The taxation of life insurance policies – part 1

Many clients come into my office and indicate that they have life insurance coverage and that they were told by their insurance agent that they would be protected from all taxes by the life insurance death benefit. They are also told that they can access the cash value of their life insurance policies on an income tax free basis during their life for retirement, or other purposes (paying for children’s college expenses, medical needs, etc.). While all of these statements are generally correct, I often meet with people who have misunderstood their life insurance agent or who really do not understand the different ways that a life insurance policy can be subject to taxation. My goal in this multiple part series of posts is to identify some of the common misconceptions regarding the taxation of life insurance and educate you on what you should look for when you are reviewing your own planning to identify potential problems that need to be fixed.

Initially, we must deal with the income and estate taxation of the death benefit of the life insurance policy. Under section 101(a) of the Internal Revenue Code (26 USC §101(a)), the general rule is that, “gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.” Based on this statute, the death benefit of life insurance is generally exempt from income taxation. We will see some situations in future posts where this may even be incorrect, but the general rule is that there are no income taxes payable due to the receipt of a death benefit under a life insurance policy.

Unfortunately for many people they do not understand that just because the proceeds are not subject to income taxation, this does not mean that they are not subject to some other tax that is set forth in the internal revenue code. If the owner of the policy is the insured under the policy and they continue to have the power to change the beneficiary of the policy throughout their lifetime, then the death benefit will still be income tax free when it pays out, but under section 2042 of the Internal Revenue Code the proceeds of the life insurance policy will be subject to estate taxes. This means that while income tax will be avoided, estate taxes will not.

To illustrate this, an example may be of some help. Let’s say a single individual has a 1.0 million estate and has a life insurance policy of 5.0 million dollars on him or herself. Let’s also say that this insured has one child who is the beneficiary of the life insurance policy. When this person dies, the death benefit of the insurance (the 5.0 million) is paid to the child who receives the death benefit income tax free. However, since the insured owned the policy and had the ability to change the beneficiary through his or her lifetime (what the Internal Revenue Code refers to as the “incidents of ownership”), that death benefit will be added to the decedent’s other property and be subject to estate taxes. Based on that, the gross estate for estate tax purposes will be 6.0 million. By doing a rough calculation of the estate taxes payable in 2009 on such an estate, we would take the 6.0 million, reduce it by the individual’s estate tax exemption (currently 3.5 million) and then take the net result (2.5 million) and multiply that by the highest marginal estate tax rate of 45%. This would mean that while the child received 5.0 million income tax free, 1.125 million would have to be paid for the taxes on the estate based on the inclusion of the death benefit in the taxable estate (and would be due within nine months of the date of death of the insured). This is a rough estimate which could change with other planning or variables, but it shows the initial issue that the owner of a life insurance policy should not always be the insured. In the next post we will look at some ways to deal with life insurance policies that are owned outright in your own name and some other planning techniques that can both keep the death benefit income tax free but also estate tax free. If you have any questions about this or anything else on this blog, do not hesitate to contact me at mziebold@ferruzzo.com.