Life Insurance & the Dirty Little Estate Tax Secret

Dec. 26, 2007

In 2002, both Vera McLoud and her life partner purchased $500,000 life insurance policies in preparation for the arrival of their first child. Their insurance agent assured them that the death benefit (a $500,000 payout) would be income tax free, and would allow the surviving partner to meet the financial obligations of a new family. However, when they met with their accountant a few months later, they were surprised to discover that if one of them died, the other might owe a substantial estate tax on the benefit paid out by the life insurance policy.

When buying life insurance, the income tax implications are usually straightforward. However, the estate tax implications are often unknown, ignored, and much more painful.

Income Tax and your Life Insurance Payout

Life insurance policies can be paid out in a dizzying array of ways which bear such intuitive names as "lump sum", "joint and last survivor life income," and "specific income". However, the type of payout has little bearing on whether the recipient owes income taxes. With a few exceptions, life insurance payouts are income-tax-free.

For those of you who won't be able to sleep until you know what those exceptions are, they include:

• If your employer paid for your life insurance, then anything over the first $50,000 of the payout will be taxed.
• If you take money out of your benefits yourself before the benefit payment period begins, that amount may be taxed.

Beyond those few exceptions, the beneficiaries of a life insurance policy don't owe income taxes on the payout that they receive. However, estate taxes may apply, depending on how the insurance policy was set up.

Estate Tax and your Life Insurance Payout

The US federal government has the right to impose an estate tax on all the property that you own upon your death. If the value of your estate exceeds $2 million (in 2007-2008), a federal estate tax will be assessed. Many people cross that threshold unwittingly. For example, if you have purchased a life insurance policy but you haven't specified a beneficiary (or you specified yourself or your estate as the beneficiary), the payout on that life insurance policy increases the size of your estate. Should that payout push you above the $2 million exemption, the cash is taxable -- at rates of up to 46%!

There is one common exception to the estate tax: there is an unlimited marital deduction for the surviving spouse in a marriage. However, this exemption does not apply to non-married life partners, as Vera and her partner discovered.

There are several effective strategies for protecting life insurance payouts from estate taxes. (In fact, these strategies are so successful that many people incorporate life insurance policies into their estate planning because of the income tax exemption.) The first strategy is for each person to buy a life insurance policy on their loved one, rather than upon themselves. If their loved one dies, they receive the life insurance payout, and it is not included as part of the estate of the deceased. An accountant can help you develop more sophisticated strategies as well, such as irrevocable life insurance trusts.

Always consult your accountant or tax advisor when you make substantial changes to your life insurance policy or when the size of your family changes.