Life Insurance and Taxes

Life insurance and taxes relate to each other. How? Life Insurance proceeds are exempt from income taxes by the bene. Life insuranc proceeds can also be used as a estate planning tool. There are two types of taxes to consider when thinking about life insurance. One is INCOME TAXES and the other ESTATE (or INHERITANCE) TAXES.

Income Taxes

With regards to LIFE INSURANCE AND TAXES, life insurance proceeds, or benefits (including earnings), are generally exempt of INCOME TAXES and this a significant benefit resulting from owning a life insurance policy. For instance Joe Smith buys a life insurance policy on his life and names son Jim Smith as beneficiary. Upon the death of Joe, the proceeds are paid to Jim and Jim does not have to report the life insurance proceeds, whatever the amount, in his tax return for the year when he received that amount of money.

 If you own a policy of the type that increases in value, such as WHOLE LIFE, or UNIVERSAL LIFE, you do not pay INCOME TAXES on the increase in cash value for as long as that increase in value remains inside the policy. However, if you make a withdrawal, any portion of the cash received that represents an increase over the premium you paid, will be subject to income taxes.

 If on the other hand, you withdraw cash from your cash value policy via a loan, then you do not pay any taxes on the amount withdrawn, including increases in cash value. If you do not repay the loan, with interest, before death, then whatever amount due on the loan is deducted from the proceeds paid to the beneficiary upon the death of the insured.

Estate Taxes

The U. S. Government imposes a tax on property owned by a person at the time of death. Calculating the amount of tax due could be complicated and it is recommended to consult with a tax accountant as to the exact amount of taxes due, if any, at the time of death.

 If a person owns a life insurance policy in his/her name at the time of death, then the policy is included in the calculation of the Estate Tax. One way to avoid that the policy be included in the Estate Tax calculations is by placing the life insurance policy in a trust. The owner of the policy then becomes the trust, which is administered by a trustee in accordance with the terms of the trust that you created. As a result, at the time of death, since the life insurance policy is not owned by the decedent, but by the trust, the life insurance policy is not includable in the estate of the decedent.

 NOTE: The above does not constitute tax advice or legal advice. You should consult your tax adviser or financial planner in connection with any decision impacting your INCOME TAXES or ESTATE TAXES.