Taxation of Life Insurance

Taxation of Life Insurance
Eileen St. Pierre, The Everyday Financial Planner

estate-planning-pictureThis column is the last in a 5-part series on life insurance. Regardless of the type of life insurance policy, beneficiaries generally receive death benefits income-tax free. However, there are some situations where you have to think about income, estate, and gift taxes.

Cashing in Your Policy

If you decide to surrender (or cancel) your policy, the cash value you receive may be reduced by surrender fees. These fees are highest for new policies. Any gain will be subject to income tax.

If you sell your life insurance policy, this is referred to as life settlement. You may have seen the TV commercials for these companies. To qualify for settlement, you generally have to be:

  • at least 65 years old
  • have a life expectancy of 10-15 years or less
  • have a policy with a death benefit of at least $100,000

You will have to pay income taxes on the settlement. It’s a bit too complicated to explain here. Please consult your tax advisor BEFORE signing over your policy.

While selling your policy can generate more cash than just surrendering your policy, Investopedia urges you to be aware of the following:

  • You will lose control of the death benefit.
  • You will have to pay hefty commissions and fees to the settlement company.
  • The buyer will now have access to your medical records and may be entitled to ask for updates on your health.
  • These firms are not heavily regulated.

Gifting or Transferring Your Policy

It is better to gift your life insurance policy to a family member or trust than to sell it to them. Basically, you would just do a transfer.

  • You can give annual cash gifts of $14,000 a year and not worry about gift taxes. So if the annual premiums are less than $14,000, you can just gift the money to the new owner.
  • Life insurance contracts are not subject to probate unless your estate is named as beneficiary.

Depending upon the ownership of the policy, the death benefit proceeds may be subject to federal estate taxes.

  • You need to transfer it to your family member or trust more than three years before your death or else it will become part of your taxable estate.
  • In addition, the trust needs to be irrevocable in order to avoid estate taxes.
  • In 2016, single estates under $5,450,000 ($10,900,000 if married) are exempt from federal estate tax.

Transfer of Value Rule

Under this rule, if you transfer your life insurance policy, then part of the death benefit becomes subject to ordinary income tax (there are five exceptions. This situation generally arises in a business setting, not with personal policies.

As you can see, things can get real complicated really fast if you do not know what you are doing. Life insurance can be a valuable component of an estate plan if used correctly. This is one area where good advice is worth the price.

Visit my Estate Planning page to read my other columns on life insurance and fact sheet.