How Can That Be?
Call us taxpayers skeptical but how can anything in this day and age be tax free? IRS publication 525, page 21 states “Life insurance proceeds paid to you because of the death of the insured person aren’t taxable“. There are a few caveats to that statement that I will get to, but the IRS goes so far as to state that life insurance death benefit proceeds aren’t required to be reported when you file your income tax. If you have a $500,000 life insurance policy to protect your family, they can count on keeping all of it. Let’s just call it a gift from the past and not fuss with it.
What are those caveats that could change that tax free status?
There are multiple rules that deal with taxation of cash value withdrawals from whole life or universal life insurance policies, but the thrust of this has to do with the death benefit, the life insurance proceeds that are paid to a surviving beneficiary.
- During the two year contestability period that life insurance policies have, the company has the right to review the medical information they used for underwriting and even acquire additional information. This very rarely ends in a policy being successfully contested and proceeds not being paid, but it can take a few months. The life insurance company pays interest on the death benefit from the date of death until the claim is paid. Some portion of that interest could be taxed as interest income.
- This is rare, but if you bought a life insurance policy from someone, the gain you realized when that person passed away and you received the death benefit could be taxable. I’m not talking about if you buy a policy from a life insurance company, but rather if someone were to sign their policy over to you in return for some amount of money. Again, it is rare to sell your life insurance policy to an individual.
- If you have a business life insurance policy and you take a deduction on the premiums paid for that policy, the tax free proceeds benefit could be lost completely. This would essentially be using pre-taxed or untaxed money to gain a tax free outcome. I’ve had to coach a lot of business people to visit their accountant about how the purchase of business life insurance should be handled.
The great news!
The IRS is there to snatch a portion, sometimes a giant portion, of any large gains you may have some into. Sometimes they don’t even wait for you to file taxes. If you win any significant amount in the lottery they are going to make sure your taxes are covered before you ever get a check. Not so with life insurance proceeds that will ensure your family’s future. Contact us with any questions.