You may already know that life insurance proceeds generally pass to your named beneficiaries without income taxes. So, if you have a $100,000 policy and name your spouse as the beneficiary, your spouse will receive the entire $100,000 death benefit when you die.
Beyond the income tax savings when policy proceeds are paid out, there are some other ways people use life insurance for tax planning purposes, including estate tax planning and qualified policy exchanges under Internal Revenue Code section 1035.
Estate Tax Planning
If your estate is large enough to be subject to state and/or federal estate taxes, you may want to consider using life insurance to pay those taxes when you die. One common planning tool is using life insurance to fund an irrevocable life insurance trust. With this approach, you work with an estate planning attorney to create an irrevocable trust. You then either buy a new life insurance policy or transfer an existing policy to the trust, naming the trust as the policy beneficiary.
When you die, the insurance company pays policy proceeds to the trust. Your trustee then uses those proceeds to pay the estate taxes, distributing any remaining funds to the beneficiaries named in your trust agreement. This allows you to leave the legacy you want to your loved ones without worrying about the impact of estate taxes on their inheritance.
Section 1035 Exchanges
Another tax planning strategy involving life insurance is what’s referred to as a “1035 exchange.” With a 1035 exchange, you can replace one life insurance policy with another one, or one annuity contract for another one, without incurring any tax consequences. This offers people the ability to exchange outdated policies or annuities for newer versions with more attractive features, all while keeping the original policy’s or contract’s cost basis. There are specific requirements for 1035 exchanges to be valid, so it’s important to ensure your exchange follows the letter of the law in order to preserve these tax benefits.
Talk to your tax professional to find out exactly how various life insurance transactions might impact you and your loved ones.
To learn more about the many benefits of using life insurance and to explore what types of coverage can help meet your coverage needs and goals, contact Christopher Ferguson Insurance in Tyngsboro, MA. You can reach us by calling (617) 386-6572 or simply contact us online.