EDMOND — EDITOR’S NOTE: This is a weekly series of columns written by attorneys at Lester, Loving & Davies law firm in Edmond. This week’s column is part one of two about the possible taxation of life insurance.
Q: Will my children have to pay taxes on my life insurance proceeds?
A: The principal amount of life insurance proceeds is not subject to income tax. As a result, life insurance benefits are often represented as “tax free.” Life insurance benefits are, however, generally subject to the payment of estate tax.
Under the current structure of federal and Oklahoma estate tax, most estates will not incur larger estate tax liability as a result of life insurance proceeds because most estates are too small to be taxed at all. But the future structure of estate tax, particularly federal estate tax, is unknown. As a result, you always should evaluate what impact a life insurance policy might have on your estate plan.
Life insurance death benefits are included in your taxable estate if you had any “incidents of ownership” during your life. You are treated as the owner of the policy, regardless of the name listed as the owner of the policy, if you have the right to change the beneficiary, assign or cancel the policy or pledge the policy as security for a loan, or if the policy reverts to you on certain conditions. Whether you actually pay the premiums for the policy is irrelevant to a determination of whether you own the policy.
The proceeds also are taxable if your estate is the beneficiary of the policy. If you name your estate as the beneficiary of your life insurance policy, the proceeds become part of your taxable estate. Even if you do not name your estate as the beneficiary, the proceeds will be taxable if you require the policy to pay your debts or estate expenses before paying beneficiaries.
If your life insurance proceeds are taxable because you owned the policy or because the benefits are payable to your estate, the entire proceeds may still get to your beneficiaries without the payment of any estate tax. This is true because no part of your estate, including life insurance proceeds, will be taxed until the total value of your estate exceeds the exemption amount set out in the tax code at the time of your death. Because you cannot know at the time you buy insurance what amount the estate tax exemption will be when you die, you should design the policy in a way to make the benefit tax free. We will discuss some options to consider in future articles.