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Life insurance and tax liability

This article is not legal or tax planning advice. You should always get advice from a professional who can assess your personal situation and be sure the advice given is correct for you. All this article does is discuss the general principles and give examples of how calculations might be made. So let us start with the basic situation. People buy insurance because they want peace of mind. There are so many situations of hardship in our communities where people have been hit by an unexpected death and find themselves in difficulties. Buying a policy therefore always looks to be the right thing. One of the standard advantages you see when reading about or discussing this type of insurance is that aspects of the policy are tax-free. We need to be clear what this means. The federal government wants to encourage you to save and invest for the benefit of your family. It therefore allows you to deduct the regular payments from your gross income before tax. Once this "tax-free" money is in the hands of your insurer, investments are made and, assuming the markets do well over time, there will be capital gains. At all points during the term of the policy, no income tax is payable and no tax is paid on any investment income generated. So, when you see a quote offering you a guaranteed minimum benefit of so-many dollars, that amount will be available to your family or any other person nominated as a contingent beneficiary.

Unfortunately, the actual sum of benefit received may be subject to estate taxes. The key to this liability is the question of who owns the policy. If you insure your own life, you are the owner and so, when you die, the policy would be one of your assets and the benefit would be counted for tax purposes. If, for example, you live in New York and have a policy worth $2 million. This is far less than the federal limit of $5 million but the New York tax exemption is only $1 million. For the record the federal exemption will be cut to $1 million in 2013, bringing a large number of life policies into the taxable zone. But now and in the future, you should plan to avoid the policy being considered a part of your estate.

The standard way of avoiding the tax liability is to place ownership of the life policy into an irrevocable trust. This is something you can do yourself although, if there is a lot of money involved, it will be better to take professional advice to ensure both that the trust has been properly set up, and that creditors cannot touch the life insurance policy or any resulting money. You should aim to ensure all the benefit passes to your surviving spouse or any contingent beneficiaries without anyone else being able to take a part of it. There is only one rule you need comply with. For the transfer of ownership to be considered effective, you must live at least three years after setting up the trust. If you only survive 2 years, 364 days the life insurance policy is still your property and estate tax will be payable.

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