New York State Tax

Life Insurance and Tax

As people age, one of their greatest concerns about passing away is leaving their family with a financial burden. This is why there are services like funeral pre-planning and pre-payment available. Another very common option is purchasing life insurance. However, before purchasing an insurance contract it is also important to consider and understand the tax implications associated with both the payments and the benefits.

Federal tax laws typically allow for life insurance proceeds to be treated as tax free income for the beneficiary; with a few exceptions. It is very common for there to be a delay in the payment of benefits as the estate of the deceased goes through probate. During this time, the proceeds will typically be held in an escrow account that may earn interest. When determining his or her taxable income, the beneficiary can exclude the benefits due to them at the time of the insured person's death. This means that any interest earned between the death and when the proceeds are actually received, will be considered taxable income. Additionally, any interest earned on these assets after payment is received will also be considered taxable income.

In the case that life insurance proceeds are received in installment payments rather than a lump sum, the IRS has a specific formula to determine the taxable and nontaxable portions of each installment. Simply divide the lump sum benefits that were due at the insured's death by the number of installments. Anything in excess of this amount is considered interest and must be claimed as taxable income. For example, if the policy was for $100,000 and the number of installments is 100, then only $1,000 of each installment will be considered nontaxable.

Though the proceeds from life insurance policies are considered primarily nontaxable, if the policy was owned by the insured, instead of a spouse or other beneficiary, the proceeds will be included as part of their estate. This means that the proceeds could be subject to estate tax. This is why an important tax-planning step is to legally assign the policy to the beneficiary. However, this assignment must be completed more than three years prior to the death, otherwise the proceeds will not be excluded from the estate.

For those looking for a way to build wealth to benefit their surviving family, a permanent life insurance policy is an option. By putting money into this type of policy, the investment will grow, tax free, until the investor's death. At that point, the entire amount will be paid to the beneficiary without incurring any taxes. This is a good option for individuals who have maxed out the allowable retirement savings for the year, but want to continue to set aside money.

Finally, it is also recommended, especially for people of modest means, to give away the money prior to death. A person is allowed to give a gift of up to $13,000 per recipient, per year without either party incurring taxes. By distributing one's wealth prior to passing away, a person can avoid the high taxes often associated with estates and ensure that money is distributed exactly how it should be, without involving probate lawyers.

If you need help filing your income tax return or have other questions regarding life insurance and tax, you can use these links to find professional legal services, accountants and CPAs in your area.