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The Tax Consequences of Life Insurance Death Benefits

Senior couple puzzling over documentForbes’ recent article, “Are Life Insurance Proceeds Subject to Taxes?” says that your beneficiary typically won’t be required to pay income tax on death benefits. Those funds typically are tax-free.
But this doesn’t mean you get to ignore how that money will be distributed—there are options available. The insurance company can cut a check, but you can have the insurer hold on to all or some of the funds and distribute them at a later date or in periodic distributions. If the money is held by the insurer, it will continue to earn interest—and that interest is taxable.
Another option is to transfer those funds to a trust that could control the proceeds of the policy based on the stipulations you set when creating it. However, remember that trust planning can get complicated if you establish “incidents of ownership” in the policy, in other words, if you are controlling the policy in some way. For example, such “incidents” include borrowing against it, using it as collateral or assigning it in a contract. If that happens, the proceeds of the policy might be considered a part of your estate and be subject to estate taxes when you die. Those estate taxes may be delayed if your spouse is the beneficiary, but taxes may be due when he or she passes away.
Also, remember that while you can state in your will that the proceeds of a life insurance policy should go to one of your beneficiaries, only the named beneficiary of the policy gets the funds. When your intentions change, you must contact the life insurance company to update your beneficiary designation. You should also update any 401(k)s or IRAs.
Talk with your estate planning lawyer to be certain that your life insurance policies work in concert with the rest of your estate plan to give your family protection and to help avoid unintended and potentially unpleasant financial consequences.
Reference: Forbes (August 30, 2016) “Are Life Insurance Proceeds Subject to Taxes?”

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