Is Life Insurance Taxed?

Many people do not like to think about insurance for two reasons:  it involves having to deal with insurance companies and it also has to deal with thoughts of their own death—both are most unpleasant.  No matter how gloomy, life insurance makes a great tax-saving gift because it’s valued for tax purposes not at what the proceeds are going to be when you die, but at the cash value you have paid in—a much smaller amount.  The beneficiary does not pay any income tax on the proceeds either, another benefit.  You can also opt to use life insurance to help your charitable giving.

Most estates are not subject to the federal estate tax, those estates valued in excess of $2million in the year 2008, however are.  People who are concerned about passing on all they’re worth, to compensate for these taxes, often will purchase life insurance to provide additional funds from which to pay these taxes.  Without even thinking about it, the life insurance may be just adding to the tax it was meant to pay.

Many feel that life insurance proceeds are not taxable.  How wrong they are!  Life insurance proceeds don’t count for income tax purposes, but proceeds paid to anyone other than your spouse or charity do count toward your estate for estate tax purposes, if you are the insured person and the owner of the policy.

Although the proceeds of a life insurance policy paid to your spouse won’t be taxed when you die, the money augments her estate, and when she dies, it may exceed the exemption threshold.  To escape these taxes, you must see the policy is not, therefore, owned by your estate.

If you take out a policy that benefits your children or other beneficiaries, this method is called third party owners.  It places ownership in your beneficiaries’ names—usually your children.

You can then give the money yearly to pay the premiums just make sure that your total gift is below $12,000 per year to avoid the gift tax.  As long as you then live for three more years after you have transferred the ownership, the policy will then be out of your estate.

Life insurance trusts provide another method of accomplishing the same goals. A couple who are married has a combined taxable estate of $1,000,000 after they have used tax-avoidance devices.  The trust they set up are the owners of the policy on their lives—not themselves.

They can do this with both an existing policy and a new one.  The husband buys $10,000 worth of premiums in the policy.  Upon his death, the policy pays off $400,000—none of it taxable as a part of his gross estate—to the trust.  The wife then lives off the income from the trust.  When she dies, her children will take the principal that remains—again, all is tax-free.