Tuesday, April 26, 2011
Life insurance proceeds are generally received by beneficiaries free of any income taxes, but avoiding the federal estate tax requires some planning. If someone possesses “incidents of ownership” in a life insurance policy (e.g., you retain the power to cancel the policy, change coverage amounts, or change beneficiaries), the proceeds will be included in his or her taxable estate. One solution is to set up an irrevocable life insurance trust to own the policy. The trust pays the premiums, and the trust’s beneficiaries receive the death benefits. Such a strategy is very complex, however, so be sure to hire an experienced estate planner to get it done right.
Long-term disability insurance is another type of insurance that you want to plan for properly. Such policies usually limit benefits to 60-70% of earnings before income taxes. If you don’t plan properly and are required to pay income taxes on the benefits, this will cut your benefit amount down to 36-49% of pre-tax earnings. Benefits are typically taxable if your employer pays the premiums rather than yourself, or if you pay the premiums with pre-tax dollars. To avoid such a tax hit, pay the premiums yourself with after-tax dollars or purchase a supplemental long-term disability policy to cover the income taxes on the company-provided insurance benefits.
See Bill Bischoff, How to Avoid Taxes on Life Insurance, Smart Money, Apr. 20, 2011.