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Is Life Insurance Taxable?

Life insurance benefits are typically not subject to federal tax in most circumstances. Understanding how to protect the benefits for your beneficiaries from a hefty tax liability will help when choosing a life insurance plan. If your policy is interest-bearing, it could be subject to tax liabilities. This article explores various expert-recommended alternatives to prevent beneficiaries from owing taxes on insurance proceeds.

Key takeaways:

Why have life insurance?

Life insurance provides financial protection for surviving loved ones in case of the unexpected death of one of the household income earners. Its purpose is to replace the unexpected and untimely loss of income. If planned correctly, the beneficiaries will receive money for funeral costs, mortgage payments, credit cards, educational costs, living expenses, and other expenses the decedent would have taken care of.

When discussing life insurance, a common question is whether the benefits received are taxable. The main intention is to share some essential information to shed light on this critical topic to make an informed decision, not a potentially devastating emotional one.

In most cases, the benefits received from life insurance are not considered taxable income. The money from the policy claim is typically not subject to federal income tax. Whether you receive a lump sum payment or periodic installments, you can rest assured the money is yours to keep, free from the burden of taxation.

This benefit is significant as it allows beneficiaries to utilize the total amount of the life insurance as intended without having to set aside a portion for taxes. However, it's important to note that while the life insurance benefits are not taxable, any interest may be subject to taxation. For example, if the death benefit is $250,000 but earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $25,000 growth. This tax consequence also applies if an estate is the named beneficiary.

By understanding the potential implications, legal options are available to avoid tax liabilities that may suit the beneficiaries.

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Protecting benefits from taxing

Let's explore some expert-backed alternatives sanctioned by the IRS.

Transfer of ownership

A transfer of ownership may be suitable if the estate of the decedent exceeds the current estate tax exclusion amount established by the Internal Revenue Service (IRS). If this is the case, transferring the life insurance policy ownership to another person or entity is recommended, as this may be considered a portion of the taxable estate.

The transfer of ownership helps protect the life insurance benefits from taxation and ensures the designated beneficiaries receive the total amount without any unnecessary deductions.

The "catch" or "tradeoff" of transferring the ownership:

  • By doing so, the original owner forfeits any legal rights associated with the policy, such as changing beneficiaries or borrowing against the policy.
  • This is an irrevocable event, so you should thoroughly consider the impact before executing this option.
  • If the transfer is not properly completed, the policy's proceeds may become taxable income to the beneficiaries ("transfer of value" rule).

Acquiring an irrevocable life insurance trust

This option would allow you to transfer the insurance benefits value from your estate to a beneficiary in the trust, reducing the estate's overall value.

The irrevocable life insurance trust will protect assets from creditors and reduce estate taxes.

The "catch" or "tradeoff" of an Irrevocable Trust:

  • Moving the assets into the trust, the owner relinquishes its rights, such as modifications, amendments, and or termination.

Although we've identified two great options for legally protecting insurance benefits from taxation, the IRS has some specific rules we must consider:

  • Any "gifts" from life insurance policies within three years of the insured's death will be subject to estate taxes.
  • This rule applies to the transfer of ownership and irrevocable life insurance trusts.
  • For transfer of ownership, there still may be some tax liability if the total cash value exceeds the current "gift tax" exclusions (these may vary).

Always consult a tax professional to help navigate the options based on your family's needs, tax status, applicable tax laws, and potential tax implications of any interests earned on the life insurance benefits.

Things to consider

Besides consulting a tax professional, you must be proactive as well. Maintaining documentation and reporting requirements associated with the accrued interest on the life insurance benefits is essential.

As the IRS may solicit supporting documentation, having clear and accurate records available may save you from an unwanted headache while also dealing with the grieving of losing a loved one. Fulfilling these requirements can minimize taxes associated with the interests earned during collection.

"Death can't be cheated on!" But when it comes to taxation on life insurance benefits, there's no need to try to cheat on them. As shown in this article, there are multiple ways to be protected. Because not all cases are equal, it's always recommended to seek professional advice. Please share your experience with other Healthnews readers in the comments section. Your knowledge and feedback greatly help someone navigate these sometimes choppy waters.

Take advantage of other Healthnews related articles readily accessible. They'll complement what you learned and improve your understanding of the matter.

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