What are the Tax Benefits of Life Insurance Policy?

Life insurance policies are often thought to have considerable tax benefits, but it requires a detailed knowledge of the tax ramifications in your locale to assure that your beneficiaries can take advantage of them. In the United States, for example, although premiums paid into a life insurance policy are not tax deductible, life insurance policy proceeds paid by the insurer when the insured party dies are usually not included in gross income of the beneficiaries for either federal or state income tax purposes.

Also, increases in the cash value of permanent life insurance policies are not subject to income taxes unless certain things happen such as: owner withdrawals or large deposits of premium on flexible-premium policies. Accordingly, such policies can act as a legal tax shelter, and the tax benefits might even offset their lower returns when compared to other investment vehicles.

Since life insurance benefits are generally paid free of taxes to your beneficiaries under Internal Revenue Code Section 101(a)(1), this can be a very attractive feature of life insurance for those considering how best to leave their estate to their family. However, some exceptions do apply, so it is strongly recommended to consult with your accountant and your attorney to determine the best way of structuring your life insurance policy ownership and beneficiary designations in order to avoid a very unpleasant (and probably unnecessary) tax surprise for your beneficiaries.

For example, if life insurance policy proceeds are included in the estate of the deceased, then they could be subject to federal and state estate and inheritance tax. So, if you are wealthy enough to have an estate valued at more than the current federal estate tax exemption amount (which increases from $2.0 million to $3.5 million in 2009, and is then removed in 2010, but reinstated in 2011 at $1 million), then your heirs may be required to pay taxes on your life insurance death benefit.

Specifically, if your life insurance policy names yourself or your estate as the beneficiary, then your policy’s death benefit is paid to your estate where it may then be exposed to estate taxes if your estate is greater than the federal estate tax exemption amount. So if you want to own your policy, it would probably be better to create an irrevocable trust to be the owner and beneficiary. If applicable, you could alternatively have your adult children own and be beneficiaries of the policy. Either of these options will avoid having your life insurance policy’s death benefit included in your estate, and therefore potentially subjected to estate taxes.

Even when the owner of the policy insuring your life is someone other than yourself, if the designated beneficiary dies before you, then the death benefit may be paid to your estate. Accordingly, be sure to name a contingent beneficiary on your policy so that the policy proceeds will go to that person instead of your estate, thereby avoiding both estate taxes and the long trip through probate.

Another life insurance tax pitfall could occur if you make a gift of life insurance to another person (other than your spouse). Such a gift may carry gift tax consequences, and if you fail to survive your gift by three years, the policy’s ownership can revert to your estate. If this happens, the policy’s death benefit will again be subject to taxation if your estate’s value exceeds the federal estate tax exemption amount.

Furthermore, if your life insurance policy is sold or transferred for valuable consideration, and the transfer does not qualify for an exception under Internal Revenue Code Section 101(a)(2), then a taxable event occurs. Also, an insurance policy owned by an employer may not pay tax-exempt funds unless it meets the qualifications for an exception under Internal Revenue Code Section 101(j).

In conclusion, since issues of taxation and the mechanics of estate transfer are complicated subjects, and since the preceding ideas are not intended to serve as advice, you should consult your attorney and CPA before either purchasing or making any changes to your life insurance policy for tax purposes.