Whether life insurance payouts are tax free or not are a concern to policy holders and beneficiaries alike. When policy holders purchase life insurance they expect their beneficiaries to receive the death benefit in full should they pass away. It is peace of mind for policy holders that their loved ones are taken care of after they are gone. For the most part, term life insurance payouts are indeed tax free; but be aware of Federal Estate Tax and how to avoid losing a good chunk of your beneficiary’s financial security to estate taxes.
What the IRS notes about Term Life Payouts
Regarding term life insurance tax, the IRS states “life insurance proceeds, which were paid to you because of the insured person’s death, are not taxable unless the policy was turned over to you for a price.” So, simply put, term life insurance payouts are not taxable as income. The IRS does not require tax-paying citizens to include a term life insurance death benefit to be included as income for tax purposes. There is however, a Federal Estate Tax that may cause term life insurance tax to be paid on a life insurance payout.
Federal Estate Tax
Federal estate tax can be charged for term life insurance death benefit payouts in the instance that the owner of the insurance policy retained the ability to change the beneficiary on the life insurance policy. Federal estate tax will reduce the death benefit pay out and the reduction can be considerable. Consumers who purchase life insurance for the sole purpose of providing for their loved ones after they are gone should understand the possibility of term life insurance tax by federal estate tax and that it can reduce the amount paid to their beneficiaries.
Avoiding Federal Estate Tax
Federal estate tax may be assessed to any life insurance plan that the policy owner had rights to changing the beneficiary; therefore if the policy owner were to revoke their own right to make this change then the policy would not be subject to federal estate tax. The good news is that there is a way for the policy owner to revoke their ability to make any beneficiary changes to the term life insurance plan. The policy owner can elect to create an irrevocable life insurance trust.
Irrevocable Life Insurance Trust
An irrevocable life insurance trust will remove the ability for the insured to make any beneficiary changes to the existing life insurance policy, thus eliminating term life insurance tax in the form of federal estate tax. The policy owner can simply establish an irrevocable life insurance trust and appoint a trusted friend or family member as the trustee. Once the trust has been created, the policy owner can simply make the trust the beneficiary, removing the ability to make changes to the beneficiary and protecting the death benefit from taxation.
Term life insurance death benefit payouts are not taxed as income, but they can be taxed by federal estate tax. The life insurance plan that policy holders purchase to protect their families may not be protected itself. To avoid term life insurance tax it is important to understand that estate taxes may be assessed on a death benefit payout if the policy holder kept the right change the beneficiary. Creating an irrevocable life insurance trust is a simple way to avoid your loved ones losing a potentially large amount of the term life insurance payout to taxes.
Ask our agents to help you set up your irrevocable life insurance trust!