When considering whether or not to invest in life insurance, the tax implications of your policy can be a factor that can influence your decision. Although it is possible to get a life insurance policy that delivers tax-free benefits in the case of death, beneficiary and ownership designations must be carefully crafted to avoid heavy taxation.
In general, if your life insurance policy is privately owned, the benefits it will pay out in case of your death will not be taxable. By themselves, all cash benefits paid out by universal life and whole life insurance policies are considered income that does not need to be taxed. Unfortunately, however, although the benefits of privately-owned life insurance policies may, by themselves, be imparted tax-free, there are some conditions under which those benefits could be subject to taxation.
If you, as a policy holder, have life insurance benefits that can be considered part of your estate, these benefits may be subject to taxation if they contribute toward your estate exceeding the minimum non-taxable estate value of $3.5 million. If, including a life insurance policy owned by you, the total value of your estate exceeds this amount, your property will be faced with a tax rate, imposed by the IRS, of up to 45 percent. If the value of your estate is nearing this amount and you wish to avoid possible taxation due to a large life insurance payout, there are a few steps you can take to make sure your life insurance benefits are not included in the total value of your estate.
The simplest way to avoid complications is to assign ownership of your life insurance policy to another party. As long as the policy is legally owned by someone else, the payout will not contribute to the total value of your estate, and the benefits will not be taxable.
It’s important to also make sure that the beneficiaries of the policy are in no way included in your estate. If the policy’s beneficiaries are included in your estate, the benefits paid to them will add to the total value of your estate and could possibly cause it to exceed the limit.
In order for this loophole to be legal, the transfer of ownership of a life insurance policy must be done at least three years before the person that it covers dies. If less than three years have passed between the transfer of ownership and your expiration, the benefits of your policy will still be included in your estate. It’s important to act early to make sure that your life insurance policy has as few tax implications as possible so that it is able to benefit your loved ones as much as possible.
As with all tax matters, consult your accountant.