Businesses may have come to a grinding halt during the pandemic. But, the phones of many estate planners and insurance professionals we know have been ringing off the hook. Millions of Americans have suddenly been forced into contemplating the fragility of life; they’re dusting off estate plans and upping their insurance policies like never before.
But, one thing that often gets over looked in the mad-dash for peace of mind during these unsettling times is the tax implications of interest and appreciation on those life insurance policies—for yourself and your heirs. Fortunately, three of our clients are well-versed in this subject, and they have been sharing their expertise with the national media recently. Below are excerpts from their interviews:
Can interest gained on life insurance benefits be taxed?
There’s a lot of confusion in this area. According to Randy Fox, founder of Two Hawks Consulting, LLC (Skokie, IL) it depends on how the policy is originally funded. “If the policy is a modified endowment contract (MEC), then funds borrowed or distributed from the policy will be taxable as ordinary income. Otherwise, the answer is usually NO.”
Dr. Guy Baker, Ph. D, founder of Irvine, California-based Wealth Teams Alliance said it depends on what is done with the interest. “If the interest remains in the policy, generally the answer is No. Gains within a life insurance policy are taxed only if the policy is cancelled,” Baker noted. “Premiums are considered basis. Any gain over basis is taxable upon cancellation.”
According to Tom Suvansri, founder of Premier Trust Advisors, LLC in Stamford, Connecticut, the answer is Yes, if the policy is surrendered. “The interest earned above the amount contributed would be considered taxable. Also, if cash value is withdrawn above the amount contributed, then any interest earned would become taxable,” Suvansri explained. To avoid that situation, Suvansri said you can start borrowing from the life insurance company “once you’ve withdrawn your contributions.”
So, would a trust help to avoid certain taxes?
Suvansri said yes, since there are “irrevocable life insurance trusts” that can be used to remove the life insurance proceeds from potential state and federal estate taxes. Fox said the appropriate trust will keep “insurance proceeds out of the estate of the insured and avoid estate taxes.”
Baker said that generally speaking, under IRC 101, “death proceeds are not income-taxed. However, it is possible under the transfer for value rules or having a third party pay the premiums, the otherwise tax-free benefits become taxable.” Baker explained that’s because death benefits are includable in the estate. “If the estate is subject to tax, then some or all of the insurance proceeds would be estate taxed, if they exceed the exemption. To avoid this, the owner could be a third party, where the premiums are paid by loans or gifts. A trust is an ideal owner of the insurance. However, intervivos trusts do not exempt the life proceeds from estate tax, only irrevocable trusts can do that, if they are set up properly,” added Baker.
Our experts are also asked frequently if you can be taxed on cash-value policies?
Fox said Yes, it’s possible you can be taxed if you withdraw money from a modified endowment contract policy.” Baker also agreed you can be taxed in certain instances, such as if you cash a policy—”but only on the gain over basis.” Suvansri agreed that yes, you can be taxed “if you surrender a policy with cash value and it exceeds the amount paid in premiums. Any gain would be considered taxable. Also, if you withdraw cash value above the amount of the premium paid into the policy then it would also be considered taxable,” added Suvansri.
What about gift taxes?
According to Fox, every individual is currently allowed to transfer $11.58 million during their lifetime, adding that they are also allowed to give any other person $15,000 per year without utilizing any of their $11.58 million exemption. “Should they choose to give more than $15,000 to an individual during any year, that amount would be subject to a gift tax. At that point, they can choose to utilize some of their allowable exemption, but should file a gift tax return in order to track their total lifetime gifts,” added Fox, who is also the editor-at-large of the Planned Giving Design Center.
Baker concurred that a gift tax is paid on any gifts that exceed the $11.58 million lifetime exemption per spouse. “So only transfers of property greater than $11.58 mil (or $23.16 mil (in the case of a married couple) are subject to tax,” said Baker.
Back in 1789, another tumultuous time in our nation’s history, Benjamin Franklin observed that “in this world nothing can be said to be certain, except death and taxes. As was the case 231 years ago, it takes a crisis to get people to act. Don’t let your clients infect themselves and their loved ones with chronic taxes while rushing to get their affairs in order during these unsettling times. They’re counting on you.
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