What is the impact on tax liability for a life insurance policy’s beneficiary?

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Asked October 14, 2013

1 Answer

Life insurance policies build value on a tax-deferred basis. What that means is that money invested in a life insurance policy, including that put into investments for variable or universal life insurance policies, is not taxed as long as it is locked up in the policy. Once the person named in the policy passes away, the beneficiaries of the policy will receive the benefits you allotted to them, and that time the taxes on the policy go into effect.

Most financial and insurance experts will advise against leaving cash values directly to your beneficiaries. Instead, they recommend taking advantage of the tax-deferred nature of the money and naming a trust as the beneficiary. This method will allow the trust to make regular payments to your beneficiaries, and will avoid the largest portion of the taxes being paid. The proceeds, even being doled out, still count as taxable income, but it is classified differently and carries fewer taxes.

Another way to avoid taxation on the proceeds of a life insurance policy is to set up trust which manages household finances. For example, paying the monthly utility bills, mortgage payments, etc., out of the trust automatically rather than pass through your beneficiaries as taxable income. This removes a lot of the freedom of how the money can be used, but it eliminates a majority of the taxes associated with a life insurance payout.

If the taxes cannot be avoided, prepare yourself for a large reduction in the value of the proceeds. The Internal Revenue Service taxes death benefits at a higher rate than ordinary income, and you could be faced with paying as much as 40% of the proceeds into taxes unless you are able to find some sizable deductions. In this situation, your best plan of action is to hire the services of a financial advisor or planner to minimize your losses.

Answered October 14, 2013 by Anonymous

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