Life Insurance is Tax Free
I don't know how many times I've heard that life insurance is tax free. That's not entirely true. Life insurance proceeds are income tax free, but they can be subject to estate tax at either the Federal or State level. But, if the deceased didn't own the life insurance policy, it isn't part of his or her estate. And that can be a good thing. You can also mess things up.
Military Officers Need to Understand the Insurance Triangle
There are three "parties" to an insurance policy in addition to the insurance company. They are:
- The policy owner. This is the person who is required to make the payments
- The insured. When this person dies, the death benefit is paid.
- The beneficiary. The person (or potentially persons) who receives the death benefit.
While there are three parties mentioned, in order to avoid potential tax problems, no more than two people or entities can occupy the three positions. For instance, the policy owner and insured can be the same person and the beneficiary is a second person. Or, the policy owner and the beneficiary can be the same person and the insured can be a different person. It wouldn't make sense for the insured and the beneficiary to be the same person.
It is important to note, that if someone has an insurable interest in another person, he or she can purchase a life insurance policy on him or her. A classic example of this would be a divorced spouse that relies on alimony from an ex-spouse. This would be an insurable interest and the divorced spouse can purchase (and pay for) an insurance policy on his or her ex-spouse without the ex-spouse's knowledge or approval.
By making the owner and beneficiary the same person, the insurance proceeds are not included in the insured's estate on passing.
Three is a Crowd
If there are three different people in each of the three positions, there is a problem. Since the beneficiary is not the owner of the policy, the death benefits will be considered a gift (potentially taxable) from the policy owner. Additionally, if the insurance premiums exceed the annual gift tax exclusion, then they could be considered a taxable gift as well.
Don't Make Un-Forced Errors
With proper planning and use of tools like insurance trusts, you can remove your life insurance proceeds from your estate and avoid the insurance triangle. A Financial Planner or Estate Planning Attorney should be able to help you make sure you don't make any mistakes.