Life Insurance Benefits – Are they Taxed?

Generally, life insurance death benefits paid to a named beneficiary do not subject that person to federal income tax liability. This tax advantage makes life insurance attractive for American families; parents can take comfort knowing that, upon their death, their beneficiary children will be protected financially and no portion of their policy payout will be seized by the federal government. Beneficiaries also enjoy tax-free benefits made under nontraditional policies such as worker’s compensation insurance contracts, employer group plans (requires active employer-employee relationship), endowment contracts, or accident and health insurance contracts. Still, diligent policy owners should inquire with their insurance agent regarding the tax implications of their specific plan.

On the other hand, life insurance proceeds can subject an insured person to the estate tax at his death (by way of inclusion in his estate). The tax is applied if:
1. The policy is payable to or for the benefit of the insured person’s estate; or
2. The insured person held any ownership rights to the policy’s economic benefits at death. This includes the right to name/alter beneficiaries, cancel policy for cash, pledge policy as loan collateral, or borrow against the policy.

Therefore, if an insured person wants to avoid estate inclusion he must named someone other than himself (or his estate) as beneficiary and be certain to relinquish all policy management rights. A safe was to do so is by transferring the policy to an irrevocable trust with someone else as trustee. Additionally, all policy “assignments” must occur at least three years prior to the date of death or the IRS will still consider the deceased as the policy owner for estate tax purposes.

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