Dave Ciambella

Life insurance proceeds are tax free, aren’t they?

This question has been asked of me many times in my career. Most times the question arises during presentations when we are addressing estate liquidity with clients. Generally speaking, life insurance proceeds are income tax free but they are not necessarily estate tax free. The consequences could be severe so I encourage you not to take this lightly!

For many the mere thought of life insurance makes them nauseous as they have a difficult time dealing with their own mortality. However, life insurance can be a wonderful financial tool which can help to protect your family’s financial security (pay off a mortgage, help fund college etc), create estate liquidity and to inject capital into your business in the event a key person dies prematurely to name a few. For those of you who recognize this and have implemented a life insurance portfolio, congratulations! For those of who have not, hop to it! The welfare of you family and your business could be in jeopardy.

Individually owned life insurance is income tax free to the beneficiary. For example, if I own a $1,000,000 life insurance policy and my wife is the beneficiary, upon my death she would receive the entire $1,000,000 income tax free. She would be able to use the proceeds any way she wanted (to reduce debt, invest the proceeds to generate annual income etc.). Let’s suppose my wife and I had a net worth of $10,000,000 and I also owned the $1,000,000 policy listed above. My wife would still receive the life insurance proceeds income tax free. However, in the event she never consumed the life insurance proceeds and she subsequently passed away, the estate would now be worth $11,000,000 (the life insurance proceeds are added to the value of the estate for estate tax purposes).

There are ways to ensure life insurance proceeds are available to a surviving spouse but are not includible for estate tax purposes. One common solution is to create an Irrevocable Life Insurance Trust (ILIT) with an independent trustee which purchases and owns the life insurance policy. Naturally, it would be prudent to consult with your tax attorney and CPA as there are a few hoops to jump through to successfully keep the proceeds out of your estate. The key to keeping the proceeds out of your taxable estate is to ensure you do not retain any incidence of ownership (maintain the right to change the beneficiary, maintain the right to pay income to yourself, maintain the right to have access to cash value etc.). Other options are available as well and there are many considerations involved.

Here are a few suggestions regarding life insurance that you may find helpful:

1. Do not let the tax tail wag the dog! Sometimes it is best for a surviving spouse to have access to unencumbered cash, especially if the vast majority of the estate is tied up in closely held stock and/or real estate.
2. Match the proper type of insurance to the specific need (i.e., short term needs consider term insurance and long term needs consider permanent life insurance).
3. Review various ownership options with your tax attorney, CPA and Financial Advisor.
4. Monitor the performance of permanent policies annually as they are sensitive to interest rates and expenses! 

Please note, the information above is intended for educational purposes only. Everyone's situation is different and competent local counsel should be consulted prior to implementing any of these techniques.

Posted by Dave Ciambella on May 13, 2008 | Comments (4)