How to Avoid Taxes on your Life Insurance

ARE LIFE INSURANCE BENEFITS TAXABLE? HOW IS LIFE INSURANCE TREATED BY THE TAX MAN?

We hear these questions every day.  Ready for the good news?

For 95% of our readers, your life insurance benefits will be income and estate tax-free!

In the following we are going to explore the specific tax questions we answer most often, then go over some events that could trigger a tax event.  Before you worry about taxes though, shouldn’t you get the perfect policy for your family in place?

WE ARE EXPERTS IN FINDING THE ABSOLUTE BEST LIFE INSURANCE FOR PEOPLE WITH HEART AND CARDIOVASCULAR PROBLEMS

So if you need to begin that process, start with a free quote here:

Here is a handy guide to this article, feel free to head directly to the section you need.

• Are Life Insurance Benefits Taxable? How Is Life Insurance Treated By The Tax Man?
• We Are Experts In Finding The Absolute Best Life Insurance For People With Heart And Cardiovascular Problems
• You Must Know This Before Discussing Taxes And Life Insurance
• How Much Is Life Insurance Taxed
• Do I Have To Pay Taxes On Money I Received From A Life Insurance Policy?
• Is There State Income Tax On Life Insurance?
• Can I Get A Tax Deduction For My Life Insurance Premiums?
• When Does Your Life Insurance Policy Become Taxable?
• In Six States, Life Insurance May Be Subject To Inheritance Taxes
• The Best Ways To Avoid Taxes On Life Insurance
• How Do You Gift A Life Insurance Policy?
• Is Life Insurance Taxable? The Final Word
• Your Family Will Be Thankful You Considered Their Future

YOU MUST KNOW THIS BEFORE DISCUSSING TAXES AND LIFE INSURANCE

Who is the owner of the policy?

There are different parties to a life insurance contract.  For tax purposes, we need to focus on the primary insured and the owner.

The primary insured is the life that the policy is based on.  If this person dies during the contract, the life insurance company would pay a benefit to the beneficiaries of the policy.

The owner is the person who makes the payments on the life insurance policy.  The owner is also the person who can make changes to the policy and take cash out of the policy (if it is permanent life insurance that allows that feature).

Often times, the primary insured and the owner are the same individuals.

This is an important distinction that you need to know now.  If you don’t know who the owner of your life insurance policy is, call us and we can help you out.

Who owns the policy – why does that matter?

If the owner of the policy is the same as the primary insured, once that person dies the amount of life insurance is included in their estate calculations for tax purposes.

FOR EXAMPLE!

Jack takes out a policy on his own life and names his son Jackson as the beneficiary. Jack is the owner of the policy.

When Jack dies, the entire death benefit from the life insurance would be included in his gross estate for tax calculations.  This is because Jack is the owner of the policy.

The proceeds would pass directly to Jackson free of income tax. Would Jack’s estate owe any estate taxes at the state or federal level? That’s a different issue entirely.

As you can see, who owns the policy is very important from an estate tax standpoint.

How is the death benefit distributed?

In a normal life insurance policy, once the insured dies the benefit passes to the beneficiaries with no issue and no income tax.

From the insurance company straight to the beneficiary

What if the beneficiary is dead already?  Or, what if the policy owner never named a beneficiary in the first place?

In either of these cases, the proceeds pass onto the estate of the owner and may be subject to estate taxes.

Are death benefits taxable income?

No!  The amount of money that passes to a beneficiary from a life insurance policy is income tax-free.

However – any amount above the death benefit would be taxable as income at regular interest rates.

FOR EXAMPLE!

Jackson is the beneficiary of a $1,000,000 life insurance policy from Jack.  Jackson elects to receive his payout over 10 years instead of one lump sum.

Over the ten year period, Jackson is paid a total of $1,100,000. Jackson will be taxed on the additional $100,000 that he earned as interest income.

Do not let the taxes discourage you from selecting a longer-term payout. Interest income is “free money” that you did not have to work to earn. Even if you get taxed at a 25% tax rate, you still keep the rest of the income. We highly recommend this option for any policy of over $100,000.

Extending the benefit payout over a longer period of time keeps your beneficiaries from going broke as many lottery winners do.

Find out about all of your distribution options for your life insurance when you start a quote here:

Is life insurance taxable upon death?

No.  Life insurance proceeds to beneficiaries are not taxable upon death as income.

However – If the owner of the policy was also the primary insured, the amount of life insurance will be included in the gross estate for estate tax purposes.

The federal estate tax exemption is $5.49 Million in 2017, so anything less than that is exempt from federal estate tax.  The exemption is double that if you are married.

There are estate and inheritance taxes at the state level too for 18 states and Washington D.C.

The state estate tax exemptions are usually much lower (MA has only a $1M exemption for instance). So if you are fortunate enough to live in one of these states, you have a higher chance of paying estate or inheritance taxes in some cases.

