Daniel Mace, CPA, PA


Life Insurance - Avoiding Taxes on the Proceeds

When you purchased your life insurance, you probably thought about things like how much coverage you should have and the cost. The subject of taxes may not have come up, or you may have simply assumed life insurance proceeds are not taxable. As with so many tax matters, though, it's a little more complicated.

In a Nutshell

Although the beneficiary of a life insurance policy usually receives the policy proceeds free of federal income taxes (exceptions apply), federal estate taxes are a potential problem. Your life insurance proceeds will be included in your gross estate for federal estate tax purposes if:

  • You keep specific ownership rights in the policy. These include the right to: change the beneficiary; assign the policy or pledge it for a loan; borrow against the policy's cash value; and surrender or cancel the policy; or
  • Your estate is the beneficiary of the policy. This occurs if you name your estate as beneficiary or if the proceeds default to your estate because the named beneficiary predeceases you.

Estate inclusion might not be a problem if you've named your spouse as your beneficiary, since federal estate tax law generally allows an unlimited marital deduction for amounts payable to a surviving spouse. But relying on the marital deduction for estate tax avoidance may not be wise since your spouse could predecease you and policy proceeds may end up being payable to your estate.

Without an estate tax deduction, insurance proceeds generally will be fully includable in your taxable estate, possibly triggering tax if your estate is over the available exemption -- $12.06 million in 2022.

Tax Strategy

You may be able to avoid estate tax on your policy proceeds. How? Simply transfer ownership of the policy to someone else. If you transfer all "incidents of ownership" and you survive for three years afterward, all of the insurance proceeds escape estate inclusion.

You don't need to transfer the policy to another individual. You can also place the policy into a life insurance trust. (The three-year rule also applies in this context.)

For more tax strategies, contact us today to speak to a financial professional.