The Tax Benefits of Life Insurance

Did you know that life insurance proceeds are not taxable?

For the most part, and there are a few exceptions, your beneficiary will not have to pay income tax on the death benefits they receive.

This applies to both term and permanent life insurance policies.

In the majority of cases, a named beneficiary will receive the death benefits as a lump sum payment and these proceeds are not subject to income tax.  Your beneficiaries can use the life insurance proceeds immediately and in any manner or purpose they choose.

There are a few situations where life insurance proceeds can be taxable and I explain later where you might get dinged by the IRS if you make a mistake.  However, I’ll tell you how you can avoid making these mistakes.

Naming your Beneficiary

This is one of the most important things you need to think about when you buy a life insurance policy.  When you decide on the person or persons, as you can name more than one beneficiary, you should do the following:

  • Give Full Names – Provide the full names of the person(s) as the beneficiary.  It’s also a good idea to specify their birthdates or Social Security Number to clarify their identity.  This is just in case there are other family members who happen to have the same name.  This will avoid potential legal complications if 2 people with the same name challenge the payment of the death benefits.
  • Spouse and Relatives – If you are naming your spouse, then make sure you clarify the name of the spouse and do not simply put a generic reference such as ‘spouse’.   The same should apply to siblings such as brother or sister.  People divorce and re-marry and sometimes neglect to alter the beneficiaries on their life insurance policies.  I can guarantee that this can result in legal complications. Be specific!
  • Estate – Do not name your beneficiary as your ‘estate’, unless you intentionally mean to do so.  This should really never, ever be done on a term life insurance policy and especially if you do not have a will.  If you name your estate as beneficiary, then the proceeds could end up in probate and the proceeds could be subject to estate taxes at both the federal and state levels.
  • Third Party Purchases – Beware of purchasing life insurance as a third party.  This is a common situation which happens when a parent buys a life insurance policy for one of their children, who happens to be grown up and already married, who then designates their spouse as the beneficiary.  The parent is the owner of the policy, while the child is the insured and their spouse is the beneficiary.  Should the child die, then it is very possible the IRS may view the life insurance proceeds which the spouse receives as a gift from the parent who purchased the policy and who is the owner of the policy, but not the named insured.

Tax Benefits of Permanent Life Insurance Policies

Permanent life insurance policies such as whole life, universal life and variable life are a little bit more complicated because of the cash value accumulation feature which is not found in term life insurance policies.

Permanent life policies consist of two parts which includes both death benefits and the cash value accumulation feature.

Now, in some instances, some people will deliberately name the beneficiary on their policies as their ‘estate’.  This is fine if they meant to do so and it is done so on the advice of their tax advisor or financial advisor.  The same applies to situations where you are setting up a trust but this should only be done with the advice of a tax consultant or financial advisor.

You cannot and should not name your ‘estate’ as beneficiary if you do not have a will as the both the proceeds from the death benefits and the cash value accumulation will end up in probate, and could be subject to having to pay estate taxes to both the federal and state governments.

Other Taxable Benefits of Permanent Insurance

Permanent life insurance policies come with a cash value accumulation feature.  On a whole life and universal policy, the cash value is generally guaranteed to grow at a minimum amount of interest.  The interest you earn in the cash value accumulation portion of your policy is also not taxable.  You do not have to pay taxes on the interest or on the proceeds payable to your beneficiary.

Variable life insurance policies allow you to make investment choices as you can opt to have you money invested in bonds, stocks or a money market fund.  If you were to invest on your own, you would be subject to capital gains, but this does apply to the money invested in a variable life insurance policy.

(Disclaimer – There are tax pitfalls that you have to be careful about when it comes to buying life insurance.  It is always best to talk to tax consultant or your financial advisor so you aware of any potential problems which might arise).

Need More Information?

You always want to talk to an independent agent like myself.  We can access and research dozens of companies so you are assured we will find the best policy at the most affordable rates.  If you have health concerns, don’t let that dissuade you because we can give you valuable advice and help you to find a policy that suits you.

Whatever your needs or questions then please call me direct at 877 – 966 – 9383.