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It is never ideal to be on the bad side of the Internal Revenue Service. As the nation’s largest and most powerful creditor, the IRS has the right to garnish your wages, deplete your savings accounts, take your property and even seize your assets when you owe back taxes or fines to the government. While the IRS can place liens and levies on your income and your property when they cannot solve the issue, you as a taxpayer have rights. Not many things are off limits, but when there are enforced collections some assets are untouchable and exempt from seizure. In many cases, one of the untouchable assets is life insurance.
When you are estate planning, it is critical that you cover every topic as you decide where to invest your money and how much life insurance should be in your portfolio. If your life insurance is deemed to be up for grabs and you owe the federal government a significant amount of money, the money you are hoping will protect your family’s financial future may do nothing more than cover your tax obligations. Here is your guide to the IRS and benefit seizure so that you really understand what your rights are as a taxpayer.
Can your IRS Seize Benefits Before a Claims Payout?
When you have a policy on yourself, you are the benefactor to the policy. It is your responsibility to build a policy and then to select beneficiaries that you want to receive all or some of your death benefit once you die.
If you have a beneficiary listed on the policy, it can make all of the difference in terms of debt and in terms of IRS seizure.
If the deceased owner of the policy owes taxes or has fines and penalties that they never got around to paying, the IRS wants to collect but may not be able to forcefully collect. This is strictly because there is a beneficiary on the policy who will stake claim to the benefits when a death claim is filed.
Why Creditors Like the IRS Cannot Take All Life Proceeds
When a life insurance claim is made, proceeds are paid out to the beneficiary as soon as the investigation is completed. This means that the proceeds transfer right from the insurer to the beneficiary and do not become part of the benefactor’s estate where the money comes from to pay off debts.
Creditors, including the IRS, can make a claim against the assets in the estate, but with an heir named as beneficiary, that money does not go to the estate. Your right as a taxpayer is that you are not obligated to pay off back taxes that you do not owe yourself. If it is the deceased’s debt and not yours, you will not be forced to make the payment.
How will the IRS get the money that is due?
The IRS may have a great deal of power when it comes to seizing assets, but protocols say that they are, in most cases, prohibited from taking your life insurance benefits and premiums. As a beneficiary, you cannot be strong-armed to pay the debts with methods like seizure, but you can voluntarily use these benefits to pay for back-taxes. This is a common choice when one spouse passes away and the other spouse pays for the back taxes in their deceased spouse’s name.
Just because the IRS cannot use its ‘carte blanche’ power to seize life payouts does not mean it will give up on collecting. Instead of focusing on taking these proceeds, the IRS will attempt to collect from the estate. This means that property and vehicles that are in the estate can be seized before the probate is settled. The life proceeds are not touchable, but any heirs of the estate will not see their inheritance until after the IRS gets what they are due.
Do the proceeds count towards estate taxes
While untouchable in the sense of seizure, life insurance benefits still count as part of a taxable estate. This is because the benefits add value to beneficiaries and heirs. If the benefit makes the estate large enough to the point that estate taxes are charged, the heirs will not be able to touch any of the assets until after all of these taxes are paid in full.
How much will the estate be taxed?
The taxable thresholds for estates change every year so it is difficult to anticipate when taxes will be charged. To prevent this from happening, there should be adequate insurance to cover the taxes when they are applicable. If the estate is not exempt from taxes, the top estate tax rate that is charged will be 40%.
Scenarios Where Creditors Can Claim Life Proceeds Before a Beneficiary
One obvious scenario where the IRS can stake claim on your life proceeds even when you are the beneficiary is when you and the benefactor file joint tax returns. When you are filing with your spouse, you and your spouse owe the debt together.
As the surviving spouse, the debt is still due and a levy can be placed on life proceeds to ensure that the IRS gets their money sooner rather than later.
Another circumstance when a creditor will have the right to claim proceeds that are meant to go to a beneficiary is when there is joint debt. If you have cosigned a mortgage or a car loan, there is a clause in the lending contract that says that the lender can collect the remaining balance of the debt because one party is deceased. This protects the creditor from defaults when only one borrowing is living.
What happens when the estate is the beneficiary?
There are a few scenarios where the estate may be named the beneficiary of a life policies. If the owner of the policy chooses the estate or the living will to be the beneficiary or when the named individual is deceased, the benefits will automatically go to the estate. This also happens if a trust is voided and there are no other instructions.
An estate becoming the beneficiary can become very dangerous. When there is no living beneficiary and no contingent person listed, this means that the proceeds will become part of the estate. Remember, the estate is where the IRS and the creditors will turn when they want to make claims for debts. Since the proceeds become an asset in the estate that can be touched, your heirs at the time will not get the financial protection that they need to live comfortably as you had intended. The IRS will take everything they can and then the remaining may be paid out after years of probate.
What happens in the beneficiary owes taxes and debts?
The IRS may not have the right to take money from the benefactor of a life insurance policy, but that does not mean that the beneficiary is safe. The life insurance proceeds become part of the beneficiaries assets. The payout, while it is not taxable income for the beneficiary, will still be reported by the insurer.
If the IRS sees that you owe fines or you have not paid your taxes, they will seize what you owe.
This is why it is very important that you take the time to review your tax situation and resolve it before the proceeds are paid out. If you have an agreement to make payments in writing and you are following the agreement, the IRS is limited in how much they will be able to seize even after a claims payment is made.
Tips to Avoid Having Benefits Seized
With some knowledge and the right amount of planning, it is possible to avoid leaving life insurance proceeds that you have been paying for up for grabs. The key is to name multiple beneficiaries, not just your spouse. Having your spouse as a named beneficiary may help you avoid estate tax, but that is not the case for back-tax seizures. By handling your tax situation while you are living, this will never become a problem.
Another tip that you should consider is naming a trust as your beneficiary. This offers you the most protection against creditors as a benefactor and as a beneficiary. Trusts help lower estate tax liabilities and can help you avoid going through the drawn out probate process. Be sure that you discuss this with a financial adviser.
There is nothing worse than having your life insurance go to creditors instead of beneficiaries. If you are paying premiums for decades on your life insurance, you want to be sure that the money is really protecting the people that you love. Start pricing life coverage with our FREE rate comparison tool below, and then you can focus on how you need to structure it.