Life Insurance & Beneficiary

When you purchase life insurance, the money your beneficiary receives when you pass away are referred to as death benefits (unlike the cash available from a whole life policy, whether it is accessed before and after death.)

Generally speaking, your beneficiary will not have to pay income tax on death benefits; that money typically passes tax-free.

But that doesn’t mean you should ignore how that money will be distributed, because there are options available. While the insurance company can certainly issue a check, you can have the insurer hold on to all or a portion of the funds and distribute them at a later date or over a series of periodic distributions. (Think of it as an annuity of sorts.) In that case the money held by the insurer will continue to earn interest, and any interest earned is considered taxable.

Or –and this is a much better option for a variety of reasons — you could transfer those funds to a Trust that could control the proceeds of the policy based on the stipulations you set for that Trust. You could have the money distributed in periodic payments, tie payouts to certain life events like buying a home, or going to college, or whatever you decide.

But keep in mind that planning can get complicated if you establish what are referred to as “incidents of ownership” in the policy.  For example, you can establish an incident of ownership if you control the policy in some way:  borrow against it, pledge it as collateral, or assign it under a contract.  If that is the case the proceeds of the policy might be considered a part of your estate and subject to estate taxes when you pass away. Estate taxes may be postponed if your spouse is the beneficiary… but when he or she passes away those taxes might be due.

And keep in mind that while you may stipulate in your Will that the proceeds of a life insurance policy should go to one of your beneficiaries, the named beneficiary of that policy will receive the funds. So if your intentions change, make sure you contact the life insurance company to update your beneficiary designation.

Life insurance is simple in principle but can be complicated. The key is to make sure any life insurance policies work hand in hand with the rest of your estate planning tools and strategies to provide the protection your family deserves while helping to avoid unintended and potentially unpleasant financial consequences.