HOW MUCH IS LIFE INSURANCE TAXED

The normal death benefit from life insurance policy passes to beneficiaries free from income taxes.

Anything above this death benefit (due to interest) will be taxed at interest income rates.

However – If life insurance is included in the gross estate, and that estate is above the federal estate exemption limits, the taxes could be severe.  The top federal estate tax bracket is currently 40%, and there could be state inheritance/estate taxes too.

DO I HAVE TO PAY TAXES ON MONEY I RECEIVED FROM A LIFE INSURANCE POLICY?

No.  As a beneficiary, life insurance proceeds pass directly to you from the life insurance company and avoid income tax and probate.

However – If you earn any income from the life insurance above and beyond the policy face amount, like interest, that will be taxable.

IS THERE STATE INCOME TAX ON LIFE INSURANCE?

No.  Life insurance proceeds that pass to the beneficiaries are tax-free at the state level too.  In fact, many states that impose an inheritance tax also allow life insurance payouts to go to beneficiaries tax-free.

However, there could be estate taxes on a state level or inheritance taxes. Check with your local tax advisor if you reside in a state that charges these taxes.

Is Life Insurance Included in the Estate?

Asked another way, is life insurance included as an asset of the estate?

The answer is: It depends.

Was the owner also the deceased?  Then yes.

Life Insurance proceeds will be included in the gross estate if the policy owner was also the primary insured.

Again, this only matters if the total estate is over $5.49 Million, or $10.98 million in the case of a married couple.

CAN I GET A TAX DEDUCTION FOR MY LIFE INSURANCE PREMIUMS?

Wouldn’t it be nice to write off your life insurance premiums every year?  Unfortunately, the current tax code doesn’t allow it.

Since life insurance premiums on individuals are considered personal expenses, there is no tax deduction.

The rules are different for businesses who take out life insurance for senior executives, or key man life insurance policies.  If that is your position, contact us so that we can discuss the matter further.

WHEN DOES YOUR LIFE INSURANCE POLICY BECOME TAXABLE?

It all comes down to if your life insurance is included in your estate – and if it is – how much your estate is worth.

Life Insurance Is Subject To Estate Tax Above The Federal Estate Tax Exemption

So in general, the IRS states that life insurance policies are not taxable for beneficiaries as income.

There are some exceptions in which they do become taxable, mostly through state estate and inheritance tax and federal estate tax.  For federal estate tax, the current 2017 exemptions are at $5.49 Million for single people and $10.98 Million for married couples.

Now, that may sound like a lot to the average American, and the vast majority of people in this country fall below this taxable line. However, you may want to take a look at all of your assets and income just to make sure that you are under the cutoff.

The reason being, there are many assets included in your estate that you might not be thinking about.

Is an asset included in your estate, or not?

These could increase the value of your estate to a number higher than the federal exemption.

• Do you have any investments? Stocks, bonds and mutual funds all count as part of your estate.
• Do you have any expensive assets that could be a part of a collection of cars, motorcycles, pieces of art, antiques or antique musical instruments? Those are also considered part of your estate and could push you over the federal limit.
• Are you a business owner? Your proportion of the business is included for estate calculations.
• Do you own another property, house, rental properties, or a vacation home somewhere? Chalk those up to your estate number unless it’s a joint property with your spouse.  How about a working farm?

After adding all of these up, you may still be under the federal $5.49 million line.  You also get to deduct liabilities (like mortgages) from the total value of the estate.

However, it’s easy to imagine a Silicon Valley tech engineer with a house in the San Francisco Bay Area and a small business quickly approaching that number.

Also consider that your assets may appreciate in the future, sometimes significantly.  What if that working farmland becomes the next big subdivision?

Life Insurance Is Subject To Estate Taxes At The State Level

Once again, if life insurance is included in the gross estate, it will be subject to taxes at the state level and the exemptions for state taxes are much lower than the federal exemptions.

See below:

Some states start charging estate taxes below the $5.49 Million federal limit, though there is legislation to change that in many state legislatures.

IN SIX STATES, LIFE INSURANCE MAY BE SUBJECT TO INHERITANCE TAXES

So this gets really confusing really quick.

Maryland and New Jersey have an estate tax and an inheritance tax.

Three states – KY, MD, NJ – exempt children, parents and grandchildren (linear heirs) from inheritance taxes.

Nebraska and Pennsylvania tax linear heirs at a very low rate.  Pennsylvania exempts life insurance proceeds from the inheritance tax.

To add to this complexity, the rules are changing all the time.  For passing on assets to a nonlinear heir, like a sibling, niece or nephew or non-family member, it pays to get an expert involved if you live in these states.

Take a look below, because these inheritance taxes can get expensive.

Nebraska tops out at 16 percent!

State Inheritance Tax Rates Across Bequest Size and Heir Class (2017)

Sources: State statutes; Bloomberg BNA; Taxfoundation.org

THE BEST WAYS TO AVOID TAXES ON LIFE INSURANCE

There are a couple of great strategies that you can use to avoid taxes on your life insurance.

