How to Avoid Taxation on Life Insurance Proceeds

While it is not possible to pass on an entire estate tax free, there are ways that you can avoid tax consequences in the future. If you have life insurance, one of your biggest concerns might be how to avoid taxation on life insurance proceeds.

Death Benefits

The death benefits of your insurance policy will get lump-sum money for your beneficiaries. Moreover, there is no federal tax on the proceeds of the insurance policy. However, they may fall under your estate tax calculation.

Discussed below are some of the ways on how to avoid taxation on life insurance proceeds.

Ownership Transfer

Now, to avoid the insurance proceeds from falling under the estate tax calculation, you have to perform ownership transfer. You have to change your policy ownership to someone else, an entity or a person. Change of ownership is irrevocable.

To transfer ownership:

  • You need to choose a capable entity or person and inform your insurer about your decision.
  • The proposed owner must start paying the premiums.
  • You will have to relinquish your rights to effect any change in the policy.
  • Ensure you get a written proof of ownership transfer from the company.

Life Insurance Trusts

Another way to avoid your insurance proceeds from being taxed under your estate is to go for ILIT- Irrevocable Life Insurance Trust. This is another way of transferring ownership, and the new owner will be a trust. You cannot be a trustee in that trust. You cannot revoke that trust. When the trust owns your policy, you are not the owner anymore, so the insurance proceeds will not come under your estate.

The benefits of a trust over a person are that, you can still control the policy to an extent legally and be assured that the premium payments will not be defaulted.

IRS Regulations

Even with the above two options, your insurance proceeds still can be taxed under your estate, if your death occurs within three years of the ownership transfer. IRS can tax the proceeds under your estate if it finds that you had some sort of control over the transferred policy.

Even with all the regulations, transferring your ownership will cut down tax largely, saving your beneficiaries a large sum of money.