What taxes do I have to pay on life insurance?

August 25, 2009 at 6:14 pm

Here’s a common question I see about life insurance. There are a few different ways to interpret this, but perhaps the most common way it is meant is this: A relative, friend, or business partner recently died and left the life insurance money to me; do I have to pay income tax?

The answer is generally no. The only exceptions to this are in business situations where the premiums were deducted as a business expense. So if you are a widow or widower who was named the beneficiary of a life insurance policy, you do not have to worry about paying income taxes on it. Of course, it is always a good idea to have a talk with an accountant who can come in handy. Personalized financial advice can come in handy during a trying time and an unusual circumstances.

Now that we know the answer is usually no, I’ll spend the rest of this article discussing two uncommon events when life insurance is taxed. I do not want to confuse with this advice, but perhaps demonstrate that if you are not sure about your situation, you need advice beyond what you can find for free on the internet.

Situation 1.Corporate-owned buy-sell life insurance

Suppose you are a business owner who decides to sell part of your business to another person. Now you are owners together and there is probably some value in the partnership because you both contribute to the business on a regular basis. The problem arises that if one of the two of you dies, the business will suffer (for any number of reasons).

You heard about one of these fancy buy-sell agreements online that might solve the problem, so you go talk to your lawyer who drafts up some documents to make sure the business stays between the partners and not their subsequent estates. But now that you create that agreement, where would you get the money to buy out your partner’s share of the business? Are you going to get a bank loan to fulfill your obligation right after a significant contributor to the business died? Probably not.

The simplest and cheapest answer is life insurance. So after you get personalized life insurance quotes for the two of you, you decide (along with your accountant) that an entity purchase buy-sell or stock purchase plan works best. This way, the business gets to deduct the premiums as it pays them, your accountant tells you. And since neither of you really plan on dying, tax deductions sound like a good trade-off.

The problem is that now that your partner is dead and the business has the life insurance to buy the stock from his estate, the business will now be taxed on that amount. Ouch. That stings because the life insurance benefit could be substantial and you owe tax on the entire thing.

Situation 2. Very large estate that includes life insurance policies

Now let’s assume you have a very large estate (I won’t specify the size to avoid dating the article because this is a moving target and also because with some basic planning with an attorney you might be able to reduce the size). Among other assets like cars, real estate, and investments, you also own your life insurance in your name. If your estate is large enough to be taxed for state death taxes or federal estate taxes, then all the assets in your estate (including your life insurance policies) will be taxed the same way. This could mean a loss of 20%, 30%, or more.

Of course, there is an easy way to avoid this tax on your life insurance and reduce the size of your taxable estate at the same time. Go talk to a lawyer about it today. You cannot do life insurance planning after you are gone.

Is life insurance taxed?

For most of us, we don’t have to worry about the tax man making an extra visit for the life insurance money when our loved ones pass on. But like anything else in life, there are a few exceptions to the rule. If you still are not sure about your situation, seek personalized financial advice from professionals to help guide you through this maze.


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