Entrust Your Spouse As The Owner Of The Policy

If you are the primary insured and the owner of the policy, it may be subject to estate tax.  One of the simplest ways by far to protect your policy is by giving it to your spouse.

How do you do this? Simple. A change of ownership is very easy to do through your current life insurance company.  It’s also usually free, just a few forms and you’re done.

By transferring ownership to your spouse, the life insurance policy will not be part of your estate and you avoid the estate tax issue altogether.

If you need some help with the process, just contact us. For estate planning purposes, there is a 3-year look-back on asset transfers.  So the sooner you move forward with an ownership change, the better.

Make Sure Your Beneficiary Information Is Current And Up To Date

Remember: beneficiaries receive life insurance benefits avoiding probate and bypassing the estate of the deceased.

So keeping your beneficiary information up to date is crucial, especially if your spouse dies before you do.

What If Your Estate Is Pretty Large?

Even if you fall above the federal and state limits for tax exemptions, there are still some ways that you can protect your assets, investments and life insurance.

These strategies make sure your life insurance policy is not included as part of the total of your estate. Here’s how you can accomplish that.

Set Up An Irrevocable Life Insurance Trust

If you want to or need to select a beneficiary as someone other than your spouse, you may need to set up an irrevocable life insurance trust (ILIT).

This shifts the ownership of your policy to the trust itself, so then it will no longer be considered or calculated as part of your personal estate. Setting up an irrevocable trust can be a bit more of a complicated legal maneuver that will require legal expertise.

Transfer Of Ownership Of Your Policy To Another Person

You can also transfer ownership of your policy to another member of your family.  Then your life insurance policy is no longer considered as part of your estate. That decision also comes at a cost, namely a gift tax and a loss of some control over the policy.

That decision also comes at a cost, namely a gift tax and a loss of some control over the policy.

HOW DO YOU GIFT A LIFE INSURANCE POLICY?

Gifting a policy to another family member is simple, and you don’t even need a lawyer to do it. All you need to know is the total current cash value of your policy. If that total is over $14,000, it will be subject to a gift tax that’s imposed by the IRS.

The person making the gift is the one who pays the tax.

However – the gift tax is not paid until after the death of the insured.  Since the cash value of the policy is often far below the death benefit, usually there is no gift tax at all.

FOR EXAMPLE!

Jack is the owner of a $1,000,000 universal life insurance policy where he is also the primary insured.  That policy has a current cash or surrender value of $40,000.

Jack chooses to gift ownership of that policy to his niece and beneficiary, Diane. If this was just $40,000 in cash, Jack would owe a gift tax on $26,000. Since it is a life insurance contract, he does not.

When Jack dies five years later, Diane receives the full $1,000,000 and is exempt from income and estate taxes.

All you have to do from there is fill out the paperwork from your life insurance company to assign or transfer ownership to the beneficiary. You can usually fill out the paperwork for free.

Remember – A three-year look back on gifting assets such as life insurance applies for federal and many state estate taxes.

Single-Premium Policy vs. Monthly Premiums

If you have a life insurance policy set up for monthly or annual payments, the person that you gift your policy will have to continue paying those premiums to keep the policy from lapsing.

Or, you can gift them less than $14,000 annually they could use to pay the policy.

How Gifting Affects Your control over Your Policy

The main thing that you need to keep in mind when gifting policy is that you relinquish all control and ownership of that policy. Therefore, you will not be able to

• Cash in on the policy and get your money out
• Decide what your beneficiary does with the policy
• You cannot cancel the policy transfer, even if you are having a dispute with the beneficiary

With this in mind, it’s important that you trust the giftee explicitly with your policy.

Once it’s out of your hands, it’s out of your hands for good.

IS LIFE INSURANCE TAXABLE? THE FINAL WORD

Here are the key pieces of advice you must take away from this:

First, for most people life insurance will pass hassle-free to your beneficiaries tax-free.

Make sure your beneficiary information is always correct and accurate.

If you have a large estate, to avoid estate taxes consider transferring ownership of your policy to a trusted person or an ILIT.

This article cannot be constituted as legal or tax advice.  These are free opinions, based on the sources provided, deemed reliable at the time of authorship.  We are neither lawyers, accountants, tax professionals, or astronauts.

We are underwriting experts trying to give you the best information we have.

So do your due diligence.  Check your state’s bar association and find a reputable elder law attorney or probate attorney to guide you.

YOUR FAMILY WILL BE THANKFUL YOU CONSIDERED THEIR FUTURE

If you care enough about the tax treatment of your life insurance, don’t you care enough to get the right policy?

You deserve the very best protection for your family, especially if you suffer from heart problems like a heart attack or atrial fibrillation.

We are the experts in life insurance with heart conditions.  Give us a call today, or hit the quote button to get started.