No they are not – if you take a few simple precautions. In fact, it’s very easy to avoid paying income tax on life insurance proceeds. Then again, all it takes is a little sloppy bookkeeping and you can inadvertently name Uncle Sam your new life insurance beneficiary. Who needs that? Let’s make sure that doesn’t happen.
When you buy life insurance there are three parties involved; the owner, the beneficiary and the person who is insured. Typically the person who buys the insurance is the owner and the insured. If I buy life insurance on myself I own it and I am probably the insured. As the owner I get to name the beneficiaries. Simple as that.
I can name anyone I want as the beneficiary. If I die, the beneficiaries will get the loot and they won’t pay a cent in income or estate tax. Sweet (for them). The are really only a few exceptions to this.
If I name my estate or my living trust as beneficiaries or if I fail to name a beneficiary, the proceeds will be included in my estate and therefore taxable. Why? Because according to the IRS I have an “incidence of ownership” in those situations. That’s bad news because my estate may have to pay estate tax on those proceeds.
What is an “incidence of ownership”? It includes having the ability to change the beneficiary, the right to take out loans or the right to cash the policy in. If that describes your situation it’s time to re-think your strategy.
But the good news is that this is completely avoidable. All you have to do is make sure to name someone else as the beneficiary. Since the entire reason you buy life insurance to provide for others, this isn’t a hard requirement to comply with.
The second exception is if you buy life insurance through your employer using pre-tax dollars. If you go this route and then die, the death benefit becomes taxable income.
Your beneficiaries won’t have to pay it per se but the income tax is going to going to take a huge slice out of that pot of dough and there will be a lot less available for the family as a result.
Many employers offer life insurance group policies and they are usually a fantastic benefit. Just make sure to check with HR. If you have the option, think about buying that life insurance with after-tax dollars instead. That way, if you pass away, your family will get 100% of the benefit and beat the tax man at his own game.
There is one other reason why your beneficiaries might pay some tax on death benefits and that’s when the money earns interest before being distributed to the beneficiaries.
Let me explain.
Once there is a death claim and the paperwork is settled, the benefit becomes available immediately. Sometimes the beneficiaries leave the money on deposit with the insurance company until they decide what to do with the money. In that case, the insurance company pays interest and that interest is taxable. This isn’t a huge problem and it’s not something you should worry about but it’s something to be aware of.
As you can see, it’s easy to shield life insurance death benefits from the tax man. Make sure you have the right beneficiaries that you have no incidence of ownership and that employer-provided life insurance is paid for after-tax. Of course there are always exceptions. Depending on your particular situation, you may want to use other tactics. That’s when a good qualified estate planning attorney really comes in handy.
Have you considered how to structure your life insurance to minimize tax? What have you done? What are your major concerns?