employer. Given that tax time is upon us, I want to cover the taxation of life insurance proceeds.

I’ve said it before, and I’ll say it again: Term Life Insurance is one of the most cost-effective forms of financial protection available.  In addition to the obvious–its ability to create a huge estate for a minuscule premium– there’s another reason: Life Insurance death benefits are paid in a lump sum to the beneficiary and are generally not subject to income tax. So if you’re the recipient of a death benefit and you’re worried about the government taking a chunk, don’t be.  It’s all yours!

There are a couple of exceptions to this income tax advantage, but they’re not likely to affect most individual buyers.  If the ownership of a policy is transferred to a third party for consideration, the death benefit may be taxable to the extent it exceeds the premium paid.  This is referred to as “transfer for value.”  Keep in mind this has nothing to do with changing a beneficiary, only transferring ownership.  The other situation under which death proceeds may be subject to ordinary income tax is when an employer owns a policy on an employee and has not completed appropriate disclosure forms with the employee.

If the death proceeds are held by the insurance company and earn interest, the interest would be subject to income tax.

If you own a permanent Life Insurance policy that builds cash value and you withdraw any of that cash during your lifetime, there could be income tax consequences, but I’ll discuss that in a later blog.

Life insurance proceeds will also avoid probate as long as the beneficiary is other than the estate of the deceased.  This doesn’t mean they escape estate tax, but death proceeds paid directly to a named beneficiary by a life insurance company will not be subject to the public disclosure of probate court and will escape probate charges which can be about 2% of assets.  There is a caution here.  The named beneficiary will receive the death benefit proceeds, regardless of who you have named in your will or living trust, so be sure all beneficiary designations are up to date.

Life insurance death proceeds are subject to Federal Estate Tax—regardless of whom the beneficiary may be–unless the ownership of the policy is held by a third party, other than the deceased (more on that later). However, at this writing there is no Estate Tax until your total net estate exceeds $5,120,000 and any amount left to a spouse who is a citizen of the U.S. can be excluded from estate tax under the full marital exemption provision.

Coming Up Next: Return-of-Premium (ROP) Term Life Insurance

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