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Yes, Life Insurance is Taxable
If you believe your beneficiaries will receive your life insurance tax-free, you may be in for a surprise. Insurance proceeds are free from income tax but not estate tax. The value of a business and the related insurance that is used to fund most buy-sell agreements cause many surprised people to realize that they may indeed be subject to estate tax. If your estate is greater than $675,000, there may be tax due at your death, with rates as high as 55%.

A very simple estate planning technique to remove insurance proceeds from taxability is the use of an irrevocable life insurance trust. Very basically, a trust that you create will be established to actually own the insurance policy. You give the trust each year the amount of the insurance premium that is due on the policy and a trustee that you name then writes a check to pay the premium. At your death, the insurance comes into the trust and is distributed to the beneficiaries of the trust. This money is not included in your estate. The beneficiaries then use that money as needed to pay any estate tax that may be due. Assuming that the beneficiaries of your life insurance trust are also the main heirs of your estate, this is simply moving money into their pocket through a different channel. On a $400,000 life insurance policy, this may save your heirs from writing a check to Uncle Sam for close to $200,000.

With a public outcry over the steep rates of tax on estates, Congress raised the exemption, currently at $675,000 to $1,000,000 in the year 2006. Think you can relax then and not properly plan? If your estate is currently at $675,000 and grows at 8% per year it will be almost $1,100,000 in the year 2006.

The largest asset in many estates is life insurance. By removing this from your estate, it may keep your beneficiaries from paying estate tax.

Drayton R. Honeycutt, CPA