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When you purchase life insurance the death benefit that is paid out to your beneficiaries is remitted tax free.
That is one of the major benefits to the surviving family, friends, or dependents.
Furthermore, you may be wondering how the death benefit payouts impact your actually tax return, from an income standpoint.
Straight from the Internal Revenue Service, the answer is three-pronged.
- Benefits received from life insurance do not get reported on your return.
- Do report any interest on the proceeds as income, however.
The final factor in the tax situation is that of an individual who has transferred the policy to you in exchange for cash. In such cases, the cash and premiums that you paid are not taxable.
The additional value is taxed, though you base the tax payment on the type of form you receive from the person who transferred the life insurance to you.
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It is noble to want to leave your children money directly from you and/or your spouse.
Be careful, though, as a direct inheritance to a child without a trust almost surely will go through a lengthy, stressful, and time-consuming court process. Instead, always have a will, irrevocable trust, or a living trust, that specifically names all of the beneficiaries as you wish.
That way no one else can come along and question what you had intended. The same holds true if you are living with a boyfriend or girlfriend but never intend on getting married. To help your loved one, do buy life insurance policies for each of you.
Determine what you want the surviving beneficiary to be able to afford. Do they rely upon you for sustenance, paying half of the bills, or for everything?
Consider what other expenses they may face in your absence, such as the costs of a funeral, burial, or cremation.
Incidentally, if you are only living together, most states will not recognize the intended heir, and they may not receive the benefits you intended without a will. Therefore, buy insurance as a part of a bigger picture estate planning move. It may be that your life insurance policy is best off put into a trust, which would be the named beneficiary.
Do hire the guidance of an estate planning attorney and a tax or financial planner to aid you in making decisions that live up to your intentions.
Every state has different laws that govern how trusts, wills, and insurance benefits are treated for domestic partnerships.
Talk to professionals who know your state laws.
How to Choose Beneficiaries
Start at the top of your list of close relationships. Put your spouse on the top of the list. Follow that with anyone else you is an adult.
Consider who you would want to be designated to take care of your kids if you and your spouse passed at the same time.
Again, any minors need to be entered into a trust, which has the trust named as the beneficiary. This is an important decision. It involves thousands of dollars.
You may additionally have a huge load of cash involved as well, depending upon the type of life insurance that you have.
When you are shopping for life insurance, there are three types of policies. The first major decision is whether you are going to have a term life or a permanent life policy. One runs out at a specified time, while the permanent life follows you the rest of your life, typically.
Always read the policy details, because some end at age 100.
Terms can be anywhere from 10 years to 30 years. They cost a lot less than permanent policies. Though, permanent policies provide a cash value that builds over your lifetime, as you pay your premiums.
How the premiums are divided up for you to pay the insurance is one factor in a policy. Another big factor is whether there is a cash or investment arm to the plan too. You are allowed to take out a loan or withdraw money from the savings portion of the policy once sufficient time to let the money grow has passed.
The withdrawals are on a tax-deferred basis. Loans are not taxable, and neither are any withdrawals up to the premium amounts. That is good to know if you are in the process of shopping around for insurance and wondering what benefits are worth it to you.
Compare that to trying to take money out of a 401(k) or an IRA plan, where unless you are old enough, you would relinquish roughly 30 percent of your funds for fees and then be forced to pay tax on the income.
Consider the tax rates into the equation, along with the fact that you have the flexibility to spend the funds in your life insurance however you choose.
Compare that against say, 529b plans, where you are specifically restricted to purchasing education only.
Another way to see the life insurance policy is as a method to take care of funeral costs and burial expenses, settle up the personal affairs and debt, and allow dependents and beneficiaries to live on in a financially comfortable manner.
What you may not know is that most plans are never called on for the death benefit. In fact, maybe less than one percent of policyholders pass and their families collect a death benefit.
That means that if you want to recoup that money, you may benefit from having the cash value or savings and investment arm of a permanent policy.
Do ensure that your heirs are aware of their role as beneficiary.
The reason is simple. Just because you pass, it does not mean that the insurer knows it. In other words, the estate or the beneficiaries need to file for the death benefit.
Buying life insurance is an exercise in an array of morbid what ifs, which no one wants to consider. However, to avoid sad realities, it is best to consider how you want your loved ones to live if you are gone from their lives.