Does Estate Tax Apply to Life Insurance?

In most cases, life insurance benefits are tax-free. It’s because of this that they are preferred by many, though there are other benefits that policyholders might not be aware of.

Below, we’ll explore estate tax and how life insurance and estate planning work together to secure assets.

Taxable Death Benefit

One of the main reasons why some individuals prefer a life insurance policy is because there are not any taxes added in most cases. Though it’s a good option, those looking for life insurance coverage should know how benefits could be taxable and how to avoid it to give their loved ones the full benefit.

When No Beneficiary is Named

A life insurance policy is meant to help pay financial obligations in the event of one’s death. It’s also used as a way to protect loved ones, providing them with the financial assistance they need to take care of themselves and the final wishes of the policyholder.

It’s because of this that policyholders are encouraged to choose a beneficiary, one that will benefit the most from the death benefit, and use it to keep financial burdens at a minimum. In the case that policyholders do not name a beneficiary, the death benefit becomes part of their estate, which is subject to taxes.

This is also applicable if the beneficiary dies before the policyholder, as there is no one named to receive the death benefit. In the event of the death of the beneficiary, policyholders are encouraged to select a new one to avoid estate taxes.

When the Estate is Named Beneficiary

In some cases, policyholders choose their estate as the beneficiary instead of an individual. This could be useful in some situations, especially those dealing with estates that included debts and other expenses. If the beneficiary is named as the estate, then the entire death benefit is considered an asset and is therefore subject to taxes.

Policy Ownership

The person that’s purchasing life insurance is not always the one that holds the policy. For example, many spouses take out policies on one another or some choose to take one out on their elderly parents. No matter the case, there is a clear beneficiary named, one that receives the death benefit.

Payment of a death benefit to an individual is done via a contract that is made between the insurance provider and the insured. According to the contract, the insurance provider will payout to the beneficiaries when the policyholder dies.

With some insurance policies, there is a cash value option that is collected over time due to paid premiums. These are more costly though there are not subject to taxes, even if policyholders decide to withdraw from their cash value.

No matter the case, the owner of the policy has the power to borrow against their cash value, cancel their policy, and even change beneficiaries as long as they are insured.

Marriage and Life Insurance

It’s a common misconception that, even if a beneficiary is not named, the death benefit paid out from life insurance is paid to the spouse. That’s not the case and, even if the spouse is named, it will not go to children (if applicable) if both spouses die at the same time.

In the event that spouses are married and the beneficiary dies before the policyholder, the death benefit automatically converts into an estate, subject to taxes. There are some exceptions with policies, including the first-to-die policy and the surviving spouse policy.

Both of these life insurance policies are created to help the surviving spouse keep their life afloat when their loved one dies, attempting to take away some of the pressures felt by continuing life without a partner.

Life Insurance Coverage

Choosing to have life insurance coverage comes with a lot of benefits, especially since it can cover so many critical things. For instance, some of the financial obligations that a death benefit can help take care of in the event of death include:

Ongoing debt

These can be things like car loans, mortgages, and even personal loans. When one dies, especially the sole provider of a family, these costs can add up significantly.

Mortgage

Buying a home is a long-term investment, one that takes years to pay into and eventually pays off. During that time, families will work together to pay the total down, needing all of the help they can get. If one member of the family dies, a mortgage could cause significant financial stress, one that a death benefit could ease.

Children

While not everyone looking for an insurance policy has children, those that do may need to take extra steps to secure their finances. If a spouse is left behind with children to take care of, the death benefit can provide relief, helping them secure their home and care for their children.

Life Insurance and Timing

We never know when death can come. Because it’s unpredictable, there is never a perfect time to start thinking about life insurance. Those with families and financial obligations should consider the unexpected, having a policy just in case.

Even at a young age, taking a policy out with a cash option could serve as an additional investment, one that policyholders can withdraw from whenever they need it or enjoy a loan without hefty taxes to ease any financial burdens.

Policies to Fit Every Situation

Navigating all the options out there for life insurance can get confusing, especially when considering taxes and estates. Working with a professional that understands both life insurance policies and taxes is key, as they can tailor your coverage to fit your unique situation.

Sim is one such professional, with experience working with small business owners and professionals. From finding the best policy to planning your estate, she can help you provide for your family, even when you’re no longer here to do so. Let her help you create the best policy for your situation and rest assured that you won’t lose your death benefit to taxes.