While considering your own mortality is never a pleasant thought, death is a reality for everybody. If not properly prepared, death can often lead to unforeseen financial hardships for your loved ones. In addition, there are tax consequences (and opportunities) associated with life insurance policies that policyholders may not fully understand.
At a fundamental level, life insurance is a contract between an insurer (the insurance company) and an owner of the policy (the policyholder), where someone (the named beneficiary) receives a payment (the death benefit) when a certain person (the insured) passes away. Wait, what? Do not worry. It is not as complex as it sounds; it often involves just two people and an insurance company, but it is not always that simple.
Example: Bob buys a life insurance policy on himself and names his wife, Alice as the beneficiary. Bob is both the policyholder as well as the insured and Alice is the named beneficiary who receives the death benefit.
Bob could also buy a policy on his wife’s life and name their son Alexander as the beneficiary. Bob is the policyholder; his wife is the insured, and their son the beneficiary. This is known as a “Goodman Triangle” and has the potential to be very costly.1
With all these parties, who is responsible for paying the taxes? In most cases, the death benefit paid out to the beneficiary does not generate a tax liability. This means the beneficiary does not have to include the benefit received on their tax return or pay any taxes on the amount received. This often comes as a surprise to people given the size of some policies.
However, in some cases such as the “Goodman Triangle,” the life insurance proceeds may be considered a gift and subject to state or federal gift or estate tax.2 This could turn a well-meaning gesture into a costly financial mistake. It is important to consult a tax or insurance specialist to avoid these types of unintended consequences.
Cash value is a component of certain types of life insurance. For permanent life insurance policies, such as whole or universal life, a portion of the premium payment goes into a cash value account while the other portion pays for the insurance and fees. The cash value account then accumulates on a tax-deferred basis, which means taxes are not owed as the money grows over time. There can be tax consequences if you choose to access your cash value, though.3
There are three ways to access the cash value in your life insurance policy:
Another way life insurance can generate tax liability is if the IRS considers it to be a “modified endowment contract (MEC).” That’s right - the dastardly MEC! This occurs when the premiums paid exceed certain IRS thresholds, causing the policy to lose the tax advantages typically afforded to life insurance policies. Both loans and withdrawals from a MEC can be subject to ordinary income tax.7 Insurance companies use a “seven-pay test” and will typically alert policyholders if their policy is at risk of becoming a MEC.8
As you can see, life insurance can be a great way to protect your loved ones in a tax-efficient manner. However, it also comes with some potential pitfalls and should only be used when appropriate. Life insurance may not be the right fit for every situation, but in most, it should be considered. To maximize the benefits of life insurance, always consult with your financial advisor or accountant before making a decision.
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Disclosures:
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