Income Tax

Insurance death proceeds are specifically exempted by law from income tax liability whether they are paid to an individual, an estate, or a corporation. There is one major exception to the rule, however, and that is where a policy is sold or transferred for "valuable consideration." In such a case income taxes are payable on the part of the death proceeds which exceed the new owner's cost.

Thus, if a $25,000 policy is sold for its cash value of $5,000 and the new owner later pays a total of $5,000 in premiums, she will have to pay a tax on $15,000 when she receives the death benefits of the policy. This is considered to be ordinary income and will be added to her other income for tax purposes.

This tax treatment holds even though a policy is sold to the insured's spouse. When transferring a policy to a member of the family, you must be certain that it is done as a gift and that nothing of value is paid for it.

Exceptions are made to the so-called "transfer for value" rule in the case of transfers to a corporation where the insured is a stockholder or officer, to the insured's partner or partnership, or to the insured himself. In these cases, even though consideration is paid for the policies, the death benefits are not subject to the income tax.

Estate Tax

There is a prevalent notion that insurance isn't subject to the estate tax. This isn't necessarily true. If it is payable to your estate or if you retain ownership of the policy, the death proceeds are going to be included in your taxable estate. This definition of ownership includes what the law calls "incidents of ownership" such as the right to surrender or to pledge the policy, the right to borrow on it or assign it, and the right to change the beneficiary.

One way to remove insurance from your taxable estate is to relinquish all rights in it by assigning the policy to someone else. However, there might be a gift tax imposed upon such an assignment. Still, only the cash value of the policy and the unearned and subsequent premiums paid by you are subject to this tax, not the face value of the policy. The gift tax can be avoided or reduced. By virtue of the unlimited marital deduction, there is no gift tax payable on an insurance policy assigned to your husband or wife, nor any estate tax on the proceeds of insurance which are paid to your spouse.

The gift tax annual exclusion of $11,000 ($22,000 if your spouse consents to the gift) means that a tax-free transfer can be made of a policy with a cash value of up to that amount and of subsequent premium payments of no more than the amount of the annual exclusions. However, if death occurs within three years of the transfer, the proceeds of the policy will be subject to estate taxes.

But are you sure you want to make such an irrevocable assignment? Are you certain you will never need to borrow on the cash value? Never want to change your beneficiary? Better look before you leap, because here as elsewhere in estate planning, family security and your own needs should not be sacrificed to save taxes.

Additional point: If a man transfers his policy to a wife with a separate estate (such as in a second marriage) and she dies before he does, the cash value of the policy is taxable in her estate. Unless his wife's estate is substantial this won't create a tax problem. But if it is large, there is not only this problem to consider, but also the fact that, if she survives him, the entire proceeds will go to her. Then, when she dies they will be part of her taxable estate.

In such cases, you should consider other forms of ownership. It may be worthwhile to have other members of the family own and be beneficiaries of the policies; or it may make more sense to assign the policy to an irrevocable trust, with income and part of the principal payable to your spouse or children according to their needs, and the remainder of the principal to your children after your spouse dies. Some taxable gift may be involved depending upon the cash value of the policies, the amount of the subsequent premiums paid by you, and whether or not the trust qualifies for the use of the $11,000 annual exclusion. The proceeds, however, will be exempt from taxation in both your estate and that of your spouse.