3 Ways to Avoid Taxes on Life Insurance Benefits

Veronica Baxter | Boonswang Law Firm

As a general rule, they do not tax proceeds from a life insurance policy as income to the recipient.

Whether the proceeds take the form of death benefits or Accidental Death & Dismemberment (AD&D) benefits to the insured, the IRS does not consider those proceeds income.

Accordingly, three scenarios exist where the recipient may get taxed on insurance proceeds, however.

Moreover, this post describes those scenarios and instructs you as the insured on how to avoid them, written from the office of a busy life insurance beneficiary attorney.

A Life Insurance Beneficiary is Late in Claiming the Death Benefit

How does life insurance usually work? The insured dies, and their beneficiary or beneficiaries claim the death benefit shortly thereafter.

However, there are circumstances where the insurance company must hold the death benefit, such as when:

-The beneficiary or beneficiaries cannot get found
-A beneficiary dispute takes place
-The death of the insured is subject to a criminal investigation

-An insurance company is investigating the cause of death of the insured
-The insured died on foreign soil
-A beneficiary asks the insurance company to hold the death benefit

The Death Benefit is Paid to the Estate of the Insured

Therefore, if the insurance company must hold the death benefit while these issues get resolved, the death benefit will accrue interest, and that interest gets taxed as income to the beneficiary.

If you are a life insurance beneficiary, the way to avoid being taxed on interest the death benefit accrues is to timely claim the death benefit. However, if you are not in control of whatever is delaying the death benefit, you may have no choice but to pay that tax.

Furthermore, when an insured has not gotten advised otherwise, the insured may name their estate as the beneficiary of their life insurance policy.

When the death benefit gets paid into the insured’s estate, and the estate becomes dispersed to the insured’s heirs, the heirs may get taxed on their inheritance. This also applies to other accounts such as IRA accounts and annuities.

It does not trigger estate taxes unless the value of the estate equals $11.58 million in 2020. The maximum estate tax rate is 40%.

While the death benefit of your policy may be well below $11.58 million, if adding the value of any real property, retirement accounts, savings, collections, and other belongings approaches that number, you need to plan ahead.

Additionally, one way to avoid estate tax on insurance proceeds would be to transfer ownership of the policy because if someone other than you owns the policy at the time of your death. They will not include the insurance proceeds as part of your estate.

Here’s how to transfer ownership:

• Choose a competent adult as the new owner. That person can be a beneficiary.
• Call your insurance company for assignment (transfer of ownership) forms.
• Obtain written confirmation of the assignment from your insurance company.

Know that you will give up the right to make any changes to the policy. Although you could ask the new owner to make changes for you. Change of ownership is irrevocable.

Also, the new owner must pay premiums on the policy. You can fund those payments by gifting the new owner an amount of up to $15,000 with no tax ramifications.

Another way to avoid estate tax on insurance proceeds would be to form a life insurance trust. This often gets done when the intended beneficiary of the policy is a minor child or an adult child with special needs.

You can name a trusted friend or family member as trustee.

The Insured Withdraws Funds from Their Whole Life Insurance Policy

Moreover, cash-value life insurance policies such as whole life or universal life insurance policies accrue value, which becomes tax-deferred.

Therefore, such policies frequently come with the right to withdraw or borrow from the policy. However, if the insured withdraws more than they contributed in premium payments, called the “basis,” they will tax the overage to the insured as income.

Under most circumstances, planning ahead becomes the way you and your beneficiaries can avoid paying taxes on the proceeds from life insurance.
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About the Author

Veronica Baxter is a blogger and legal assistant living and working in the great city of Philadelphia. She frequently works with Chad Boonswang, Esq., a life insurance attorney.

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