Most everyone believes that life insurance proceeds are tax free. This is true if there is advance planning in terms of how the policy is owned and paid for.
Many are not aware that while in most instances life insurance proceeds are not taxable as income those proceeds do not necessarily avoid estate taxes, and is a major failure in planning in many instances with very harsh if not rude awakening for the intended beneficiaries generally when they are in the most need of financial assistance when the main income provider of the family has passed away.
Life insurance should be a key element of a personal financial plan but part of the plan should be as to how that policy or policies are held. With some advance planning, the proceeds from a life insurance policy can be entirely free of taxes.
The main reason most people in the early part of family life have life insurance is to replace income for their young family that would be lost should they die prematurely. Life insurance death benefit payments can generally be received by policy beneficiaries free of any federal and state income taxes if the policies are purchased at the personal level as opposed to some corporate policy, which if properly planned for can also be excluded from income taxes. This is not to say that the proceeds escape estate taxes, they do not unless handled properly, and can be highly financially detrimental if the proceeds are in fact includable in the estate of the deceased.
For estate tax purposes life insurance is part of your personal estate if you are the owner of the policy on your own life. There is an exemption if the proceeds go to your surviving spouse, and he or she is a U.S. citizen. This is a key issue with the increase in foreign nationals now residing here in the U.S. and further planning in those instances is necessary.
When death benefits go directly to a non-spouse beneficiary, such as a child or sibling (even without passing through your estate), the proceeds are includable in your taxable estate.
Should your estate exceed $5 million (for 2011 or 2012) including life insurance coverage, property net of any debt, investments, cash, and any other assets net of any liabilities your heirs will stand second in line behind the Internal Revenue Service and possibly the state.
An overall plan should be in place should your estate exceed the exemption amount, and even estates of lesser value should in fact have an estate and trust in place coordinated with your life insurance to avoid other possible legal and tax problems. The issue is that once you have passed away you have no say so, nor can you assert your desires as to how your beneficiaries are to be taken care of financially without a plan in place before you pass on. Without a written plan many estate problems occur as there are many differing agendas in play by those that you leave behind.
One planning technique to avoid estate taxes is to have the life insurance policy placed in an irrevocable life insurance trust which is a separate entity all unto itself and outside your estate. The trust is required to pay the premiums, and the death benefits go to whomever you name as the trust's beneficiaries. By utilizing this technique the entire death benefit escapes the estate of the deceased and therefore avoids federal estate tax on the death benefits.
Setting up an estate plan is a fairly sophisticated legal procedure which requires the assistance of an experienced team of at the minimum an estate planning attorney, an accountant conversant in such matters, and your life insurance agent.
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