Question:

Will my beneficiaries have to pay taxes on the proceeds of my life insurance policy?

Answer:

If you mean the death benefits of the insurance policy, then these funds are generally free from income tax to your named beneficiary or beneficiaries.

You may elect to have the insurance company hold on to these proceeds after your death and distribute them to your beneficiary at a later date or in a series of installments. The funds that the insurer holds are earning interest, and when a payment is made to your beneficiary, it may include both principal and interest earned by that principal, or only interest. Although the principal portion of the payment is tax free, the interest portion is taxable to your beneficiary as ordinary income.

In some cases, if you transfer the ownership of your life insurance policy to another party before your death for monetary value or other consideration, the proceeds paid to the beneficiary at your death could be considered taxable income to that beneficiary. This is a complicated matter, and you should seek the assistance of a tax professional before completing the transaction.

The proceeds of your life insurance policy may be subject to federal estate taxes if you have what’s known as incidents of ownership in the policy. If you control the policy in any way–that is, you can cancel it, surrender it, borrow against it, pledge or assign it, or can change the beneficiary–then you possess incidents of ownership in the policy, and the proceeds of the policy may be subject to federal estate taxes when you die. You might postpone these estate taxes if the proceeds of the policy are to go to your spouse, but the taxes might come due later when your spouse dies. Again, these issues are complicated; seek the advice of a qualified professional when planning your estate.