Taxes and Life Insurance

“In this world nothing can be said to be certain, except death and taxes.” Benjamin Franklin

Which life event drove you to buy life insurance? Marriage? First kid? Fourth kid? Losing your own parent? For me, it was “all of the above.”

In addition to taking some time to think about how to name the beneficiaries (for more information on that, check out Naming a Beneficiary for Your Life Insurance Policy), you should also carefully consider the tax consequences.

The good news is that the beneficiary of your life insurance policy will not have to pay any income taxes so long as the proceeds are received as a result of your death.

The bad news (apart from the fact that you’re dead)? Your estate may owe estate tax on the value of the proceeds. Without very careful estate planning, the proceeds would be included in your taxable estate. Your estate would owe federal estate taxes if it is larger than $11.18 million, after subtracting the amount going to your spouse. The federal estate tax rate is 40%.

So what can you do to avoid your estate paying tax on the proceeds of your life insurance policy?

If your spouse is the beneficiary of the policy, no problem. Spouses can transfer assets to each other tax-free.

But if anyone else is the beneficiary of the policy, like your children, for example, you need to do one of two things: transfer the policy to someone else or put the policy in a trust.

If you transfer the policy to a person, make sure you trust that person. I mean really trust him. Once you transfer the policy, you no longer own the policy and lose the ability to control it.  You can’t change the beneficiary (or prevent the person you transferred the policy to from changing the beneficiary).The person you transferred the policy to could cash it in (which defeats the intent of the policy). In addition, if the amount you would get for your policy if you cashed it in is more than $15,000, you may also have to pay gift tax (yes, the federal government taxes gifts over $15,000).

A better choice might be to transfer the policy to a life insurance trust. While the trust would own the policy, be the beneficiary of the policy, and have full control over the policy, you can pick who would be the beneficiary of the trust (and the ultimate recipient of the proceeds of the policy).

Sound complicated? Yes, it is. If you are thinking about transferring a life insurance policy to someone else or a trust, be sure to consult with an estate planning attorney.

Copyright © 2018 by Siobhán Fitzpatrick Kratovil. All Rights Reserved.

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