In most situations, the beneficiary of a life insurance policy does not have to pay income taxes on death benefits, according to a recent article in Forbes, “Are Life Insurance Proceeds Subject to Taxes?” But depending on your situation, you might want to consider different options for that money that may be more productive in the long term.
The insurance company can cut a check, but you can also have the insurer hold on to all or some of the funds and distribute them at a later date or in periodic distributions. If the money is held by the insurer, it will continue to earn interest—and that interest is taxable.
Another option is to transfer those funds to a trust that could control the proceeds of the policy based on the stipulations you set when creating it. However, remember that trust planning can get complicated if you establish “incidents of ownership” in the policy, in other words, if you are controlling the policy in some way. For example, such “incidents” include borrowing against it, using it as collateral or assigning it in a contract. If that happens, the proceeds of the policy might be considered a part of your estate and be subject to estate taxes when you die. Those estate taxes may be delayed if your spouse is the beneficiary, but taxes may be due when he or she passes away.
Also, remember that while your estate plan can say that the proceeds of a life insurance policy should go to one of your beneficiaries, only the beneficiary named in the life insurance company’s records would receive the funds. Any time you change your estate plan, you should revisit your life insurance beneficiary designation to be sure it is still consistent with your overall wishes and estate plan. You should also update any 401(k)s, IRAs, or any other contract you may have. All will need to be updated to ensure they are aligned with your current estate plan.
To avoid any expensive mistakes, including creating taxable events, speak with an estate planning attorney to make sure that all of your life insurance policies are aligned with the overall goals of your estate plan. These can be complex financial instruments, and the help of an experienced professional will ensure that you reach your ultimate goal: protecting your loved ones.
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Reference: Forbes (August 30, 2016) “Are Life Insurance Proceeds Subject to Taxes?”