Are Life Insurance Proceeds Taxable?
Life insurance is not subject to the same tax rules as other investment or financial products. Life insurance receives special tax benefits that you and your family should know about. These tax benefits allow you to purchase a policy that may be used to pay off any unpaid financial obligations after your death, or provide your spouse with an income to replace yours.
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Identification
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Life insurance is not subject to income tax. All death benefits are received by the beneficiary on an income tax-free basis. However, the beneficiary may be required to pay estate tax in connection with the death benefit proceeds. This is because the death benefits are added to the value of the estate of the deceased insured. If the total value of the estate exceeds the maximum amount not subject to taxation ($1 million as of 2011), then estate tax will be due. While this money does not necessarily have to come from the policy, it may have to be paid from policy proceeds as a practical matter.
Benefit
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The benefit of life insurance is that there is no income tax on the death benefit. Unlike most investments and financial products, life insurance proceeds are passed fully "intact" to their intended beneficiaries. This gives the beneficiaries more money to invest or spend, depending on the beneficiary's financial goals.
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Disadvantage
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The disadvantage to life insurance death benefits is the estate tax. If the beneficiary is the spouse of the insured, then the death benefit may need to be used to pay estate taxes. As of 2011, the estate may be taxed up to 55 percent of any value in excess of $1 million. For a large life insurance policy, this could represent a significant portion of the death benefit proceeds.
Consideration
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To avoid having the death benefit included in the calculation of estate taxes, the policyholder and insured should move the life insurance policy into an Irrevocable Life Insurance Trust, also called an ILIT. A life insurance trust removes the policy from the insured's estate and thus eliminates any estate tax complications associated with the policy. This means that the beneficiaries won't have to worry about using any of the proceeds from the insurance policy to pay estate taxes.
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