Life insurance is used to protect against the financial loss of your death. These policies are used as protection and not to generate money as an investment. As a result, the IRS gives life insurance death benefits generous tax treatment. Your life insurance death benefit will not be charged income tax. However, it could get hit with estate taxes if the death benefit is large enough.
Before you can buy life insurance on someone, you need to prove insurable interest. This means you would suffer financially if that person died. This is why you can buy life insurance on your spouse or a business partner, but you can't buy life insurance on your next-door neighbor. Your insurance company will also limit the amount of insurance you can buy to your financial need. These rules are in place because you aren't allowed to buy life insurance to make a profit.
When your heirs receive your life insurance death benefit, they will not owe income tax. This money is coming in to replace your earnings and pay your final expenses. It is not coming in as money from a job or an investment. The IRS created this tax break for life insurance to help the heirs of the insured. If your heirs ask the insurance company to hold on to the death benefit so they can decide what to do, the interest earned on the death benefit is taxable income. However, the death benefit itself is still tax-free.
While your heirs won't owe income tax on your death benefit, they still could owe the estate tax. The estate tax is charged on a large transfer of assets after a person's death. Everything you own, including the death benefit of your life insurance, is included in your total estate. As of 2012, you can transfer up to $5 million tax-free to your heirs. The IRS taxes all transfers over this limit at the estate tax rate of 35 percent. If you owe estate taxes, they will need to be paid out of your estate before your heirs can receive their inheritance.
Avoiding the Estate Tax
The estate tax is only charged on property you own. If you don't own your life insurance policy, the death benefit is not included in your estate. If you currently own your life insurance policy and are worried about estate taxes, you can give the ownership rights to someone else. You need to survive for at least three years after the gift or the IRS will still count the death benefit in your estate. Otherwise, your heirs will receive the money income and estate tax-free.
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